2010: Shaping Up to Be an 'L' of a Year

Thursday's payroll report led to some of the worst market angst we have seen since the big rally started, with the market plunging into its third consecutive weekly decline. While the numbers didn't strike me as anything really that different from "more of the same", neither did the previous few that seemed to encourage some market participants. I was pretty lucky to be a bear who was aware - aware that the market was quite overdone in March (and February too!).

For those who follow my views, I had expected an interim low in the market in the March/April time-frame, but at slightly higher levels that we ultimately reached. Then again, the market stretched further to the upside than I expected when I projected more a big rally in mid-March after having "Sponge-Bob" called the low in early March as one of the first to note the irony of the "666" low . When looking at the markets, it's very important to remember that stocks are much more volatile than the economy (click on chart to enlarge):

See what I mean? Over the past 62 years, stocks have increased a few points more than the nominal economy on an annualized basis, but the annual returns have been +/- 5-6X the median GDP growth at the extremes. So, it doesn't seem that implausible that the stock market has round-tripped an almost 25% move as the market incorporated slowing sequential GDP decline.

We are half through the year following the worst stock markets in most of our lives. I am sticking to my forecast that we end the year down. My original forecast suggested that we would rally in Q2 (which we clearly did), but make a new low in Q3 before experiencing a strong Q4. At this point, I am not that sure that the March low doesn't hold, but I do expect a move to at least 800 on the S&P 500 and wouldn't rule out significantly more damage. Before reviewing where we are in the big picture as far as correcting the major economic imbalances as I have described for quite some time, I want to take a very long-term look at the employment situation. I am not in the "V" but in the "L" camp. I think that Obama's responses and the actions of the Fed could very well avert Great Depression II, but our best case is to see the economy growing by the next election in 2012. Deleveraging has to happen, and it will take some time.

Unemployment is a symptom, not a cause. We are "over-stored" and suffer from an abundance of goods (relative to true wealth rather than borrowing capacity). Unfortunately, it is a symptom that feeds into a negative feedback loop. The higher it gets, the worse the credit situation becomes. In the chart below (click to enlarge), you can see that this is clearly becoming the worst labor market in generations. To answer the question in the bottom panel, we are a maturing economy. The "good times" didn't lead to high employment growth, and the "bad times" are leading to off-the-charts reductions:

The worst part is that we continue to see the duration of unemployment extend:

It's going to get worse. Employers are trying to retain workers by chopping wages and hours. I will be surprised if the average wage doesn't decline year-over-year at some point in 2010. Employers were reticent to fire in most of 2008 and certainly recognized the high inflation in prices their employees faced then. Neither of these is the case at this point, as inflation is plunging and employers aren't shy about slashing payrolls. As a generalist who follows many companies from varying sectors, it is clear to me that head-count reduction is the rule not the exception (click on chart to enlarge):

So, the tick up in unemployment and in negative payroll growth along with the cut in hours worked and the flattening in overall wages not surprisingly roiled the market.

The market is starting to focus on 2010, which is just 6 months away. As usual, the analysts appear WAY too optimistic on earnings. According to S&P, the S&P 500 company earnings based upon the aggregation of company consensus estimates are expected to rise a very strong 33% to $74. This would leave them 10% shy of 2007 earnings but 50% above 2008 trough earnings. Where can I buy some of that stuff?

As I have written before, we won't resume strong economic growth until we see:

• Housing prices stabilize
• The savings rate normalize
• Deleveraging for banks, corporations and state & local governments near completion

Housing prices have stopped accelerating in their decline, but they remain steeped in a downtrend. I follow Case-Shiller for lack of any better metrics, and they continue to indicate that most large markets are down close to 20% year-over-year. Until unit demand stabilizes, this won't happen. It is worthwhile remembering that the affordability has probably never been greater - low interest rates, government incentives and lots of desperate sellers. With so many years above the mean, I will be shocked if unit growth isn't slow for the next several years (click to enlarge):

Folks aren't spending like they used to - funny how unemployment and contracting credit mix:

Spending is declining due to payroll slashing and the remaining workers trying to build savings. To me, this looks like another couple of years of headwinds for the economy and tells me corporate bonds are probably the place to be relative to stocks.

The final area is deleveraging. I don't have a pretty chart - sorry. I think that we have only started this process. I noted in May that the floodgates had just opened, and we have seen a ton of equity issuance since then. All this stock for sale is quite the reversal from the massive repurchasing that was going on up until Q3-2008. This action should help stave off Armageddon, but it will keep prices under a lid. Look for higher interest rates and equity dilution to rob from EPS growth.

So, the bottom line is that the economy will limp along at best. I can't yet offer a 2010 stock outlook because I don't know how the rest of the year will shape up. I tend to discount my original forecast of a new low in the 3rd quarter, but I learned last year and earlier this year not to be surprised to the downside. That's the risk in a deleveraging economy. In any event, I don't expect the S&P 500 to break 1000 over the next 18 months.

Disclosure: No stocks discussed

Comments

[Mad Hedge F...:]

It's an "L" or a "W". You can forget about the "V". Ouch! The non-farm payroll came in at minus 467,000. What a spanking! The monthly figure is 100,000 worse than the expectations of most suicide prone economists, and took the unemployment rate up to 9.5%. There are now 14.5 million unemployed, an all time high, at least 20 million underemployed, and who knows how many more who have taken pay cuts, unpaid vacations, and furloughs. That leaves an ever diminishing pool of employed who are going to spend us into a recovery. Commodities got slammed across the board, stocks got trashed, and for a minute I thought they were going to run out of red arrows. Traders shorting the long bond got stopped out of their positions, yet again. Looking at the data, it is clear that this is the worst case scenario. Even construction and government jobs, the beneficiaries of so much Federal largess, are still falling. Only employment in education and health care is rising. This comes on top of yesterday’s disastrous figures showing sales at Chrysler fell 42%, Toyota (TM) 34.6%, General Motors (GMGMQ) 33.6%, and Honda (HMC) 29.5%. At least this will put that annoying “green shoots” crowd out to pasture. The Obama crowd has to be sweating bullets now, having fired their best shot at the enemy, with no apparent impact. Here comes the “L”. Please see my “Sell in May and Go Away” report at www.madhedgefundtrader....

Jul 05 01:53 AM

[Dave Wrixon:]

I am not even sure you can count a recovery in 2010. It may well be that Stimulus, and the Fed and Treasury Shenanigans with all the associated hype have some how just delayed the inevitable and that much worse is to come.

I personally cannot see the consumer spending again until either housing or employment recovers. Employment is not going to improve with capital investment or perhaps consumer spending. The Government can keep pumping money in but only at the risk of reducing the worth of the money disproportionately, and the ensuing dollar weakness is likely to result in interest rate hikes which will make both the consumer and the government weaker. The deleveraging process needs to run it course. Those that are underwater need to go through the insolvency procedures. It seems to me that normal mechanism that recession invoke to redress economic imbalances have been frozen, but nothing much is getting resolved. That resolution must come and it will probably mean a lot more pain.

Jul 05 02:54 AM

[Mistrofan:]

I cannot agree more with your arguments. Right now, the unemployemnt is a LEADING indicator, because in all other recent recessions the conumer sentiment and spending stayed within reasonable high limits. But now, with the saving rate increasing and appearing to be sustainable over at least next 18 months, the earnings will continue to dissapoint as will the GDP growth. In the best case scenario we entered in a protracted consumer recession from a financial credit one. (by the way, still I do not think that the balance sheet srinkage of the banks is over, at least because the the consumer is retracting, and if we add the other bad loans not recognized yet and the probelms that just start to emerge in Eastern Europe then we have a perect self-reinforcing storm for the next 18 months).

Bottom line, GDP and the stock markets will go nowhere in the next 18 months and I can see a resurgence in the real economy of the emerging markets only 12 months from now, where the developed markets will stay in recession for 2010.

Jul 05 10:29 AM

[one eye:]

Freya: there have to be around 10 of Mad's comments which have that "ouch" touch. He probably thinks it goes unnoticed. Every Ouch comment is a rehash of a previous one.

Jul 05 10:38 AM