World of Pain

January 25, 2009

The slow erosion continued this week:  the S&P slid another 2% making this the third down week in a row.  Even worse, the low point approached 800,  only 60 points away from the November bottom.  Supporting the price drop, volatility inched up for the week as well. 

The economic data was limited, but still downbeat:  building starts and permits touched multi-decade lows, weekly jobless claims spiked and continuous claims crept higher. 

The big news was corporate earnings.  Major names from the Dow and S&P disappointed: Microsoft, US Bancorp, GE, Capital One, and State Street reported poor Q4 results, and more importantly, pessimistic guidance.  Microsoft announced thousands of layoffs, something it didn’t have to do when the tech bubble blew up earlier in the decade.

Even the winners, like IBM, admited that things weren’t so rosy: although IBM’s earnings beat expectations, it benefited from a one-time lower tax rate and suffered from a 6.4% revenue drop.  Quietly, IBM has begun to layoff employees.

Around the world, ominous signs are building.  The official slowdown in China’s growth rate may be even worse than officials care to admit.  According to Nouriel Roubini, China is in recession.   South Korea is reeling, and Japan is staring at a recession more severe than any since its bubble burst in 1990.

Britain is officially contracting and the pound fell to a 24 year low against the US dollar.   The British government may nationalize several major banks after they reported massive losses bringing them close to insolvency.  Germany is contracting.   The original BRIC nations are being displaced, in the headlines, by the PIIG’s:  Poland, Iceland, Ireland, Greece and Spain.  Iceland is essentially bankrupt; Ireland’s sovereign obligations have ballooned, and both Greece and Spain were downgraded by Standard & Poor’s.  Not to be outdone, Italy’s national debt levels are soaring and France’s woes are growing:  unemployment is rising as are social tensions.

In many past downturns, when one developed nation suffered a major contraction, there were usually others, with healthier economies, to which the sick nation could turn to for support.  Not so today, when it seems as if the entire globe is circling the drain.

On Thin Ice

January 18, 2009

Another week, another 4.5% drop in the S&P500.  According to Barron’s, the S&P’s 2009 performance, to date, is the fifth worst start since 1927.  Not a good sign.

What changed this week?  Not the data–we witnessed the same parade of bad economic news that’s been  streaming out since the late November market lows were hit.  This week, retail sales, initial claims, core CPI, industrial production and the Fed’s Beige Book all painted the same, dreary picture:  the economy is bad and getting worse.

So nothing concrete has changed.  Simply put, investor and trader sentiment became more bearish.  As expected, consensus aggregate earnings estimates are rapidly coming down, to $65-$75, and could easily be lowered more.  And without better signals that the economy and earnings will rebound at the end of 2009, the markets ought to push down the multiple assigned to these earnings. 

Still, today’s price level, already lowered from 930 to 850, is assuming a reasonably strong rebound at the end of 2009.   Perhaps traders are beginning to lower the odds of a rebound?  At least, they’re not blindly jumping on the Obama hope bandwagon throwing all caution into the wind. 

After a lot of focus on the fundamentals, economic and corporate, over the past few weeks, what can the technicals tell us?  Interestingly, on Bloomberg’s home page last week, two long time technicians (John Murphy and Ralph Acampora) outlined the downside risks.  Many traders think of the November 2008 lows as a critical test level–a level roughly equal to the lows of the 2002-2003 bear market bottom.  Traders expect the market to approach these levels sometime in 2009.  The point:  if the market breaks through these lows decisively, then the next stop will be much lower–close to 600 on the S&P.  From a technical point of view, once these support levels get broken, there’s no strong support level near the break point.  Technical traders would have to look back to levels in the mid-1990’s to find the next rung on the ladder.

Coincidentally, a low 600’s S&P reading would fit neatly with a low $60’s S&P earnings  figure and a 10x multiple–earnings and and a multiple one would expect in a situation where the Obama-led fiscal stimulus doesn’t generate the hoped-for recovery in the hoped-for end of 2009 time frame. 

Cross your fingers!

Lessons from History

January 11, 2009

The Santa Claus rally lost its legs this week, after the S&P dropped 4.5%.  Technically, however, the uptrend that began in December is still intact–on both a daily and weekly basis.  This week’s slump wasn’t big enough to break it.  But another significant decline next week, if it happens, could do it. 

The week’s economic data was dominated by jobs, more to the point, job losses.  The unemployment rate spiked to 7.2% (the highest since 1993) and December nonfarm payrolls lost 524,000 jobs.  Almost lost in the background were miserable reports on December auto sales, factory orders, pending home sales, and consumer credit.

For the current uptrend to march on, investors will have to continue to shake off this never ending bombardment of bad news.  Some short-term traders are looking for a psychological lift from the Obama inauguration to maintain upward pressure on prices.  Will this work?  We’ll see.  But it’s safe to say that the traders will be the first to run for the exits if the uptrend fades. 

Many investment pros are still waiting on the sidelines with lots of cash, looking for some signal that the ongoing global economic collapse is at least showing signs of decelerating.   Today, no such signal exists.   This suggests that the equity markets will not rally sharply in the near term.  The more plausible scenarios are: 1) rangebound or sideways action, or 2) another leg down if corporate outlooks disappoint and the economy continues to slide in the face of existing monetary stimulus and upcoming fiscal stimulus.

How likely is the economy to continue to suffer?  And how much further could it slide?  Kenneth Rogoff and Carmen Reinhart, studying asset and credit busts over the last 100+ years, uncovered some bad news.  On average, housing prices fall 36% (peak to trough) in real terms (perhaps more in nominal terms) and take 5 years to do so.  Equity prices fall 56%, taking 3.4 years to get there.  Unemployment rises 7% over 5 years and GDP contracts by over 9% (per person) over 2 years. 

This suggests that we might be far from seeing the worst of the crisis.  Housing can fall another 15+% from peak; equity prices, another 15+% from peak; unemployment could reach 11-12%; and GDP could plunge another 8%, from here.

If anything like this happens, then the monetary and fiscal stimulus that today’s equity prices depend on would have failed.  Unfortunately, history suggests–strongly–that this can occur. 

Almost all leading economists are admitting that there is no guarantee that the current monetary and proposed fiscal programs will work.  What’s even more scary is that there is no Plan B. 

That means that there is a reasonable possibility that the U.S. and global GDP shrink by 5- 10%, or more.  To say that this would put the entire system of capitalism at risk would be an understatement.   In this scenario, the continuation of the bear market would be the least of our problems.

From Spending to Saving

January 4, 2009

The much anticipated Santa Claus rally finally arrived, only a bit late.  The S&P500 jumped 6.8% for the holiday-shortened week, on low volume.  As usual, the bad economic data kept pouring in:  Case-Shiller home prices dropped sharply, consumer confidence was lower than expected, and the ISM number plunged to its lowest level since 1980.  And around the globe, gloomy manufacturing data pointed to worsening economic conditions.

But that didn’t stop the market pundits from declaring a market bottom (yet again) in the prior November and from promising rosy results for the equity markets in 2009.  The major reasons behind the cheerful forecasts were: 1) the bad economic data is already baked in to the prices, 2) with the Fed throwing everything but the kitchen sink at the economic crisis, and now that the new administration, with Congress, will throw a massive fiscal stimulus at the problem, the economy and the markets should recover.

What’s odd is that many of these same prognosticators declared that the U.S. economy would slow down (but not fall into recession) in the first half of 2008 and then bounce back–with the help of the $150 billion stimulus package–by the fourth quarter of the year. 

OK, so they were a little off the mark.

So let’s consider another, alternative scenario for 2009.  What if, as the data suggests is already happening, the U.S. consumer suddenly decides to save?  Scared by the 20+% drop in housing prices (so far), the 40% drop in equity values in 2008 alone, and the ferocious acceleration in layoffs and unemployment, the U.S. consumer may finally snap out of a decade long spending spree, where U.S. savings rates fell to zero, and household indebtedness soared.

Let’s say consumers decided to save only 5% of their incomes, a level below their savings rates in prior decades, and a level far below the current savings rates of other developed economies (eg. Germany or Japan).  If we’re starting at a zero savings rate, then we can assume that incomes equal spending.   And if spending accounts for almost 70% of U.S. GDP (about $15 trillion), then we have almost $11 trillion of income that’ll be available to save.  So saving 5% means that consumers would stop spending over $500 billion per year–starting right now.

If the new fiscal stimulus creates a total of $1 trillion in spending over the next three years, then the U.S. consumer’s pullback alone could overwhelm the new government spending.  Keep in mind that reduced U.S. business investment and reduced exports (due to a recently strengthened dollar and weaker foreign demand) would also act to push down aggregate demand in the U.S. economy in 2009.

But please don’t tell that to the market pundits.  This will be our little secret.