Bullish Stance Is Wearing Thin

Readers familiar with my views know that I believe that the current stock market rally is a bullish chapter in an otherwise bearish novel. In the spring of this year, I had said I would not be surprised if the Dow were to hit 10,000 by the end of summer.

While I was a little too optimistic on that particular forecast, it now looks as if U.S. stock markets are a bit ‘toppy' and a reversal may be in the cards. Seven factors, five tactical and two strategic, cause me to see a change in the wind.

Tactically, the employment situation, falling house prices, tight credit, a sliding U.S. dollar and depressed world trade are cause for deep concern. But as these factors could show rapid changes over the short term, I am less inclined to set my investment bearings by these readings. More troubling are the two strategic issues, the continued creation of excessive debt in the United States and the continued growth of consumer spending as the overwhelming driver of U.S. gross domestic product (GDP).

In order for a bull market in U.S. stocks to be sustainable, these problems must be brought to heel. However, making a dent in these imbalances would require the sort of political courage that is vanishingly rare in D.C.

***

For the tactical investor, the following portends a coming correction:

Unemployment

Recently, Wall Street cheerleaders seized on the falling rate of unemployment growth as a sign of economic recovery. In July, the official figures showed unemployment increasing by some 216,000. If this were a reflection of reality, it would be a sign of possible improvement. However, the often-ignored figure for employment, as opposed to unemployment, showed some 980,000 less people employed, or 4.5 times more than the unemployment figure!

How could these two vitally important totals differ by some 764,000? The short answer is that the government excludes from the unemployment figures all those who have given up hope of finding a job and all those who have settled for part-time jobs. In other words: if you have stopped looking for a job, congratulations, you are no longer unemployed! So much for government statistics. The true level of unemployment has been estimated at 20 million, or double the official figure.

Home Prices

In recent days, reports have emerged to show that home prices have stabilized. Given the dismal fundamentals of the real estate market, we had projected that national home prices would have needed to fall an additional 20 percent from current levels in order to return to the Case-Schiller 100-year trend line. But given the massive and continued Federal involvement in every facet of the home buying process, there is nothing at all ‘fundamental' about home prices today. Absent this intervention, prices would continue to fall. Since the federal treasury does have its limits, the outlook for real estate subsidies, and therefore the entire sector, is still negative.

Tight Credit

Despite reckless federal efforts to boost liquidity, credit remains tight. This reality is the market's own discipline signaling that the fundamentals remain unsound. Meanwhile, the Fed is inhibiting liquidity to shore up the money center banks by, for the first time, paying interest on bank reserves it holds. The banks thus have little incentive to lend to small businesses, the largest job creators, or to individuals. As an aide, this may also be serving to hide the effects of the Fed's currency expansion by slowing the velocity of new cash.

Collapsing Dollar

Meanwhile, for Americans, the plummeting U.S. dollar is forcing up the price of most commodities, despite decreased demand. This stagflation is a dangerous recipe not only because it neuters any attempt at policy manipulation of the market, but because it hits the underemployed and unemployed with rising prices for everyday goods.

***

While some investors fixate on the symptomatic issues above to determine their strategy, we choose to focus on the underlying malady itself. Keeping your eye on these unfortunately static conditions will provide a solid point of reference by which to navigate:

Conspicuous Consumption

The Obama Administration has shown no appetite for allowing consumers to reign in their spending habits. So, consumption still accounts for some 70 percent of American GDP. Where individuals have tried to reduce spending and increase savings, stimulus programs and quantitative easing have overridden their gains. Indeed, President Obama's massive expenditure plans for health and educational entitlements will serve to magnify this crucially damaging strategic imbalance.

Exploding Debt

Finally, contrary to election promises of “change,” the Administration shows no signs of controlling its expenditure and massive debt. Indeed, the ill-advised wars fostered by President Bush in Iraq and Afghanistan continue to drain blood and treasure. This Administration appears set to continue its predecessor's mission of unending debt expansion.

***

Due to our failure to restructure, America is finding it harder and harder to compete globally. Instead of taking our lumps, Washington is lashing out with suicidal measures like this week's Chinese Tire Tariff, an ominous prelude to next week's Pittsburgh G-20 meetings.

And the markets just don't get it. Technically, S&P profits are down some 90 percent, but the Index has risen to push P/E ratios to levels not seen since 1929. The financial media's cloying banter about ‘green shoots' is reminiscent of "Baghdad Bob," the comically delusional Iraqi information officer who denied the advances of American forces even as U.S. tanks overran Saddam's headquarters.

Some talk of a “jobless recovery.” In the past, such an event could only occur when an asset boom (such as a real estate bubble) provided Americans with non-employment income. Today, there is little prospect of such a boom.

Stock markets tend to reflect financial hope. Given today's situation, investors might be wise to prepare themselves for economic reality by investing selectively in more prudent economies abroad.

Comments

[johngonole:]

I have to agree. In Florida the construction industry is still worsening. This is only one sector but it will be hard for employment to pick up when important sectors are still slowing down.

I can only conclude that we must allow prices to fall. Expanding government debt only delays the process. We can't compete at current wages with other countries. Asset prices must likewise fall to stimulate demand. Stagflation will be the result of current policies. Deflation can be terrible. However if the deflation is caused by lower consumer debt (more savings), higher empolyment at lower wages, and balanced government budgets we should see more actual consumption due to lower prices, and thus higher employment and increased business spending. Companies are not going to spend money building their businesses without REAL demand. Demand from borrowed money is temporary and peoples memories are too fresh for those lessons to be forgotten so soon. Lower prices are necessary. We are doing exactly the opposite of what we should be doing. Prices would be must lower if not for the government interference.

Banks could suffer from the falling prices I realize this but perhaps they should. Let people who have saved their money actually benefit for a change from the saved money. This will encourage REAL demand.

Sep 17 02:27 AM

[Baboon:]

To the author: What is your Dow price target now?

Sep 17 02:41 AM

[MattZN:]

Well, I suppose when everyone thinks the market is going to work a certain way it's a sure sign that it will wind up doing something entirely different. That said, none of the points you made necessarily translates to a falling stock market. For example the collapsing dollar will have a tendency to boost the stocks of companies with large foreign operations (such as Coca Cola for example), because those operations become more valuable in dollar terms. Globalization is a reality that exists today in a way that has never existed in prior recessions.

Another point is of course the fact that the stock market tends to recover ahead of the economy. I don't particularly believe that an economic recovery could get rolling so quickly (a mere 6 months from now), but looking at today's economic woes does not predict today's stock market.

The real bottom in real-estate is not just in dollar terms, but also in dollar's relative value against other currencies. With the falling dollar combined with the fallen real estate prices, the true drop has been far FAR harder from the point of view of the rest of the world than it has from our point of view. In other-words it is quite possible that we have in fact seen the bottom in dollar terms, and all that is left to worry about is the specter of future inflation.

I'm not sure what exactly your point about bank lending is. Are you suggesting that the banks lend to unworthy borrowers like they have for the last few years? Because that is the only way you will see any significant uptick in lending activity. The government has nothing to do with it. If we were in a lending bubble before then what we see now is the prudence that we should have had but didn't. The last thing I'd want would be for the banks go on a lending binge again. The reality of the country being steeped in debt is that a hell of a lot of borrowers have and will continue to go under. There's no other way to clear the debt. That's what the default rate is all about. It just so happens that the biggest banks (Citi excepted) are the ones with enough alternative sources of income to absorb their lending losses without going under. People who rail on the big banks tend to forget the fact that they do things other then simple lending. Wells Fargo is sitting on the highest net interest margins its ever seen, for example. For these banks their stock prices simply reflect the obvious fact that they are no longer in danger of going under... I wouldn't really call it a rally, it's just reality.

That all said I'm just as surprised about the resiliency of the market as anyone.

-Matt

Sep 17 03:00 AM

[NoeValleyJim:]

As long as everyone is as bearish as Mr. Browne, you know that the rally still has a long way to run.

Sep 17 03:51 AM

[User 353732:]

1 In a stock market driven by the traditional and enduring metrics of earnings, margin, return on deployed capital, and stagnant cash flow, revenue growth, and employee productivity fundamental forces that shape the business and competitive environment of a company are dispositive. Deteriorating business environment and stagnant competitive position would cause stock prices to capture and reflect this reality and markets to retreat dramatically. However, neither fundamental analysis nor logical metrics dominate today.
2. Investors and companies find themselves in an environment where distortions, contradictions and deceits abound
the US Govt is maniacally manufacturing another bubble in equities to both recapitalize favored financial and industrial companies with failed business models and reinflate consumer and business confidence: fundamental metrics do not apply in asset markets force fed by fiat money; How can they? unreal money drives out real performance and resource allocation by fiat drives away resource allocation by choice; the Govt creates and amplifies asymmetries that competitive and transparent markets would hunt down and destroy, if allowed to function

Wall St has increasingly turned the stock market into a manipulated engine of trading profits where the asymmetries created by the Govt are exploited and monetized via preferred access to vast amounts of nearly costless credit, machine based transactional speed and frequency and economic and financial propaganda masquerading as research

Multiple contradictory trends and forces are manifest both in parallel and in sequence so we have simultaneous opposites operating(inflation in some assets; deflation in others; falling income for many; rising income for a few; compressing credit availability and net worth for scores of millions but rising credit availably and net worth for hundreds of thousands; collapsing shipping and international trade accompanied by high oil prices). These contradictions both bewilder and mislead individual and lesser institutional investors since selective observation will validate any model or fantasy or delusion the investor cares to nurture

The unreal and the untrue co-exist with the real and the true. At present, the former are strong. But, as we all know, reality and truth always prevail in time and then fundamental analysis and logical metrics can again prevail. Until then consult Orwell and Kafka for investment advice and market predictions.

Sep 17 05:49 AM

[jeremiah74:]

SanFran.. I surely dont know what 'everyone' is. but assuming everyone was as bearish as Mr Browne, the market wouldnt go up. or if everyone indeed bearish and buying back shorts, than there isnt much to hope for on the bullish side.

Sep 17 05:58 AM

[Pauly B:]

It will be interesting how the market will react if the Chinese dont show up for one of our bond auctions because of this tire tariff?

Sep 17 09:11 AM

[BullnBear:]

Your last 4 paragraphs are a great summation of the data that just doesn’t add up in our current market.

Your profit levels on the S&P in relation to the P/E ratio are something that I’ve noticed and is one of the biggest red flags that I see to sustainability going forward.

Sep 17 09:48 AM

[BullnBear:]

Great point!


On Sep 17 09:11 AM Pauly B wrote:

> It will be interesting how the market will react if the Chinese dont
> show up for one of our bond auctions because of this tire tariff?

Sep 17 09:49 AM

[adan:]

wow, from the article:

"And the markets just don't get it. Technically, S&P profits are down some 90 percent, but the Index has risen to push P/E ratios to levels not seen since 1929...."

Sep 17 02:20 PM

[Tony Daltorio:]

The problem is that "everyone" is bullish.

I expect 10,000 soon but then a quick decline.


On Sep 17 03:51 AM SanFranciscoJim wrote:

> As long as everyone is as bearish as Mr. Browne, you know that the
> rally still has a long way to run.

Sep 17 02:28 PM

[LKofEnglish:]

Still haven't seen you on Kudlow of late. What's the matter John? It's not like you've been wrong especially when it comes to gold.

Sep 17 02:57 PM

[Silentz:]

Matt, good points, but I'm gonna take a shot at detail on this one.

It partly correlates to 70% of GDP being consumer spending. If banks aren't lending, there goes GDP. One of the problems with banks now is that they're not even lending to the halfway decent borrowers. Banks are being squeezed from both sides. On one side, you've got people in government saying we need to 'unfreeze' lending to spur the economy, while on the other, you've got the regulators in a snit over capital ratios. There are two banks local to me that are actually on lending freezes because of concerns over those ratios. They're not under any C&D(yet), or other regulatory mandate, but they've voluntarily stopped any new lending. In fact, I'm about to pick up a relatively decent deal because the other bank that's looking at it doesn't want to lend any more money out.

The institution that I work for is in relatively decent shape. We've tightened up quite a bit, but we've still got some money to lend. In the market that I'm in, two years ago, you wouldn't get a sniff at a loan if you tried to charge any points. Now? People are getting a point and a half because no one else wants to compete for the loans.

So if you don't have lending to get money flowing, we ain't got nothin' else that'll do it. So it's irrational for the market to act as if things are all rosy.

But as the corollary states, the market can stay irrational longer than you can stay liquid.


On Sep 17 03:00 AM MattZN wrote:

> I'm not sure what exactly your point about bank lending is. Are
> you suggesting that the banks lend to unworthy borrowers like they
> have for the last few years? Because that is the only way you will
> see any significant uptick in lending activity. The government has
> nothing to do with it. If we were in a lending bubble before then
> what we see now is the prudence that we should have had but didn't.
> The last thing I'd want would be for the banks go on a lending binge
> again.
> -Matt

Sep 18 01:11 PM