Tick Tock….

October 24, 2009

The S&P500 slid about 0.75% last week in a string of seesaw trading sessions.  Volume, in this down week, was greater than in the preceding two up weeks.  And volatility inched back up, although it is still near 52 week lows, suggesting that complacency is beginning to set in.

The economic data  were mixed to weak.  Housing permits and starts came in much weaker than expected–both fell when they were both expected to rise.  Producer prices were lower than projected, suggesting that there is little inflation in the goods and services pipeline.  Jobless claims jumped up to 531,000 when they were expected to drop to 519,000.  Leading indicators were slightly stronger than expected.  Existing home sales, boosted by the federal tax credit for first time home buyers, rose 9.4% m.o.m. on a seasonally adjusted basis; on a raw, unadjusted basis they actually fell 5% m.o.m.  Unfortunately, median prices continued to fall (dropping 8.5% on a year-over-year basis) implying that any stabilization in UNIT volume sales does not translate into a PRICE stabilization.  The bottom in home prices has NOT been reached.

Technically, the S&P is turning bearish on a daily basis.  Numerous price indicators are suggesting that the rally is running out of steam, and up volume has been consistently lower than down volume.  From a weekly perspective, the S&P is still maintaining its uptrend, but here too, the strength of the up moves is diminishing.

The Economist, this week, featured a good news, bad news piece on America’s upcoming debt crisis.  It began by quoting Harvard economics professor Ken Rogoff who warned that “There is every reason to worry that the baking crisis has simply morphed into a long-term government-debt crisis”.

The Economist focused its analysis on the reasons why such a “crisis” need not be acute, or catastrophic.  Instead, the author of the piece argued that this crisis ought to be chronic, as though our nation will be suffering from a type of debilitating obesity over many years, rather than from an acute, or fatal heart attack.

The problem with the piece is that the author ends his analysis by outlining–inadvertently–the many reasons why our particular type of obesity could be especially dangerous:  40% of our national debt matures in less than one year (subject to rollover risk); our likely deficit trends imply that we will get much fatter over the next ten years than we already are today (government debt to GDP will balloon past 100%); our government debt will crowd out private investment (dragging down GDP growth that would otherwise help pay down debt) and steal away a growing portion of the federal budget to pay interest (diverting funds from social services); our devaluing dollar won’t necessarily boost GDP by pushing up exports (our trading partners are sick themselves and exports don’t make up as much of our GDP as they do in other economies); half of our debt is owed to foreigners (unlike Japan’s debt which is mostly owed to more tolerant domestic citizens).

Still, the author concludes that–despite all the reasons above–America’s battle with debt-obesity will be merely protracted and uncomfortable.

Unfortunately, that’s akin to claiming that a morbidly obese person will have more a “burden” than one who’s simply obese. 

Instead, critical observers would rightfully counter that a morbidly obese person should be less concerned about losing a couple of pounds over the next few years, but more about dropping dead from a heart attack tomorrow.

No, although we hope that we can slowly work off our excessive weight, the markets may not be so tolerant.  Confidence can disappear very quickly, as we’ve learned over the last 12 months.  If our nation keeps packing on the pounds, we increase the odds of suffering from fatal coronary–and much sooner than than later.

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Dow at 10,000 or 7,500 or 3,333

October 18, 2009

The S&P500 creeped up 1.5% last week.  Volume was very light when compared to the average weekly volume over the course of the year.  And the VIX, or fear, index dropped for the week, even though the long-term basing pattern (that began in the summer) was maintained.

The economic data were mixed.  Retail sales fell 1.5% for the month, but not as much as expected.  Business inventories fell more than expected.  Core and headline CPI was higher than expected; both came in at 0.2% vs. the 0.1% consensus.  Weekly claims were 514,000 but the prior week’s claims were revised higher.  The Empire State Manufacturing survey was better than expected, but the Philly Fed Survey was worse.  Industrial Production was stronger.  And consumer sentiment fell unexpectedly.

Last week, the Dow Jones Industrial Average crossed back over the 10,000 level last week.  Because the public loves the Dow as a measure of the stock market’s strength, the mainstream media touted this event.

But here are a few caveats.

The first time the Dow crossed above the 10,000 level was in 1999.  On a nominal basis, the Dow has gone nowhere in 10 years.

Then consider the depreciation of the dollar (against a basket of other currencies in the DXY index).  The U.S. dollar has lost about 25% of its value since 1999.  That means that on a constant dollar basis, the Dow’s 10,000 is actually equivalent to about 7,500.  Not so hot.

But what’s really frightening is today’s Dow value expressed in terms of ounces of gold.  In 1999, the Dow at 10,000 converted to about 30 ounces of gold.  Today, the Dow at 10,000 converts to only about 10 ounces of gold.  That’s a whopping 66% loss in gold terms, or the Dow at 3,333.  Ouch.

Finally, consider the other macro and policy factors.  Today’s unemployment at almost 10% is expected to rise and stay near 25 year highs for all of 2010.  So consumer spending is falling, which will put continuing pressure on corporate sales and profits.  Consumer, corporate and government debt loads are at record highs and must contract.  Consumer and corporate debt has already started to drop; federal government debt is still growing but is approaching the breaking point.  All this credit contraction will also put pressure on corporate sales and profits.  And monetary stimulus is about to decline; the Fed’s Treasury purchase program (quantitative easing) will end next week. 

Put it all together and you get a set of competing scripts where the stock market (and Wall Street) is saying one thing, yet the real economy (and Main Street) is saying something totally different.  

Very soon, we will learn which one of these scripts is representing the truth and which is misleading.


Dancing Near the Exits

October 10, 2009

The party doesn’t seem to want to end.  And until the Fed takes away the punchbowl, it really shouldn’t end.  On extremely low volume, the S&P500 jumped 4.5%. 

There was very little economic news, and most of it was weak.  The ISM non-manufacturing index came in slightly less than expected at 50.9.  Consumer credit fell by $12 billion, even though the Cash for Clunkers program added billions of dollars of consumer installment debt.  Initial jobless claims were 521,000, which was slightly better than forecast but still solidly in the dismal 500,000 range. 

The technicals still point to a topping formation on the daily charts.  The uptrend in the weekly charts continues, although it is suggesting a topping pattern as well.  The long-term monthly downtrend that began in the fall of 2007 is still in effect.

After touching on the various reasons why the equity markets are levitating, it would be useful to examine the actual valuations today relative to valuations in prior periods.   Are today’s valuations cheap, fair or expensive?

David Rosenberg, who spent 20 years at Merrill Lynch, tried to answer this question in a paper he published last week.

Using trailing operating earnings, the S&P500 now trades at a 28x multiple, up 10 points from the March lows.  But according to David, the economy begins expanding (as it probably did in Q309), it typically trades at a 15x multiple.  So today’s P/E is almost 100% higher than in past economic turning points.

Also, David points out that the trailing as-reported P/E is almost 140x, which is three times higher than the P/E at the peak of the tech bubble. 

He states that “going back 60 years, there have been only 14 months when the trailing multiple was as high as it is today, and that covers 10 recessions.  This implies that the market is in the top 2% expensive terrain historically, and those other times basically covered the tech mania of a decade ago.”

David goes on to review the dividend yield, the forward earnings multiple, and the price-to-book ratio.  On all counts, the S&P500 is extremely overvalued relative to other historical periods.

He concludes with the reminder that 60 years of historical data suggest that “the market typically faces serious valuation constraints once it breaches the 25x P/E multiple threshold.  The average total return a year out for the S&P500 is -0.3% and the median is -6.2%.”

So as many traders and investors continue to dance at the party thrown by the Fed, the wisest ones are keeping an eye on the exits.  They’re convinced that when the music stops, they’ll be the first ones to dash out the door, making a clean escape from the carnage left behind. 

Unless, of course, they all get trampled before reaching the door.


Japan: Coming to America?

October 4, 2009

The S&P500 dropped a second week in a row, this time almost 2%.  The VIX, or fear index, soared almost 12% suggesting that traders are willing to pay more for insuring against downside losses.  Volumes also rose, providing more support to the direction of the price movement.

The economic data were mostly poor.  Consumer confidence fell, when it was expected to rise.  Chicago PMI also dropped after economists had projected an increase.  Personal income and spending were both up slightly, month over month.  Unemployment claims rose to 551,000, above the consensus.  After the expiration of Cash for Clunkers, September auto sales collapsed–suggesting that natural, unsubsidized demand is very low.  September non-farm payrolls were much worse than expected: they jumped to -263,000 from -216,000 in August.  Consensus estimates called for a loss of only 170,000 jobs.  The unemployment rate rose to 9.8%, the highest since June 1983.  Hourly earnings fell more than expected and average weekly hours worked also fell back to the lowest level ever recorded (33.0).  Even worse, the most broad measure of unemployment (U-6) rose to 17.0%, the highest level recorded in this data series.

Technically, the S&P500 is topping, on the daily charts, from an extremely overbought level.  It also showed very strong bearish divergence:  prices rose to higher levels yet may underlying technical indicators did not rise to equally higher levels.   On a weekly basis, the S&P is also toppy and showing signs of weakness.  On a monthly basis, the downtrend that began almost two years ago is still in effect, although barely.  If prices continue to back away from the mid-September highs, the downtrend will have re-asserted itself.

In August of 2008, The Economist published a piece titled “Lessons from a lost decade” where it highlighted the eerie similarities between the economic prospects for America and the stagnation of Japan after 1990.  Both had housing bubbles that burst.  Both had strong monetary responses to these bursts.  Only one, Japan had a stock market crash.  Only Japan initiated quantitative easing (printing money).  And only Japan avoided the clean up of the banking system’s toxic assets and the explicit deleveraging that is associated with it. 

In conclusion, The Economist warned that “by learning from Japan’s mistakes, America can avoid a dismal decade.  However, it would be arrogant for those in Washington, DC, to assume that Japan’s troubles simply reflected its macroeconomic incompetence.  Experience in other countries shows that serious asset-price busts often lead to economic downturns lasting several years.  Only a wild optimist would believe that the worst is over in America.”

Then the U.S. stock market crashed. 

Then the U.S. initiated its own massive quantitative easing program.

Then the U.S. began to systematically avoid the clean up of toxic assets from its banking system.

Twenty years after the Japanese housing and stock market bubbles burst, the economy is still in the doldrums.  Unemployment is at record highs.  The stock market is still 75% off peak.  Japanese sovereign debt has reached 200% of GDP.  After almost 50 years of rule, the LDP led government fell. 

And yet, Japan has several advantages over the U.S.  1)  Over 90% of its sovereign debt is funded from its own citizens who saved a large portion of their incomes.  2) Japan, during the last 20 years of stagnation, was able to generally maintain a positive balance of trade, thereby generating income from abroad.

The U.S.?  Nope and nope.  We rely on other nations to buy a huge chunk of our sovereign debt; and lately, we’ve relied on the Fed to print money and monetize our debt.  Also, the U.S. has generally maintained a negative balance of trade, thereby borrowing more capital from abroad to finance its deficit. 

So fourteen months after The Economist published its piece, the U.S. finds itself staring at an ugly reality–Japan and the Japanese experience. 

Is Japan coming to America?  Arguably, it’s already here.  Let’s hope things don’t get even worse.