Is the Market Flying on Autopilot Despite Increasing Turbulence?

by: Smart Guy Stocks

Despite mounting data that the economy is quickly weakening relative to the past few years, the stock market continues to price itself near all time highs and bulls continue to control perception. The stock market says the economy is strong, while creditors, retailers, homebuilders, and CFOs say the economy is weakening. Which data should investors follow? If the market rallies, should we jump aboard? Or, is this a classic sucker’s rally?

The most worrisome indicator for investors should be the increasing divergence between stock market action and economic action. As we all learned when we studied market history, the stock market and underlying economy do not always move in perfect tandem. However, given that the stock market is a derivative of economic activity, investors should pay very close attention when the value of their pieces of paper do not reflect the true underlying value of the business(es). When stock certificates are worth less than the underlying business, a buying opportunity exists. When stock certificates are worth more than the underlying business, a selling opportunity exists.

At the moment, stock market valuations remain near all time highs, yet banks are writing off years of profits, core credit markets are crunched, rating-agency confidence has been suspended, homebuilders are in a crisis, the housing market is in free fall, and bellwether retailers (e.g., Target (NYSE:TGT), Wal-Mart (NYSE:WMT)) have been issuing ominous warnings about traffic and sales. Banks are now undergoing a second wave of write-downs because, as UBS AG (NYSE:UBS) declared Tuesday, the “ultimate value of our subprime holdings … remains unknowable.”

As housing market prices continue falling, banks must readjust the inputs for their valuation models and ultimately write down more losses. This will only end when the housing market finds a bottom or all toxic loans have been completely purged. Unless either of these scenarios occurs in the immediate future, we have a lot more adjusting to do – and, despite mini rallies in bank shares, banks will be worth less.

Moreover, credit issues are beginning to spread. This week student lender First Marblehead Corp. (NYSE:FMD) announced that rising defaults and decreasing federal subsidies are hurting their business. On a related note, as consumers watch their huge home equity and refinancing loans dry up (you didn’t think they were investing, did you?), we will watch their spending slow and their credit card debts come under pressure.

I am not attempting to predict how bad things will get before they get better. I merely want to point out that things are not well, yet the stock market is humming along like a teenage varsity athlete. I wonder: has the five year bull run created an inertia that will keep the market near all time highs until we have no choice but to acknowledge that the economy is hurting? Or, like Pavlov’s dog, has 60 months of “buy the dips” caused us to go on autopilot despite the increasing turbulence?

I leave you with an image to ponder. During the most recent market pullback (a 10% correction), notice how selling volume was strong and strengthened with the sell off. Now, notice how during the recent rally buying volume has been weak and weakened with the recovery. This is a classic sign of a waning bull market. This activity indicates that less investors are willing to go long regardless of the market gain. In my opinion, this activity also indicates that the smartest money is done buying, and what you are looking at is the 85% of the institutional investors who will not beat the market and the countless uneducated individual investors who have yet to shift from greed to fear. These two latter groups are why the term “sucker’s rally” starts with the qualifier “suckers.”

Changing the direction of the economy is like turning the Titanic. No matter how much the Fed cuts and the President freezes ARMs, many issues must play out in order for the economy to strengthen. During these times, the music must stop so the DJ can change records, yet suckers keep dancing. However, SmartGuys and SmartGals raise cash and prepare to strike once the ship has turned and the new tune hits the speakers.