Beware of the 2008 Sucker Rally

U.S. stocks markets appear to be in the process of finding a bottom, and it seems likely that we may soon see a rebound. "If we're in a recession now, which is pretty likely, we've probably seen most of the worst of the downside to the stock market," said Jennifer Ellison at Bingham, Osborn & Scarborough. "The market tends to rebound when the economy reaches its worst quarter."

I feel that a rebound from current levels will probably be a suckers rally, for reasons I will now explain. Apologies for the length of this note, but I've tried to summarize a few of the bearish arguments in 7 points:

1. The possibility of a double-dip U.S. recession
2. There is just not enough money going around to push stocks higher
3. The U.S. may avoid a recession, and enter a period of slow growth
4. Trouble in Europe may sour Wall Street's potential rebound
5. More subprime writedowns to come
6. Stocks may look deceptively cheap
7. The Fed may face limits in its efforts to simulate growth

I'm going to briefly discuss each argument in turn.

1) The possibility of a double-dip U.S. recession

Let's assume the U.S. enters a recession. Usually the stock market starts to fall before a recession starts, then it falls very sharply during the first stage of a recession, and then starts to recover in the late stages of a recession before the recession has reached its bottom. This pattern makes sense because equity prices are forward looking.

I think there is an outside chance of a double-dip recession, where the GDP rebounds briefly, only to fall into negative territory again. This may cause the stock market to rise, anticipating an end to a recession, only to drop again once the second dip of the recession is priced in. The U.S. economy may rebound in the summer as the rebate checks give a jolt to consumer spending, but growth may slow down once again as that impact wears off.

2) There is just not enough money going around to push stocks higher

"Since August, 90% of non-conforming loans loans have not gotten funded. That translates - based upon quarterly federal reserve analysis of equity (cash) extraction from homes via cash over mortgage at sale, cash out from refi's and home equity loans - into about $20 billion less per month going to the economy," Charles Biderman of TrimTabs.com recently told Herb Greenberg. "That is equal to about 4% of the $430 billion monthly after tax take home pay of all 140 million or so on payrolls." He summarizes his view: "That's a long way of saying that with individuals generating less new money, there is less new money available for investment."

3) The U.S. may avoid a recession, and enter a period of slow growth

"Stocks do worse during times of slow growth than they do during recession," said Brian Gendreau at ING Investment Management. In related commentary, Goldman Sachs chief economist Jan Hatzius explained why a mild U.S. recession does not mean a short U.S. recession. "The reason why the economy is likely to stay weak for quite a while is that it's hard to see a genuine acceleration while home prices are still falling and estimated mortgage credit losses are still rising," he warned.

4) Trouble in Europe may sour Wall Street's potential rebound

It seems likely that the much-discussed “decoupling” between America and the rest of the world economy will happen in the case of Asia, but not Europe. Anatole Kaletsky, columnist at The Times, explains: "The main European economies, apart from Germany, have been powered by exactly the same combination of rising house prices and easy credit as the US economy. They are simply 12 to 18 months behind the US in the same credit cycle. Germany, meanwhile, is very dependent on the strength of consumer demand in the rest of Europe. The best that Europe and Britain can expect, therefore, is a performance in the economy and housing markets similar to America’s in 2007. If the US suffers a recession, the housing and consumer slumps in Europe and Britain will be that much more severe."

Kaltesky also believes that Europe could become more vulnerable if trade imbalances start correcting: "If the US trade deficit shrinks by $200B or so in each of the next two years, simple arithmetic seems to suggest that the trade surpluses of other regions will have to fall by the same amount. Because Japan, China and Opec are the only US trading partners with surpluses that big, it seems natural to assume that they will be the ones that suffer from the loss of US trade. However, this simple arithmetic is misleading: the US trade deficit could easily shrink by $200B or more, even if the Chinese and Japanese surpluses stayed as big as they are today or kept expanding. This could happen if Europe moved from its present position of rough trade balance, to an American-style deficit of several hundred billion dollars. In that case, Europe would prove more vulnerable than Japan, China or the Middle East to a US slowdown, just as it did in 2000-02 and in 1991-93."

5) More subprime writedowns to come

Americans and Europeans have so far confessed to $130 billion of the estimated $400 billion to $500 billion subprime losses. Somebody, somewhere, must be sitting on a vast amount of undisclosed losses. The lingering uncertainty will probably limit the strength of a rebound if it occurred in the next month.

6) Stocks may look deceptively cheap

Several analysts say that U.S. stock valuations are looking attractive, but appearances can be deceiving. I agree with another SeekingAlpha blogger, Vitaliy Katsenelson, who says that "the cheapness argument falls on its face once we realize that pretax profit margins are hovering at an all-time high of 11.9%, almost 40% above their average of 8.5% since 1980. Once profit margins revert to their historical mean, the "E" in the P/E equation will decline. If the market made no price change in response, its P/E would rise from 17 to 23.8 times trailing earnings."

But shouldn't average profit margins be higher now, as the U.S. economy has transitioned from an industrial (low-margin) economy to a service (higher-margin) economy? "It is not as much of a change as we might think," explains Katsenelson. "In 1980, services represented about 48% of GDP. After 27 years and a lot of changes like outsourcing, services have increased to 58% of GDP. If we assume that the service sector has double the margins of the industrial sector (a fairly conservative assumption), increases in the service sector should have boosted overall corporate margins by about 40 to 70 basis points above their 27-year average - between 8.9% and 9.2%, but still far below today's 11.9% margin. Thus, if we adjust corporate margins to reflect the transformation toward a service economy, corporate profit margins are still 30% above their long-term mean."

7) The Fed may face limits in its efforts to simulate growth

Given current inflation levels, the Fed may be running out of room to cut rates. As PIMCO's Bill Gross points out: "Dollar depreciation leads to higher inflation and ultimately forces foreign creditors to question their rationale and indeed their sanity for continuing purchases of U.S. Treasuries," which pushes up interest rates (leaving Fed rate cuts impotent). If the Fed can't save the day, stocks will have limited upside, and any rebound will quickly fizzle out.

If we are in a bear market, markets are far from pricing it in properly. 2008 may well turn into a suckers rally...

Disclosure: none

Comments

[JGS007:]

Great article. I've been skeptical of the activity for the past few weeks in the market.

2008 Feb 13 08:08 AM

[zenalgorithm:]

8. Liquidity crisis: Banks don't want to lend to people while assets are plummeting in value. Foreign banks don't trust the U.S. anymore - thanks to the investment banks. Try getting a loan right now - banks are in delay mode.

9. The FED and SEC are colluding with the banks to hide the losses from the CDOs and to hide the real asset values controlled by these banks - thanks to the banking cartel and corrupt government officials. If the banks were forced to declare their current asset values - there would be massive margin calls all over the place.

Unfortunately, big banks don't have to abide by the same rules as the rest of us do.

Can anybody say banking "bailout"?

100-150 day MA becomes major resistance points for the SPY and DIA in a bear market. Keep an eye out for these points as this bear market plays out.

2008 Feb 13 08:37 AM

[Kunst:]

The joker in the deck is all those dollars we keep shipping overseas to buy toys and oil. Even if the economy suffers, US stocks could look like a good way to trade in those dollars for something of long-term value.

2008 Feb 13 06:44 PM

[GKM:]

10. We still don't know what we don't know. Ex. it came out tonight that a syndicate sold the first commercial mortgage back triple A securities since the credit meltdown. The rate on these was by some estimates 4 times the pre-meltdown spread. How many companies holding other securities like these have allowed for that kind of devaluation in what they have on their books?

11. ROW. I think that since the meltdown began most of the attention has been spent on picking at the US problems. I suspect that the next round of issues (the double dip?) will come from elsewhere in the rest of the world. You don't get blindsided by the bus that you see coming.

2008 Feb 13 10:53 PM

[jaytrade:]

The people who commented above, and the writer are probably shorting the stocks, and stand to gain if the market falls further. There seem to be a disconnect between the market pandits, and independent researchers, majority of whom do not predict a recession, specially after the big stimulus by the Fed. Most expert predict a roaring second half of this year. And the market is supposed to respond six months ahead. So it should be going up now.

Big money is most probably on the short side of the market now, and won't change side until the market conditions are dangerous enough for shorting. They are using media like CNBC to create, and sustain panic, and negative psychology in the market . This is not only discouraging buyers in the market, but is also influencing a lot of things far more important for the country. This negative psychology may cause employers to hold off hiring, buyers to hold off buying, and the public to hold off spending, which can start a chain reaction, and in turn can start a real recession, when thousands of Americans would lose their jobs, and most of us will suffer, except the short sellers . Instead of the constant drumbeat of credit crunch and recession, I would like to hear and get an idea of what percentage of average Americans are being denied credits, and get an actual idea of the doom and gloom, and educate myself.

We are living in a time, when there is tremendous competition in the world of business, and technology. China is blazing ahead, sometimes with unfair trade laws, and government support. A real recession can also set us back in the field of new research, and technology, and lose our lead in the world, which can have far reaching effects. So, lets not make profit by cannibalizing ourselves by spreading hypothetical doom and gloom !!

2008 Feb 14 04:46 PM

[jcrash:]

I agree, jaytrade. Foreclosures in my area of the country are DOWN. Housing prices are up. I get more offers for credit at 3.9% to 0% than I can shake a stick at. My wife just started a new job where she is going to make 20% more than her old one.

Do the math and see how much damage would need to be done to equal $500 billion in subprime loan fallout. Assume you lose 25% on 10,000,000 homes that average $200,000 each. That gives you $500 Billion. Do you really think that many households are going to lose that much? Maybe in California you have 5 to 10% but not in the majority of the country.

It's all overdone. They weren't making enough on the long side so they switched to the short side. Thing is, it is called short for a reason. i.e. SHORT TERM. The rebound will come and it will be just as swift. I'd rather not try to guess when, so I will just buy the cheap stuff now and wait out my earnings.

2008 Feb 14 10:53 PM

[globalview99:]

There's just too much fear being pervaded and its got legs because the story keeps turning and twisting which makes for great news drama and ratings: sub-prime mess turned into CDO black hole twisted into liquidity crisis now the credit crunch with all kinds of fallout: mass layoffs in the mortgage and housing sector, foreclosures at all time highs, housing prices falling, consumers cutting spending, slow growth. recession, aagh.

There's nothing better than drama that has a kernel of truth to it and that is what this story has going for it. The housing sector represents some 12% of the economy and its not going to come to a complete standstill. There's going to be significant reduction in GDP due to this cumulative mess, maybe a reduction of 25% of its sector so we're talking about an impact of 3%. In other words, its going to take down the US growth rate from 4-5% to 1-2%. But fear rules the day and that's when fortunes are made.

2008 Feb 15 08:42 AM

[jaytrade:]

Thanks to the good son of this country, Warren Buffet who removed some of the fear of doom and gloom by his offer a few days ago !!! It does not matter if he trying to profit from it or not. At least he is not trying to make a profit by hurting the country - like a lot of others are !!!

2008 Feb 15 10:26 AM

[hattryx:]

the end is nowhere in sight i tell you. pack up and leave is the trade of the year

2008 Feb 15 12:08 PM

[prospector:]

Warren Buffet is a very smart investor. Absolutely, he's trying to make a profit off of the "deal" he offered to the bond insurers. He offered to take ALL of the nearly 0% risk muni bonds off of the "big three" insurers hands and leave them with the subprime junk bonds. This effectively removes any certainty of income for the companies in the future after the subprime worries are a thing of the past.

Buffet, in my opinion, doesn't care if MBI or ABK goes bankrupt. I don't believe there's enough junk in their portfolio that would cause them to go bankrupt. Berkshire Hathaway, owned by Buffet, is in competition with MBI and ABK. Why would Warren not want 2 less competitors.

The offer he made was to help speed up the insolvency process of the insurers in question.

2008 Feb 15 12:31 PM

[brewer:]

Repeat it enough, and it's like a self-fulfilling prophecy. My stocks are still up over last year. I am holding on though, I am long term and I am not a 'weak hand' that will be shaken out.

2008 Feb 15 02:01 PM

[jaytrade:]

Hello prospector, don't you see that with his offer, Warren put a minimum value to MBI or ABK, below which they won't fall. Before his offer, the market, and short sellers were treating them as if they were going down to zero. This has a tremendous psychological value of assurance, which propped up the market.

And I absolutely agree with you that MBI or ABK most probably don't have enough junk in their portfolio to take them to bankruptcy !!!

2008 Feb 15 04:28 PM