Strong price action is impossible to ignore. While analyzing fundamentals and looking at data is important, the market can always stay irrational longer than most traders and investors can stay solvent.
The S&P 500 and its tracking exchange traded fund, (SPY), has rallied over 20% from the lows of last year, and nearly 12% since early June. Market leaders in cyclical sectors such as GE (GE), Caterpillar (CAT), and Citigroup (C), have also rallied over 10% in the last several months. Technology stocks such as IBM (IBM) and Apple (AAPL) have rallied very hard as well.
Still, the economic data has continued to deteriorate over the last month, with unemployment rising in July, and most leading manufacturing and service data continuing to be weak. Europe and Asia continue to be particularly weak as well, with Germany recently reporting PMI at a six month low, and Japan recently reporting just a .3% GDP growth on a sequential basis. China's recent export numbers and PMI data have been very weak as well.
Draghi's statements and the follow-up comments made by key members the European Central Bank's governing council continue to suggest that ECB is likely to take new and aggressive action to lower the PIIGS short-term borrowing costs in the next several months. Hope that Bernanke will at least talk about stronger potential stimulus initiatives at Jackson Hole remains as well.
The first reason the recent rally is likely to end this month is because the ECB remains significantly constrained by the central bank's limited mandate and inability to build a political consensus. The ECB's mandate is limited to controlling inflation, and the central bank has very limited authority under its existing charter agreement to pursue pro-growth and stimulus policies. While Draghi and the ECB governing council continue to suggest that the central bank has sufficient authority to pursue significant new policy initiatives, the ECB still faces significant political opposition from Germany and other important EU member states as well.
While countries such as Spain have recently been more receptive to widening the use of the ECB's bailout funds, Germany continues to oppose issuing Euro bonds or the direct purchase of long-term sovereign debt. EU member states such as The Netherlands and Finland also continue to oppose more direct use of ECB funds to recapitalize banks as well. Draghi has repeatedly reiterated his intention to focus on the short-term borrowing costs of the PIIGS, any major new policy initiative that does not force the PIIGS to restructure long-term debt is unlikely to significantly lower the short-term borrowing costs for these troubled nations. With recent GDP data suggesting many EU nations are already in a recession, Draghi's inability to take strong near-term action likely suggests that significant political opposition to new and more aggressive monetary or stimulus action remains high.
The second reason the market rally is likely unsustainable is because the market lacks leadership. While Apple (AAPL) continues to make new highs, most cyclical companies in sectors such as energy, the industrials, and the financials are moderately to significantly overbought. While cyclicals have been the strongest performing stocks over the last several months, market leaders in the industrial sector such as GE and Caterpillar are trading at growth multiples even as these companies' earnings growth rates continue to slow. GE trades at 12x average estimates of next year's likely earnings despite recently reporting earnings growth of nearly 6%. Caterpillar trades at 8x average estimates of next year's likely earnings despite reporting minimal sequential growth over the last several quarters and issuing very weak guidance. Caterpillar also reported record profits just last year.
The third reason the market is likely to sell-off in the coming weeks is because the growth outlook in China and most major emerging markets will likely continue to deteriorate as well. While crude oil has rallied nearly 20% since late June, demand for energy and most major commodities remains weak. Iron ore prices recently hit a new three year low in late July, and recent economic data coming out of Asia has deteriorated significantly in the last couple months. Japan reported anemic economic growth this past quarter, and China's recent export data show flat export growth. China is the largest importer of crude in the world. China's real estate and infrastructure is significantly overbuilt, and the country's heavily in debt regional banks continue to loan less each quarter.
Most major industrials companies reported strong growth in North America in the first quarter. Still, the U.S. economy has slowed significantly in recent quarters, and the growth outlook in emerging markets has deteriorated significantly in the past several months. While nonresidential construction demand in North America drove significant earnings growth of key industrial companies such as Caterpillar and engine maker Cummins in the first quarter, these companies have issued very cautious recent guidance and lowered forward estimates as well.
To conclude, the market has consistently rallied over the last several months on aggressive statements by the ECB, but the economic outlook continues to deteriorate. China and Europe both continue to aggressively talk about new stimulus policies. Still, China's leadership will not change until next year, and the ECB faces significant political opposition to potentially more aggressive policy initiatives as well. Equity valuations have remained appealing while market sentiment has been fairly pessimistic over the last several months. With traders more bullish at almost any time this year, short positions likely significantly reduced in the last couple months, and many cyclical stocks trading at or near fifty-two week highs, the market will likely have difficult moving higher in the short-term.
