I started writing this newsletter in late July with the intention of publishing it in August but fell sick in the first week of August. While I recovered in less than a week, it was almost mid-August before I could burn the midnight oil again and I decided to just wait until September to publish it with updated data. Instead of picking a stock this month, I figured I would try something different and get a read of the pulse of the economy and determine if I should revise my bearish outlook in light of recent economic data and the rise of the market.
On March 9, 2009 all three indices, the Dow Jones Industrial Average, the Nasdaq and the S&P 500 simultaneously hit lows that could very well end up becoming the low of this bear market. The Russell 2000 (^RUT) and the much broader Wilshire 5000 Total Market Index (^DWC) also confirmed this bottom amid a backdrop of fear that the entire system could collapse and we might see the second great depression.
The Dow has posted gains of 45%, the S&P 500 51% and the Nasdaq has risen a whopping 58% from the March lows. At this juncture even most bears don't expect the market to breach the March lows unless we have a catastrophic event. The unregulated Credit Default Swaps market, which was estimated at $45 trillion at the end of 2008 is now estimated at $26.4 trillion and is facing increased calls for regulation. Before all of us let out a collective sigh of relief, this is still twice the size of the entire U.S. GDP, which is estimated to be $14 trillion.
I will be the first person to admit that the market does not always follow economic activity and has at times risen during a jobless recovery period like the recovery following the 1990-1991 recession.
However, things were very different in the recession following the dot com bust. Even though that recession officially ended in November 2001, the economy lost an additional 1 million jobs following the recession and the stock market did not reach its low until more than 10 months after the end of that recession. With the federal deficit expected to grow to $2 trillion by this fall, consumers switching to survival mode (we went from a negative savings rate to a 7% positive savings rate) and the true unemployment number probably running closer to 20% instead of the official number of 9.4%, I find it hard to get excited about stocks right now.
To be sure the outlook is not entirely bleak and there are positive data points or green shoots as some like to call it that are showing up. I happened to have a couple of conversations in early August with a NetJets pilot and the Vice-President of sales for a major medical devices manufacturer and both of them confirmed that they were seeing signs of improvement.
I have compiled a list of various economic and sentiment indicators below with some commentary on each of them to help you come to your own conclusions.
|Indicator||Period||Bull Case||Bear Case|
|New Home Sales (PDF)||July 2009||Increased 9.6% when compared to June, which in turn had posted a 9.1% increase from May. Could it point to a bottom in housing?||The margin of error on this 9.6% increase is 13.4%, which means we could have very well had a decrease in July and will find out more when the number is revised next month. Moreover on a year-over-year basis, new home sales fell 13.4% below the July 2008 level. Since people start buying in Spring and most of those sales close in early to late summer, the year-over-year number is more important as it eliminates seasonal variances.|
|Housing Starts (PDF)||July 2009||Dropped 1% from June 2009. Single family housing starts however improved with a 1.7% gain when compared to June.||Once again the margin of error on this is 8.5% on the aggregate number and 5.1% on the single family housing number. Year-over-year, housing starts dropped a whopping 37.7%. Building permits, which are more of a leading indicator, dropped 1.8% from June and 39.4% year-over-year from July 2008.|
|Existing Home Sales||July 2009||Increased 7.2% in July and have been going up for four months in a row. Sales also increased 5% from July 2008. Sales of foreclosures were only a third of total transactions when compared to nearly half earlier this year.||Median home prices fell to $178,400 in July when compared to $181,800 in June and dropped 15.1% year-over-year. With new appraisal standards kicking in on May 1st, we could continue seeing pressure on the median price in August and September.|
|Total Homes Inventory||July 2009||Inventory stands at 9.4 months unchanged from June but better than the 9.8 months in May. Raw inventory totals fell 10.6% from a year ago.||A wise real estate industry expert who was once the Vice-chairman of Wells Fargo told me in so many words back in 2006 that the s**t will hit the fan when inventory numbers go above 9 months. He also asked me to watch for regulators stepping in to review the mortgage portfolios of lenders. This conversation lead me to buy naked puts on Countrywide Financial, a trade that was profitable but not nearly as profitable as it could have been had Angelo Mozillo not kept showing up on TV and claiming that everything was just fine and dandy while selling his own shares. Prices will start stabilizing when inventory levels come down to 7 months and we still have a ways to go before we get there, not to mention the shadow inventory on the sidelines that is just waiting for prices to improve.|
|Homebuilder Confidence||July 2009||The homebuilder confidence index is currently at 18, a 14 month high and well above the 9 reading back in December 2008 when we discussed Timber as an Asset Class.||It is hard to make a bearish case when the homebuilders are feeling happy except for the fact that the outlook for the next six months has been flat for the fourth consecutive month. I wonder if the abundance of liquidity available to apartment REITs is in some way helping lift the mood of the homebuilders. It is also important to keep in mind that only a rating of 50 or higher indicates more positive or good responses.|
|Consumer Sentiment||August 2009||The Reuters/University of Michigan consumer sentiment fell slightly in August to 65.7 from 66 in July but was better than expectations. The forward looking consumer expectation index was however 65.0 in August, up from 63.2 in July and significantly above 57.9 in August 2008.||While the consumer confidence index declined only slightly in August, it also represented a four month low for the index. While consumers are certainly more confident than they were back in November 2008 when the index hit 55.3, there is little doubt that high unemployment and lower home prices have hurt consumers and in some cases may have permanently changed spending habits.|
|VIX||August 2009||The CBOE Volatility Index or VIX, also known as the fear index, has dropped dramatically to 26.01 as of August 31, 2009 when compared to the previously unchartered territory of over 80 back in November 2008.||I was buying stocks last October just as the VIX was getting into unchartered territory and fear was rampant. With investors much calmer now and fearful about missing out on this rally, I am less enthusiastic about stocks. However it should be noted that the VIX is not a leading indicator and its forecasting ability has been questioned.|
|Insider Buy/Sell Ratio||August 2009||Insiders have been known to be good market timers and there is nothing bullish about the recent wave of insider selling.||As Jason Zweig put it in a recent article in the Wall Street Journal, "In August, corporate insiders -- officers and directors of public companies -- sold nearly 31 times as much stock as they bought. From last September through this past March, in the depths of the bear market, that ratio was just 2 to 1, according to TrimTabs Investment Research of Sausalito, Calif. The long-term average is about 7 to 1"|
|GDP||Q2 2009||Gross domestic products in the United States decreased by 1% in the second quarter and was not revised lower. The popular Cash for Clunkers program combined with inventory rebuilding is likely to have a small positive impact on third quarter GDP.||Real GDP declined 6.4% in the first quarter of 2009 and was revised downwards from 5.5%. It remains to be seen if Cash for Clunkers and inventory rebuilding can offset declines in personal consumption and break the streak of four consecutive quarters of negative GDP growth.|
|Durable Goods Orders||July 2009||Inventories of durable goods shrank for the seventh consecutive month by $2.7 billion to $314.1 billion while new orders for durable goods and shipments increased. New orders have increased in three out of the last four months.||Hard to make a bearish case with these numbers.|
|Unemployment||July 2009||Unemployment in July unexpectedly dipped to 9.4% from 9.5% in the prior month leading some analysts to question if we will hit the 10% mark anytime soon.||I am firmly in the camp of skeptics when it comes to the official unemployment figures. Not only does the unemployment number exclude people who are too discouraged to continue looking, it also excludes part-time workers who would have preferred full time jobs if available and the people who are denied unemployment claims. With businesses increasingly fighting unemployment claims, the actual unemployment number is probably over 20% as you can see from the chart below.|
Conclusion: It is hard to ignore the positive signs from several of these indicators including new home sales and durable goods orders but when viewing the big picture that includes unemployment and consumer sentiment through the lens of a 51% rise in the S&P 500 index, it is difficult to make the case for further increases in stock prices.
According to Yale Economist Robert Shiller, the P/E10 is now at 17.67. The P/E10 is similar to the standard P/E ratio but uses the average of 10 years of trailing inflation adjusted earnings for the earnings component. The current P/E10 is certainly much higher than the values seen at major market bottoms (the market bottom following the dot com bust was an exception) and also happens to be just above the long-term average of 16.34.
Overall my opinion continues to be slightly bearish and I am happy to hold the positions I already have without putting new capital to work right now.