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Don's Outlook: Competing for Capial

 

A slowing market rally was hit by a decline in April retail sales this week. The S&P 500 Index tumbled 2.69 percent and investor optimism appears to be shaken. Financials and retailers, two sectors that led the market higher, reversed course on Wednesday.

 

Economic data hasn’t turned for the worse. In the midst of a global recession, lower retail sales, higher foreclosures and other disappointing results should be expected. After the rapid drop in equities earlier this year, investor sentiment declined until it bottomed in March. Equities were cheap, with a decent number of companies, mostly small capitalization stocks, trading for less than their net cash. Financial companies were feared to be on the verge of bankruptcy and even General Electric’s viability was in question.

 

Fast forward a couple of weeks. Bottom-fishers, value hunters, contrarians, et al, pushed stock prices higher. The S&P 500 Index gained more than 20 percent off its low in just two weeks, but many stocks had far greater rallies. Citigroup gained 200 percent off its low in a week and Bank of America jumped 100 percent in six days. After talking of a dire recession that could last years, President Obama reversed his rhetoric following the passage of his stimulus bill. Recovery was the watchword, and Ben Bernanke echoed the positive assessment.

 

The mood of investors went from extreme pessimism to hopeful optimism in short order. Mild improvements in the economic data were viewed as the beginning of a recovery before any corroborating evidence surfaced. Even negative economic data that showed a contracting economy was viewed positively by the press and some investors because it showed a slower contraction.

 

Events underneath the surface of rhetoric and headlines show the economy remains in a difficult state. An article in Bloomberg today explains the type of issues facing companies. “The highest inflation-adjusted borrowing costs since the 1980s are hindering U.S. companies’ ability to build their businesses.” Americans did not save enough for a decade and depleted the nation’s capital. It will be difficult for business and consumers to obtain credit until the “lost” savings are replaced.

 

By itself, the lost capital is a drag on the economy. Additionally, emerging markets will compete for savings with their higher returns, while the U.S. government’s massive budget deficits gobble up all the U.S. savings for the next few years. Never before have business and consumers had to simultaneously compete with three billion new capitalists of the developing world and the major governments of the developed world. While the economy may stabilize and the contraction may stop, stagnation may be the in cards for several years until these headwinds abate. And if people decide that business and consumers are a better investment than the U.S. government, inflation rates will make Americans long for the 1970s.

 

Pessimism might creep into the market now, but the rally of the past two months showed the power of investor emotion.  If investors remain optimistic, they will not derail this rally until the underlying economy deteriorates—and that may not happen. Stimulus spending and Federal Reserve intervention may be enough to stabilize the economy, albeit with the risk of greater inflation. Furthermore, a drop of nearly two hundred points on the S&P 500 Index would still leave the market above its previous lows and would only constitute a correction of the rally, not a reversal.