Last issue we covered some of the questions that we believe are key when working with an investment advisor. Periodically we devote an issue to the current state of the stock market and how an inflection might be at hand. It feels like we have written one of those issues every month this year. In reality the tenuous nature of the domestic economy and recovery makes every overbought/topping process appear perilous.
Stocks looked to be sitting on a precipice in late August with the often scary months of September and October looming. On the last day of that month the FOMC minutes were released and Fed head Ben Bernanke alluded to the strategy of another round of quantitative easing (QE2). This is a process where a central bank will create money (done electronically, not with a printing press) and purchase securities. These are mostly government related securities and the intent is to bring liquidity and confidence to the markets and economy. That day, August 31st, the market bottomed and since then the major indices have climbed steadily with the S&P 500 gaining 14% and the Nasdaq 100 a remarkable 20%.
Frankly we are somewhat skeptical of the effect QE2 will have on the economy as we believe the economic challenges revolve around demand and not necessarily liquidity. With the consumer on a major deleveraging drive and corporations already flush with cash we are concerned that the process could cause another asset bubble in stocks, bonds, and/or commodities. Well we guess we are sure they know what they are doing in Washington? We plan to write about this topic in detail next time.
With much of a productive earnings season behind us and several internal indicators revealing fatigue within the indices, We thought this might be an opportune time to do the Ben Franklin ledger of positives and negatives regarding the current state of equities. First the sunshine side of the ledger:
Corporate Earnings and Balance Sheets - We are all aware of the slimming down of expenses by most companies (we heard someone describe it as anorexic) and the fattening up of cash to handle any unforeseen events. If Washington becomes more business friendly, corporations gain some visibility, we might see a deployment of that cash leading to increased revenues and possibly an earnings explosion. Long term equities tend to respond to sustainable earnings in a positive way.
Foreign Impact - The globe’s growing middle classes could spur some economic growth. We sense that the falling dollar may be orchestrated so our multi-national firms can sell goods to this demographic.
Innovation Boom – Some have commented that a boom with communications and the Internet is in the wings. We have not seen any strong evidence of this yet, but if it occurs it would obviously be beneficial.
Managers Behind The Curve – Many institutional money managers are trailing the major averages from a performance standpoint and the drive for year-end bonuses could see an increased appetite for equities. Many believe this occurred a year ago and was a factor for the strong 4th quarter performance.
High Dividend Payers – Many stocks have yields higher than the Ten Year Treasury and with the possibility of growing those dividends make this class of equities appealing to many investors.
Election Results – A broad dismissal of those entrenched on both sides of the aisle could spur optimism. As we mentioned some clarity on taxes could spark capital expenditures by corporations.
Quantitative Easing – If the above factors do not play then the Fed is hoping this will save the day. Could this be their last bullet? On the more challenging side of the ledger we have several regulars and a couple of new additions.
Unemployment – Not much has changed on this front and a recovery in corporate earnings and equities can occur without job growth although economic sustainability has a higher probability with it.
State Budgets – It seems the elections have brought a spotlight to the deficits and the apparent widespread mismanagement. Without Fed help the road back could be a long one for many states.
Mortgage Mess Multiplies – A recent wrinkle to the woes of the housing industry is the revelation that many institutions were less than forthright in the foreclosure process (imagine that). A delay in the foreclosure process could delay the bottom in housing. Another interesting new wrinkle is that several institutions are demanding sellers of securitized mortgage products, such as BofA, reimburse them fully for these products for failure to accurately disclose the quality of the mortgages.
Dollar Bottoming – As you can see the US Dollar has been essentially in a San Diego Charger like free fall. Against a basket of currencies the index has fallen over 12% in less than five months. There are signs of bottoming here with the MACD appearing to want to lead the currency higher. It has been unusual, but stocks and the $ have had a strong inverse relationship for the last several months and a rally in the $ could put the skids on the market rally. Historically the two move more in tandem.
China Real Estate Bubble – Another newbie to this side of the ledger. Some analysts have equated the current Chinese real estate market to the likes of Florida’s in 2006. They showed a picture of a modern shopping mall that is virtually empty of retailers, it’s called the Great Mall of China (here is a link to a related article). If China experiences a similar bursting real estate bubble as Japan did in the nineties and the US did the last four years, it could obviously affect the global economy.
A couple of other challenging issues we follow closely are the aforementioned overbought readings in the market’s internal indicators and the bullish readings many of the sentiment polls are currently flashing (a contrary indicator indicating complacency). This has easily been the most mystifying market we have observed in the fifteen years we have been watching closely (most technicians we think will echo that). In the macro the mystery is what attracts us to this vocation, in the micro sometimes it “kinda sucks.”
Our best guess for the intermediate term at this point is that we have a mild correction and if the fourth quarter earnings continue along the same path the market might be able to climb significantly higher into the New Year. Remember at the top in 2007 earnings outlook was constructive. The market tends to rollover before the earnings do and tends to rise before the earnings do. This is certainly a time where the ostrich strategy is probably ineffective. Unfortunately vigilance may be the watchword for a while.
Did You Know
STOCK HISTORY - 81 years ago this week the stock bull market of the 1920s collapsed. A 5-day trading panic began on Thursday 10/24/29 and culminated with the infamous “Black Tuesday” (10/29/29), historically thought of as the start of the Great Depression. In the 114-year history of the Dow Jones Industrial Average, Monday (10/28/29) and Tuesday (10/29/29) of that week rank # 2 and # 3 on the list of greatest 1-day percentage drops for the index. There have been 10 bear markets for the S&P 500 since 1957 (defined as a peak-to-trough decline of at least 20%). 6 of the 10 bear markets ended during the month of October (source: BTN Research).
Final Thought
“Be thankful we're not getting all the government we're paying for” - Will Rogers
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