Trash Is King: Beware Being Late to the Party

Markets are pricing in a dramatic improvement in fundamentals which often happens after steep recessions. If one believes that demand will return to where it was earlier in the decade, we would see a sustained period of dramatic growth justifying the fastest surge in stock prices since the 1930s. A growing middle class in China, India, South East Asia and South America is going to lead to increasing domestic consumption in these countries for decades to come. Most importantly, the massive government stimulus packages in the United States, Japan, China and Europe have begun to work as intended. This is causing factories that produce machinery, steel, aluminum, household appliances, furniture and cars which were idled for much of the first half of this year to restart in the second half leading to a massive surge in GDP growth worldwide. This surge will create a virtuous cycle that will cause consumer spending and corporate profits to increase and unemployment to decline. This is the bull case for stocks.

Anyone who has sat on the sidelines since my last letter has lost opportunity, and the market may indeed go higher in the near future. Like all good stories there are a number of truths to the above scenario where one can make a case that the things are getting better. The future certainly looks more promising for emerging markets than it has in the past. The massive increase in bank lending in the first half of the year in China has increased consumption. Some factories will indeed need to be restarted, for a short time at least, after being idled. We believe there is a growing disconnect between the rational expectations for the future and current market prices. This disconnect is due to the massive amount of liquidity pumped into the financial system which is flowing into the financial markets.

It has become increasingly clear to us that the underlying fundamentals of both the US and world economy do not justify the price increases that in equities. Money is flowing directly from the world’s biggest banks into the stock market and commodity markets. Similar to when the internet bubble was inflating, prices on many stocks have lost all connection to the underlying earnings power of the business. People will come up with good stories to justify the price increases as long as stock prices keep rising, and mutual fund managers will talk of V shaped recoveries. Just like when internet stocks lost touch with realty in 1999, it did not mean that prices would immediately drop. We would like to urge a word of caution however, and advise those who have profits to take them now. If you did not sell before the 2008 crash, now is the time to sell. This rally is going to end in tears for those who hold on for too long. At some point reality will take hold, and there will be almost no place to hide.

We looked at the universe of companies traded on the US exchanges that have volume of at least 100,000 shares a day, market cap of 25 million dollars and revenues of 25 million a year. Only 84 of the 2408 stocks that meet these criteria have declined for the period from March 6th through November 10th. Many stocks were trading as if they were going into bankruptcy at this point, particularly in the consumer discretionary and retail space. The opportunities that existed at this time have disappeared with the rally. 953 of these stocks we screened have advanced more than 100% since the March low. Out of these stocks only 399 have positive net income, the rest lose money. 101 stocks have advanced more than 500% since this time. The biggest winners are Dollar Thrifty (DTG), Avis Budget Group (CAR), Smurfit-Stone and Dana Holdings (DAN) up 2980%, 2960%, 2350%, 2230% respectively. The net incomes of these companies for the previous twelve months respectively were -49 million, -1.18 billion, -2.82 billion, and -684 million. ArvinMeritor (ARM) and Tenneco (TEN) made the top 10 list with gains of 1790% and 1770% respectively, while losing a combined 1.87 billion. Smurfit Stone is currently bankrupt, and there is still a significant chance that some or all of the other companies will declare bankruptcy as well during the next year.

For all the talks of recovery and improving fundamentals the news flow remains terrible. Earnings are down 30% from a year ago. Consumer credit posted the biggest drop on record by a landslide in July dropping 21.5 billion dollars. It has fallen 110 billion dollars in the last year. The previous record in a twelve month period was approximately a 15 billion dollar drop in wake of the 1991 recession. Total bank lending has declined over 200 billion dollars since July, the largest contraction on record. Economists are predicting a 2.9% gain in GDP this quarter. This prediction is looking increasingly unlikely as new data comes out. Advanced retails sales were down .1% in July from the previous month. While sales jumped 2.7% in August this was due almost entirely to the cash for clunkers program and an increase in gas prices. Expect a large drop in September. We have officially lost 3.85 million jobs since the beginning of the year, and the birth death adjustment added over a million mythical jobs that were supposedly created by small business since February. The real numbers of lost jobs is probably closer to 6,000,000. Under employment is fast approaching 17% of the workforce in the official tally. Job openings nationwide stand at the lowest level since the labor department began tracking this metric in 2000. Does anyone really expect a robust pickup in consumer spending with increasing unemployment and decreasing consumer credit? Credit card companies have also cut about 1 trillion of open credit lines this year. These are not good omens for spending.

The trade deficit increased at the fastest pace in a decade in July, and oil prices have increased on average over $10 from the second quarter in August and the first half of September. We could see a large increase in the trade deficit, which would be a negative headwind for GDP. Inventories are still contracting, falling 1.4% in July from the previous month. There are no signs of the expected inventory build that is being thrown around on CNBC as a veritable certainty this quarter. Nor should we expect to see one. Sales were down 19.8% from a year ago according to the September 11th commerce department report, but inventories have only dropped 12.8%. The sales to inventory ratio is still well above pre-recession levels. Unless we see a large inventory build in August and September this will be a negative headwind as well.

This leaves only government to boost GDP in the 3rd quarter. Does anyone really want to buy a market where the Russell 2000 has surged over 80%, based exclusively on government stimulus. The GDP number coming in weaker than expected is not necessarily the catalyst that will make this rally end, but it is certainly a risk. Much like when the “America’s Oil Crisis” CNBC special came within a few weeks of the market top in oil, one has to believe the “ Banking on Geithner” special is a sign this rally is just about over. Geithner has done nothing to fix the banks. He has not addressed any of the issues in a meaningful way. Lending is plummeting at the fastest pace on record specifically because the issues with the bank’s balance sheets have not been addressed. Those of you who don’t have to invest should probably be on the sidelines at this point. If you are worried about missing some upside, use a trailing stop on your positions. There are massive risks right now that people are blissfully ignoring in the financial media. This rally is going to end very badly for those who are late to the party.

Comments

[market ace:]

This dose of reality is badly needed and should be heeded - but

What is an investor to do for the longer term? I agree with the ride the current market and use trailing stops and I have and am doing that, but there is also a false side of the coin that may keep the whole house of cards afloat for longer than people think and then their losses in the stock market will be even more terrible, but not near as bad as what their gov't is doing under their very noses.

The falling dollar will soon crush Americans and especially retirees. In the meantime it makes US stocks and commodities look cheap to foreigners, will falsely boost corporate earnings for international companies and cause many to flee cash driving markets even higher. All of this will prop up markets and make it look like everything is wonderful even while the US dollar is dying and every US citizen will pay a big price in the end as false values are created but purchasing power actually drops.

While protecting ones self from the stock market one must also be taking great care to protect against massive "inflation" from dollar deflation. The rest of the world has lost all faith and trust in the US and will take it out on the currency. The dollar may be getting some boost now from being the new darling of the carry trade, but that too cannot last. There are also foreign forces that would like to kill the dollar and they just may get their chance as the reckless US Gov't and FED defy all logic with their current economic policies.

Beware of a crashing stock market, but more afraid of what a major devaluation of the US dollar, which could happen over night, will do.

Sep 17 06:28 PM

[Travis K Mi...:]

Very well laid out article. You've brought together a lot of great reasons why this rally is unfounded.

I just keep waiting for the other shoe to drop. Unfortunately I've been on the sidelines for about a month now, and missed a lot. I know that as soon as I go against my better judgment and get long, the market will turn. So right now, it's taking about all I can muster to keep sitting out.

Thanks for the great work!

Sep 17 06:52 PM

[Larry House:]

Let's consider the possibilities: 1) the market goes higher steadily from here over time with pauses and modest corrections along the way; 2) the market goes relatively flat from here for an extended period of time; 3) the market has a correction soon and then resumes the march upward; 4) the market has a correction (perhaps to the March lows) and goes flat from there; 5) the market double dips to the March lows and then rises; 6) the market crashes and we go into Great Depression #2. Have I left out any real possibility? What chance do you give each possibility? I give #1-10%; #2- 15%; #3 -15%; #4 -25%; #5- 20%; #6- 15%. Now I know there are a lot of holes in this but, as an investor, I have to some way quantify my risk/reward in stocks. Now, if #1, #2, or #3 happen, I want to hold the stocks I have now. For #4, #5, or #6, I don't want to be in stocks. That means, by my view of things, I give myself a 40% chance of a good outcome in holding stocks from here. However, I give myself a 60% chance of a not-so-good outcome. Right or wrong, my own assessment (and I am the only one I answer to) is that the odds are against me, and I don't want to play this hand holding stocks. In addition, considering that any upside from here may be quite modest but the downside is almost limitless, I prefer not to be in stocks, even if I miss some upside. I bought stocks in March but sold in June. I have caught some upside since, but I just don't like the looks of the game right now. I'm going to fold.

Sep 17 09:05 PM

[tripleblack:]

I bought in - big time - in March, but I too am getting wary.

I was thinking an 11k Dow back then, but now its beginning to look like maybe 10k...

And I think we have had our intermediate correction already, soft as it was, but have the "big one" staring us in the face somewhere around 10k...

Which is sort of where we are right now.

LOL, like the others who have commented here, I am not feeling the love of the equity markets right now, even with the admonishments that the recession is ending and good times are ahead.

I am pulling back into commodities and cash, and will study the problem for a while from here.

Sep 18 12:01 AM

[untrusting ...:]

Would certainly agree that the large downside risks far outweigh pretty limited upside potential in equites at this point.

Sep 18 12:49 AM

[TheFounder:]

Very hard to immagine significant equity upside from here. But the technical forces are strong in the short term and the kyy technical points are 50% correction from the march lows (666) or 61.8% which are appx 1150 and 1200 respctively.

In any event a balanced portfoli at this point needs to include debt, cmmodities, gold and certain low priced equities. And obviously a reserve to average down if we hit a great depression again.

Sep 18 02:39 AM

[David Van K...:]

"If you are worried about missing some upside, use a trailing stop on your positions."
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That's it in a nutshell. Don't sell now--you don't have any idea how long this rally will last, no more than those who screamed "sell" (or "short") in April-May-June-July-Au... had.

And don't, for God's sake, average down.

The market has been going up for more than 6 months. That was unexpected. But those who bought into the rally have been well rewarded. Don't try to predict the exact turning point. You can't. Simply stay long, and use whatever trailing sell stops make you comfortable: 3%, 5%, 8%, the 20-day MA, the 50-day MA, some "support line" that you draw on a chart. Use whatever you like to set your stop-out level. But don't sell in anticipation of a reversal that you cannot predict.

Sep 18 08:59 PM

[satyr:]

All interesting. Of course, all of the "experts" have been telling us that the market is due for a tumble for about 6 months. Eventually, they will be right, and not one will mention how wrong they were leading up to that moment.

There is no doubt that there are some headwinds that should not be ignored, and no matter what the long term holds in store, there will be some down days in the markets. Maybe there will be a lot of them. But, keep in mind that there is still a lot of money sitting in cash accounts accumulating close to zero interest, and it appears that it is gradually being deployed into equities. Reasonable or not, this creates upward pressure on the markets.

Finally, if we are going to be intellectually honest about valuing equities, let's not talk in terms of percentages. How many stocks went up how many percent during what period of time is not relevant to anything other than historians. I don't remember this (or virtually) any self-appointed expert mentioning how many percent the market or individual stocks had lost heading into March of this year and posturing it as a reason why stocks absolutely had to go up. The idea 6 months ago was that stocks would go down, because that is what they had already done. Now, we are hearing that stocks will go down because that is not what they have done.

I do happen to know that most mutual funds have been lagging the S&P over the past 1/2 year. Why? Because they were betting against the individual investor. Now, they are hoping for a tumble so that they can save face, and many are trying to jawbone their way there. It's a tug of war, because the US government wants it quite the opposite, as do the governments of the G-20. If equity markets, currencies, and real estate values cannot be sustained at some reasonable level, no amount of stimulus or any other kind of intervention can salvage the world economies. Look for Ben, Tim, Barack, Govt. Sachs, and Warren to keep the messages positive until at least December.

Sep 20 06:10 PM