Market Bottom Already? I Don't Think So

It irritates me to hear so many talking heads confidently state that we have reached a market bottom. A review of the past market tops and bottoms reveals that investors get to recognize the tops and bottoms many months after the actual occurrence. I personally have a negative bias towards the market and am trading with an extremely short term view since I cannot get decent clarity as to what the future holds. In the last few months, there have been many data points that have surfaced. If you connect the dots, then a very bleak picture emerges. The following are some key reasons for my pessimistic sentiment:

1) People say that the bear market is behind us. But, in the 10 bear markets since the end of World War II, the S&P 500 has declined 32% on average from peak to trough. The index this time hasn't even crossed the standard bear-market threshold of a 20% decline, having dropped 18.6% from its October closing high to its closing low of 1273.37 on March 10.

2) The US economy is a consumption driven economy (70% of the growth is driven by consumer spending). Consumer confidence and its impact on consumption has been a huge impact on the growth of the economy. The University of Michigan's latest index of consumer sentiment, registered at 69.5 for March, down 1.3 points from February and the lowest since immediately following the 1990-91 recession. The Conference Board's confidence measure also plunged, with consumer expectations at their worst since 1973. In this context, regardless of the arguments of poor executions, one should not underestimate the earnings warnings by JC Penny and Dollar Tree. The following is an exact quote of the CEO of JCP:

Consumer confidence is at a multi-year low," said Myron E. (Mike) Ullman, III, chairman and chief executive officer of JCPenney. "JCPenney counts half of American families as its customers, and they are feeling macro-economic pressures from many areas, including higher energy costs, deteriorating employment trends and significant issues in the housing and credit markets. The sharp decline in sales is reflective of these trends. While the economic stimulus package may provide some temporary benefit, we expect the continuation of a difficult environment over the course of 2008.

3) Personal saving as a percentage of after-tax income has been negative the past two months and the saving rate has been near zero for the past three years, the lowest level since it turned negative in the Great Depression.

4) Let us not forget the data from last week that the U.S. economy lost 80,000 jobs in March, the biggest drop in five years. The drop in employment was the third consecutive monthly decline. In addition, the Labor Department also said that the unemployment rate jumped to 5.1% last month from 4.8% the month before. A rise of that magnitude has never occurred in the postwar period without the economy being in a recession according to many economists.

5) Businesses are pulling back on renting office space, a signal that the economic bad times are hitting landlords and that business hiring is likely to remain weak. Demand for office space dropped for the first time since the economy emerged from its downturn earlier in the decade, according to first-quarter data from Reis Inc., a New York research firm. "Any sense of immediacy among companies to sign a lease was put on the back burner," says Sam Chandan, chief economist for Reis. "What became the dominant issue is the uncertainty in the overall economic outlook." Office vacancies are strongly correlated to job growth. Companies plan for office expansion when they are confident of adding new employees. That isn't happening (source WSJ - 04/03/08).

6) In another sign of a stagnant economy, relatively few companies have plans to hire more workers over the next three months, according to a survey of employers released last Wednesday. Just 29% of managers plan to increase hiring in the second quarter of 2008, according to an online survey for USA TODAY and CareerBuilder.com by Harris Interactive. The proportion of employers with plans for increased hiring is unchanged from the last quarterly survey (source USA Today 04/01/08). An article on 4/4 issue of the WSJ states that nearly three-quarters of large corporations surveyed by Greenwich Associates expect the economy will weaken during the next six months, according to a report to be published by the firm. Most of them believe the downturn will last at least one year, and about 15% expect it could last two years or more. Please keep in mind that companies have much better insights in their respective areas regarding future growth.

7) Meanwhile, the American Bankers Association said consumer-credit delinquencies in the fourth quarter were at their highest levels in nearly 16 years as borrowers continue to fall behind on auto loans. The banking organization also predicted that delinquencies will continue to rise in the first half of 2008, warning that "no relief for consumers is in sight" amid what it called "stubbornly high" food and gas prices and "anemic" income growth.

8) Demand for durable goods, expensive things designed to last at least three years, decreased in February, down an upwardly revised 1.1%. Last week, Commerce, in an early estimate, said durables in February fell 1.7%. The Institute for Supply Management on Tuesday reported its March manufacturing index moved to a reading of 48.6, from 48.3 in February and 50.7 in January. While that was an improvement, numbers under 50, nonetheless, indicate contractionary activity.

A benefit of a weaker dollar is that exports have been offsetting some of problems in the economy. The export boost provided by a weaker dollar, which makes American-made goods less expensive for overseas buyers, is helping to avert a deeper slump in manufacturing. As dollar reverses its direction, this will have negative impacts on exports, putting further pressures on manufacturing.

9) According to Moody's economy.com 9 million homeowners, or about 10.3 percent of homes, will have zero or negative equity by the end of March. Even more disturbing, about 13.8 million households, or 15.9 percent, will be "upside down" if prices fall 20 percent from their peak. Housing continues to be a drag on the economy. KB Home, the fifth- largest U.S. homebuilder, reported a first-quarter loss as sales plunged 43 percent. Here is the quote from the CEO:

"Many potential buyers either cannot or will not make a purchase commitment today," Chief Executive Officer Jeffrey Mezger said on a conference call with investors on March 28. "Some are worried about losing their jobs, others believe prices have further to fall. Many are simply unable to qualify for financing given the more restrictive lending environment."

But a new phenomenon is taking place which could serious problems down the road. According to Bloomberg:

Banks are so overwhelmed by the U.S. housing crisis they've started to look the other way when homeowners stop paying their mortgages. The number of borrowers at least 90 days late on their home loans rose to 3.6 percent at the end of December, the highest in at least five years, according to the Mortgage Bankers Association in Washington. That figure, for the first time, is almost double the 2 percent who have been foreclosed on.

Lenders who allow owners to stay in their homes are distorting the record foreclosure rate and delaying the worst of the housing decline, said Mark Zandi, chief economist at Moody's Economy.com, a unit of New York-based Moody's Corp. These borrowers will eventually push the number of delinquencies even higher and send more homes onto an already glutted market.

"We don't have a sense of the magnitude of what's really going on because the whole process is being delayed," Zandi said in an interview. "Looking at the data, we see the problems, but they are probably measurably greater than we think."

10) Some investors are betting on a solid rebound in corporate earnings in the second half of the year. Earnings by companies in the S&P 500 tumbled by an estimated 12% in the first quarter, and are forecast to drop an additional 2.9% in the second quarter, according to Thomson Financial. But earnings are expected to rebound by 16% in the third quarter and 63% in the fourth. The hope is that financial companies will stop taking massive write-downs on subprime assets.

But this is an unrealistic expectation. There are still additional write-downs to occur, according to many banking analysts. These range anywhere from an incremental $200 billion to $800 billion. In the context of transparency, there is a very interesting article in this weekend edition of Barron's about how financial companies are using an accounting rule to to generate debt-related gains that have allowed some firms to top analysts' earnings estimates. The following is a key point mentioned in the article "Lehman (LEH), for instance, reported earnings in its most recent quarter of 81 cents a share, above the consensus estimate of 70 cents. However, the $600 million gain from the reduced value of its liabilities essentially added about $400 million, or about 70 cents a share after taxes. Excluding that gain, Lehman's profits would have been below the consensus."

The reason I am using this as an example is to reinforce the fact there is still a lack of complete transparency in the workings of the financial institutions.

In conclusion, it is very tough to be optimistic and think about a market turnaround in light of these data points. I am clearly aware of the proactive nature of the FED in ensuring that the economy does fall into a major rut. But in the very end, even the fed and the Congress can intervene only so much...at some point, the fundamentals will supersede any artificial stimulus. Poor economic fundamentals always lead to a correction in business cycles.

Disclosure: Short Financials and Emerging Markets, Long Technology

Comments

[NawarAlsaadi]

Good work, you have done excellent job of explaining the current situation, I also do agree that we are in for more pain, before the situation improves, the kind of debacle the US is going through will take more then few months to work itself through the system, I expect fundamental economic weakness to persist until 2009, the market is already pricing for a rebound by Q3 2008, which I believe is highly unlikely in light of the current economic numbers.

I believe a worthy point to add to your analysis is inflation, as I write this response oil prices are back to their record $109 price level, high energy prices are starting to significantly hurt companies profit margins (Aloca earning last night is a case in point), the continued increase in commodity prices is caused by strong Indian & Chinese demand, meaning a weaker US economy is unlikely to weaken the inflation outlook, which in turn will lead to a period of stagflation, that could prove to be extremely detrimental to the US economy. The FED in my opinion has already given up on its fight for inflation in return for saving the US financial system; while I understand the logic behind their actions, the long term implications of their choice could mean rampant inflation for many years to come.

Regards,
Nawar Alsaadi

[NI123]

Excellent article.

[richjoy]

Well done. I very much appreciate a well-thought out position (either pro or con). Questions: (a) Have you considered that Congress may be on the verge of some sort of bail-out for mortgage holders?; and (b) have you considered that the markets tend to look over the immediate problems to what is the most likely situation 6-months out?...If either/both of these come into play, how would it moderate your position?

[FreddieBoy]

Excellent work
The market seems to be in denial.

[JimHawthorne]

Outstanding job of research and presentation!
As the current "hope-based" rally (so common in bear markets) begins to sputter, your article will clearly explain why!

[fabian hug]

I liked your analysis and your way to focus on fundamentals that are so quickly ignored. Beware however of the fact that this market was manipulated (ghost profits in banks, inflation data) and is still manipulated (Bernanke just said inflation is no a problem, RE market will have bottomed at the latest by year end! and, as you mentioned, Lehman seems to interpret its figures in a funny way...again).
What do I mean whit that? It is very possible that the market starts a new rally based on whatever positive data they can find. It seems that there is still a lot of money around and what can you do with it?
When China and India will announce that they start building an Interstate road network then we may see a change.

[DCM]

Mr. Shankar, I concur in your well argued analysis. I hope you are right because I have stayed in cash for the most part waiting for what I hope are better buying opportunities. I have limit orders in but the stocks just keep going up. Most every stock that I have targeted reached their 52 week low in the 3rd week of January. Is it possible that all the bad news is already factored into the market by institutional investors? Have they decided that there is no where for the market to go but up and they continue to keep bidding the stock prices up? It has to be said that by any definition of fundamental value analysis, there are many great stock values to be found! I have been waiting for another big dip but so far the only thing that has happened is that I have lost about 20% return on average by not investing back in January. The last couple of weeks, it seems like many of my targeted stocks have moved up about 2% a day. It's killing me! Where is that crystal ball when I need it?

[puttster]

I am glad you did not add inflation to the list of down-the-road problems. When consumers in a consumer driven economy can't borrow any more and, in fact, have to apply every scrap discretionary income to credit card and auto debts, the consumption party is over. How long does it take a person to pay off half a year's salary in debts and finally start back spending on discretionary items? That's how long the recession will last.

[hattryx]

this fed and government are working overtime to help the american consumer. there's an election coming up, for added incentive. yes, earnings will be miserable and writedowns might keep coming, but we're reaching levels that should draw private equity and foreign investors into the buyout arena.

[keithofrpi]

Consumers power the market. If the dollar stays low or continues to decline, export sales will ramp up and prevent great job losses. Although high prices for commodity necessities plus housing value losses are crimping consumer spending, and will continue to do so for some time, a 6-12 month timetable for production adjustments to reduce those prices does not seem to me unreasonable. With our population growth, aggregate spending will resume its rise even if per capita spending does not. Combine exports with flat to slightly improved consumer spending within the year, and you get a resumption of sales and profits.

[NO DooDahs]

The bottom was in January. The action in March was a lower-volume retest.

[galewhitaker]

For those of you who are optimistic take a look at what author James Howard Kunstler has to say about the hight price of energy. jameshowardkunstler.ty.../

[Niko]

The problem with exports and a week dollar is that it works in the short term. Those that export, also consume, so after a while they will have to rise their prices just to stay even. So I would not count on them to provide more jobs in the near future. Also you could see some extra taxes in the future in order to compensate for the ones lost because of housing.
Rising population is not going to increase spending, but it may even reduce it. It is pretty hard to spend at Starbucks when you have an extra mouth to feed.
The market is very volatile right now, so it is very hard to peak a good stock, because there aren't many of them so everybody is trying a flight to safety.
BTW, don't bet on technology, very few will do well, and by few I mean one or two.

[vaduz]

exellent analysis. we will see lower lows than jan und march.