Coming into 2012, I was reasonably bullish on expectations for the economic backdrop to improve and the market to follow. However, as usual, the stock market has gotten ahead of reasonable economic expectations. A closer look at the market reveals a worrisome picture.
In a real economic recovery, most economists and investors look for transports to lead performance in the markets. Year to date, the transports have been the next weakest performing of the major sectors, beat only by utilities. The sector has seen its hardships this year. Rail companies saw lower coal volume as a result of an unseasonably warm winter, while truck and airline companies saw the price of one of their more significant inputs, fuel, increase notably. However, if the economy were as good as the near 13% rise in stocks would indicate, investors would want to own these names in anticipation of higher earnings farther along in the cycle. On point, Federal Express (NYSE:FDX) released results last week that showed U.S. package volume down 4% from the prior year in their fiscal quarter ended February 29, 2012. Indicating that this is not a short term trend, the company's CFO stated that the company is looking to adjust its U.S. domestic network capacity.
Click to enlarge
* ^DJT is Down Jones Transports, XLF is Spider Select Fund Financials, OIH is an Oil Services ETF, XLV is a Healthcare ETF, ^DJU is Dow Jones Utility Index and ^DJR is Dow Jones Equity REIT
Additionally, judging by the S&P 500 volatility Index (^VIX) dropping to its lowest level in nearly five years, investors are not well hedged against potential risks. The chart below shows that the current level of the VIX has proven to be support over the past 5 years.
Looking ahead, one of the primary risks is that economic expectations for the next quarter or two are overly optimistic. An unseasonably warm winter likely contributed to a pull forward of economic activity from future periods. When its snowing frequently (as it was in the 2010-2011 winter), job interviews are more likely to get pushed back or cancelled, and unnecessary shopping is less likely to happen, for everything from apparel to cars and homes.
Looking at the housing market, while the sales pace has increased, it has taken a reduction in price, as should have been expected, to reduce inventory. In order for the economy to truly rebound, people need to start being able to build equity in their homes again. This confidence in personal assets would likely fuel a wave of economic expansion.
The elephant in the room continues to be government debt and spending. Though put on the back burner in favor of the upcoming election circuit, the combination of a trillion dollar deficit and $16 trillion in outstanding debt will be daunting on any plans for a sustained recovery. At some point, the deficit will have to be reined in. My chief concern is that if the United States runs into another recession, congress and the administration will attempt to raise the deficit further, putting our country at greater risk of economic calamity. While most people agree that deficit spending can be useful in times of economic emergency, the GDP has been positive for more than two years. It is time to deal with the growing issue of runaway deficits. As we all saw last year, all it takes is for the ratings agencies to lower our debt rating for the world to start counting. The counter argument that interest rates declined amidst the panic might have held true for the last round of ratings cuts/warnings, but there is no telling what future reactions would be. It was less than six months ago that people were looking to take money out of the capital markets in favor of cash.
Also, market participants appear to be overjoyed anytime the Federal Reserve Chairman, Ben Bernanke, hints at or implements significant monetary policy. The other side of the coin is that getting market participants used to such drastic measures likely distorts the markets, and can result in unexpected moves in interest rates in the future.
The current market rally has not priced in the risk of any of the above factors coming to fruition and hurting economic growth and job creation. Investors should be cautious and take gains as the market charges higher.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.