In November 2003, EXECUTIVE predicted that the revival in stocks would prove ephemeral (‘Happy Days?’, November 2003), stressing that technical and even fundamental factors would prevent a genuine new bull market from developing out of the ruins of the old. Furthermore, the dizzying move up from October 2002 appeared to be mostly a corrective move up within a secular bear market. After a sharp speculative blip in 2004, the stock indices have rolled over showing negative returns for the year, and leaving many Wall Street analysts and most economists quizzical. The reality is hope of recovery does not a recovery make. In fact hope, in matters of money, is a fatal ingredient.
What we are witnessing now is the return of the bear market in full force. Pundits and most commentators, especially ones that want to take your money away, seem focused on many issues to highlight that in their view, stocks are a decent investment at these levels. They go through a litany of reasons, and the talking heads of CNBC attempt to reinforce these views on a daily basis. Once again, do not believe the hype and look at some current themes, which seem dear to the hearts of those who advocate investing in stocks with reckless abandon and focus on the technical aspect of the market – ie, looking at the internal dynamics of price, volume, and sentiment. In that area, it’s quite simple: price has broken down, volume is abysmal, and sentiment is still way too hopeful that help is on the way. All three major indices are below their key 40 week moving averages. The recent Google IPO goes a long way to show that, despite the reduced pricing range, people are still keen on bubblenomics. As has been written AD NAUSEUM, for stocks to be truly making a long term bottom, the speculative juices need to be all but gone, investors should not be afraid to buy, valuations need to be at historical bargains, and there should be technical support. None of these factors exist, not by a long shot. With regard to arguments of valuation, a picture is worth a thousand words. The four charts depict various measures of valuation of stocks versus historical norms, going back in some cases to the early 1930s. As you can clearly see, we are nowhere near a level, which can be considered a bargain; in fact, we seem to be in a “Bubbble II” phase. Many things seem to be missing from the argument that the US economy is improving. It has long been held that the economic recovery was unsustainable and would begin to fade once the massive stimulus from fiscal and monetary policy receded. That appears to be what is happening now as evidence of widespread economic weakness continues to accumulate. While the vast majority seems so certain that we are merely going through a “soft spot,” the recovery may be faltering more seriously than expected. While the rising price of oil is being singled out as the major villain, it is more likely just a catalyst that is exposing an economy that was already beset with major structural imbalances that made a normal recovery cycle untenable.
The evidence of softening is no longer anecdotal, but is now widespread. Consumer spending was down 0.7% in June and up only 1% in the second quarter. June retail sales were down 1.1% and down 0.2% ex-autos. Year-over-year chain store sales in July were up only 3.1%, the lowest in a year. Mortgage refinancing that resulted in hundreds of billions of dollars of cash-outs are more than 80% off last year’s peak. July employment was up only 32,000 while the June number was revised down to 78,000 from 112,000. More importantly, in 32 months of recovery since the official recession bottom employment gains have exceeded 200,000 in only three of these months. If this were an average recovery, the monthly average increase should have been about 322,000 per month for the 32-month period. In addition, wages and salaries have made up an unusually low percentage of disposable income, meaning that consumer spending was heavily dependent on non-wage sources of income such as capital gains, rising home prices and tax refunds.
The list goes on and on. GDP was up 3.0% annualized in the second quarter, the lowest of the last five quarters. Construction spending was down 0.3% in June after rising 0.1% in May. Non-defense capital goods orders, excluding aircraft, were down 2.8% in the three months ending June 30. The Conference Board leading indicators were down 0.2% in June, while the smoothed annualized growth rate of the ECRI weekly leading index was up only 0.1, down 9 percentage points since April. M2 growth on a year-to-year basis was up only 3.5%, the slowest in nearly a decade. June industrial production was down 0.3% in the US, 0.7% in Italy, 1.3% in Japan, 0.3% in the UK, and 1.9% in Germany. These nations account for 60% of world GDP. The fragility of the economy is a result of the structural imbalances left over from the late 1990s bubble. These include the twin trade and budget deficits, the extremely low consumer savings rate and record consumer debt. These imbalances were not only uncorrected, but were actually exacerbated by extremely aggressive monetary and fiscal action since that time. With the stimulation winding down, the fragile economy is sensitive to any outside negative catalysts that come along. One cannot deny the importance of oil prices to the economy – considered the straw that broke the camel’s back – and that the current economic malaise is due to the underlying structural imbalances, which need to be resolved before a truly sustained recovery can get underway. While oil is obviously important, and short-term market movements have mirrored oil prices, any substantial decline in energy prices will not produce anything more than a brief rally. The irony of the current stock market situation is that with the market completely focused on oil prices, the possibility that such prices could peak and decline may have actually discouraged further selling, and may have kept stocks from collapsing. After all, if the Street believes that oil prices are close to a peak and the economy is in fine shape, why sell stocks? In this sense, it is a lot easier to blame the depressed market situation on a temporary oil price rise than to face the fact the economy has serious secular problems that are not subject to easy solution.
One of the most dangerous arguments, or advice, being put forward to encourage people to buy or stay in stocks is that there are no alternatives, and that cash is trash. The best way to address this point is by pointing out that most meltdowns in stocks (most recently the Japanese Nikkei collapse from 1989) occurred during a period of falling interest rates, and when the perception was that cash is not rewarding. Cash is not trash, it is the most relevant asset class in the current environment, especially that bonds are not too safe from a real, inflation adjusted, rate of return point of view. As for all you Nasdaq lovers, comments by tech managements are so numerous and so much alike in their analysis of conditions that the disappointments have to be industry-wide rather than company specific. From a technical perspective, see the chart below. Individual investors should play it safe, as stocks are highly vulnerable and the downside shock could occur at any time.