I started writing this article on July 29. Half-way through, it was old news. And so on, until today. Indeed, I probably should shut up until “things” stabilize. The only reason I will give it a try is because my last calls were for S&P 1280 before 1350, and we have been there for three days now. What could happen next?
To recap, my July 28 article was about the Fortune Cookie Stock Market. When conventional analysis does not work, try something else and don’t take yourself too seriously. With the S&P at 1309 at 14:30 EST, I ventured 1280 before 1350 – a repeat of my July 17 call at S&P 1316. On the 18th, we hit an intraday low of 1295. On the 29, we hit 1282 for a close of 1292, confirmed on August 1 at 1275 for a close of 1287, and tested again today, August 2 between 9:30 and 10:50 EST. We decisively broke after that.
The volatility of the May-July period has been extensively documented on the short-term. Technically, the pattern has been toppish since February. We have had three excuses so far: the earthquake in Japan, the European sovereign debt crisis, and our own debt crisis. All three are serious and valid ones. Now we are having “hard patch – v2." Is this what breaks the camel’s back, i.e. the trend in place since the low of July 2010, or even from March 2009?
With Japan, probably not. With a lag, rebuilding is taking place. Don’t look at Q2, it is not a question of when, it is happening now. A note here: the fact that Japanese public debt is 225% of GDP is neither a hindrance for growth, nor a reason for a downgrade, nor a threat to the yen. There may be a lesson to be drawn from that.
The European sovereign debt crisis is not going away. Sponge Bob is very popular there, selling more band-aids than ever – they look good, but they leak. I am amazed at the resilience of the euro against the dollar. I have not done the forensic, but it seems to me that only Germany and France are on semi-par with the U.S. The rest of the European Union is under water. If we were to break the euro into its components, I’ll bet you a dollar that the sum of the parts falls short of the whole. Indeed, it has been having a bit of heartburn since last week.
How about our own sovereign debt crisis? When you are the reserve currency of the world, and when your constitution says it is worth the paper it is written on, why even mention the word “crisis?" Well, simply put, because we have historians, economists and Congress.
The difference between historians and economists is that the former record history, whereas the latter guess it. Historians will tell you that the Greek Empire fell, then the Roman Empire, then the Russian Empire, and they’ll throw in Karl Marx for good measure: Capitalism bears the seeds of its own destruction. Economists will postulate, which means they will issue theories that cannot be proven, only tested by trial and error.
There is one economic theorem, however. When you spend more than you earn, you borrow the difference. And when you can’t pay the debt, you go bankrupt. That’s when Congress steps in, posing as economists with doctorate degrees in rhetoric. When you spend more money than you earn, you do not go bankrupt, you just owe more. The strange thing is that, by and large, the public is bipolar – they hate it, but they love it.
Washington is trying to make a new point, which may actually be a turning point - reduce. To which extent, we will see. But with $39 trillion in receipts over the next 10 years, and $46 trillion in expenses, I’ll take any trillion dollar cut as a start. This needs to be confirmed by the next elections, and we have another year to go. Apparently, the market is not willing to look over the valley, which is starting to look like scorched earth. Too many black stars are aligning, we now need to take the long term view. Here are few charts to talk about.
This one shows the uncanny correlation between the Dow Jones Industrials of the Great Depression and the Nasdaq Composite of 1999-2009. Fortunately, it seems to have decorrelated since 2009, the composite having recovered the 2007 level.
The next one is the S&P 500 since its 2007 high. It shows support in the 1191-1224 area. This is the same support that I have identified in looking at both the moves from the March 2009 and July 2010 lows to the May 2011 high.
This last one is simply to remind us of the rollercoaster decade. What happened in the last leg down was a liquidity crisis. QE has been our answer so far, and while on hold, it’s on call. However, as long as the money sits at the Fed, the economy won’t bulge.
Of course, the mitigating factor, the great shot that brings you back to the golf course even after a lousy round, is the earnings yield. At 7.7%, Stocks are cheap. However, as I note in the revised edition of my book:
“The last time we saw this type of spread (with the 10-Year Bond) was in the nightmarish late 2007 – mid 2009 period." See the drop to the right of the chart below.
And to conclude:
“The other reason I felt uncomfortable was that stocks were cheap. Typically, when this happens, the reason is either a financial crisis or a weak economy. Stuff does not go on sale unless it does not sell, and PEs have a way to expand when the E decreases. In either case, the way out – and the reason to buy - usually is an infusion of liquidity by the Central Banks. We were experiencing either a financial crisis or a weak economy – but how could Central Banks possibly infuse more liquidity?
It looked to me as if stocks had seen their highs for a while. However, the downside was probably limited, as in 2010 – while QE had ended, it was not dead in case of emergency.”
I will stick to my 1190 target for the time being. Too much damage has been done to portfolios for the market to shoot back up. I first wrote about it on July 13. At the time, we had a few potential bazookas. Today, the armory looks pretty empty to me, and bipolar we remain. We hated QE. But we are going to grovel for QE3.
Disclosure: I am long SDS, MXWL, SANM, EXTR, ODP, MYE, WSBC, AGM.