Market Update: In The Zone For A Potential Pullback

by: Jeremy Robson

I have recently written 2 market orientated articles which have argued that a correction is upon us that will take us down to below 1300 on the S&P500. The recent advance above 1375 has negated that call, and I have been proven wrong. My basic thesis is that the U.S. is still in a growth environment of 1.5-2%, despite all the hype surrounding the February non farm payrolls release. For me there are too many indicators that this is the likely growth rate. They are:

  1. The Baltic dry index has moved substantially lower.
  2. U.S. rail carloads are almost flat for the year.
  3. U.S. withholding taxes are only just up on 2011.
  4. Growth of imports through U.S. ports is slowing.
  5. Electricity usage is down on 2011.
  6. Gasoline usage is down on 2011.
  7. Retail sales ex autos have been sluggish.
  8. The latest BLS release was for job growth of 227,000. All of this job growth can be explained by the growth in second jobs which was greater than 227,000. Takes a little away from the release's importance for me. See the SA article here by K202.
  9. I continue to believe that much of the present strength in the the PMI and ISM readings are due to seasonal factors and good weather.
  10. European recession and China growth slowdown must affect the U.S. growth rate.
  11. The U.S. Dollar has stabilized over the last 3 years, trading in a range of 74-90 on its trade weighted index. This is not supportive of U.S. export growth. The U.S. is losing the battle of the ugliest currency.

Please don't get me wrong, I am only suggesting that growth in the U.S. is not accelerating, just chugging along with the fiscal stimulus from the government. It is clear that growth is not falling now. For me there is only one present signal that the U.S. economy may be healing, and that is the growth in consumer credit and bank loans. However, I googled U.S. car loans to find companies that are giving car loans of 100% with no payments for 3 to 5 years. There are others that give 100% loans for persons with bad credit scores. It is difficult to know how sustainable this is. The latest consumer credit figures show that it is the take up of car loans (and student loans) that is the major driver of consumer credit. Credit card debt was reduced in February. If the present rate of consumer debt is sustained for whatever reason, it will be a sign that the U.S. economy is going to grow more robustly. Will it be sustained?

The latest survey of U.S. bank loans suggests that SMEs are starting to increase their demand of debt. If this is sustained it will indicate that they are becoming more comfortable with the state of the economy. This sounds reasonable as the worst case in Europe has been removed from the table due to the LTRO. However, we are now left with the reality that austerity is going to keep the eurozone in recession throughout 2012. Will this optimism last? I have argued not.

If I am correct that the growth rate of the economy is around 1.5-2%, any increase in sales growth will be difficult for U.S. companies (especially with growth in the rest of the world slowing). Net profit margins are at all time highs of 8.5%. I find it difficult to see where the growth in earnings is going to come from. There is an excellent article here from Simon Moore which suggests that profit margins will stay high. In general, I agree with the article. I feel that they will stay high but maybe not quite as high as they are now. If they were to reduce by 0.5%, that would be about all I would suggest is likely.

However, the point here is that they are not going to increase at all over the next 2-3 years (and possibly longer). Assuming no material reduction in U.S. corporation tax rates, all earnings growth will have to come from an increase in sales. In a low growth environment, what is the level of sales growth that is achievable? Whatever that growth rate is would seem to me to be the rate of growth of earnings. I am not optimistic that U.S. companies can achieve strong sales growth, unless consumer credit continues at the rate of expansion seen in the last 2 months. This is why I will be watching the consumer lending and business loan growth over the next few months.

One last point is that if profit margins stay constant around 8% and sales growth is slow, any further gains in this market will be dependent on p/e expansion from the present levels of ttm p/e of 14.1 and p/e10 of 22.2. In this liquidity driven market, that is possible. However, it is not what I expect in the longer term. Compression of the p/e ratio has never stopped until the p/e has gone below 10 in the past. It has not yet gone below 10 in this cycle.

I am presently short the market and wrong. The next meaningful resistances are 1400 and 1425 on the S&P500. No market, including this one, goes up forever. We must be in the danger zone for a potential market pullback. I have read on a couple of occasions that it will take some sort of shock to start any substantial pullback in the present market. I do not fall into this camp. What about a disappointing earnings season starting in April-- will that do it? Possibly, and if not, there will be a reason at some stage soon. Perhaps just the old sell in May and go away!

It has clearly been wrong to forecast levels on the S&P500, but I am presently no more bullish than when I made my incorrect call for a pullback. Cam Hui, a regular contributor to SA has moved from a bearish perspective to a bullish one recently. Is this the correct move or will I be correct? Only time will tell. The S&P500 looks to be in a 5th wave up at present. Wave 1 up was approximately 120 points and took 11 trading days, wave 3 up was approximately 170 points and took 52 trading days, wave 5 began at 1340 and is so far 11 trading days in duration and 60 points in appreciation. Top prediction - as suggested above, forecasting this market using technicals makes you look foolish. You decide. All I would say is that if you are buying now, you are coming really late to the party.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Long RWM

Disclaimer - This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.