Economic and Market Headwinds

The S&P500 went almost nowhere last week, see-sawing every day to finish 0.04% higher by the end of trading on Friday.  The VIX (or fear) index rose almost 2%, suggesting that the current prices are being insured against a possible drop.  Volume fell, also not supporting the slight price rise.

The week’s economic data were mixed.  Consumer credit fell, again, but less than expected.  Initial jobless claims jumped more than expected.  Continuing claims were lower, as they have been for several months.  But these 5+ million of insured unemployed are not rolling off this benefit program because they’re finding jobs; instead, they’re shifting, in droves, to the emergency unemployment claims program.  When these programs are combined, the actual total is at record highs.  Retail sales rose more than forecast but less than it did in the preceding month.  And consumer sentiment rose as well.

Technically, the daily charts have a bearish bias.  Last week, prices literally stalled at levels lower than prices reached several times over the preceding four weeks.  On the weekly charts, the S&P is also continuing to bump up against the 1,100 resistance level first reached in October.  The two-year bear market downtrend, on the monthly charts, is still holding.

As the year draws to a close, it might be useful to re-examine the big picture, secular forces that U.S. equity markets will face over the next several years.  While the S&P has bounced off decade low prices earlier this year, we must not lose sight of the long-term forces that will affect the market going forward.  And most of these forces do present a headwind–almost exactly the opposite of the tailwind forces that helped propel the equity markets since 1982.

First, regulation will rise again.  Financial, climate related, and other regulations will increase starting as early as 2010.

Taxes will almost surely rise.  The accumulated federal debt and ongoing budget deficits will need to be paid down and reduced, respectively.  State and local taxes will also rise as non-federal governments struggle to get budgets back under control.

Global trade, which has virtually collapsed over the last 18 months, will struggle to grow again.  Already, major trading nations (including the U.S., Japan and China) are engaging in unofficial currency wars to promote their respective exports.  But as more nations engage in such beggar thy neighbor policies, all trade will suffer.

Consumer spending will not roar back at former growth rates.  As consumers in the U.S. (the major engine of economic growth for the nation over the last 20 years) struggle to de-leverage, they will certainly not have the capacity to spend through borrowing as they did 10 and 20 years ago.

Consumer spending will also suffer because unemployment in the U.S. will stay at elevated levels for many years.  Currently at 10%, unemployment (U-3) could rise to 11% or higher before starting to drift lower at the end of 2010 or even 2011.  But the drift lower could take it down to only 8% over five years, because millions of the jobs lost in this recession will never come back.

Corporate investment spending will also languish for many years.  With so much idle capacity already, businesses will have little reason to boost capital expenditures when final demand will not bounce back quickly.

Finally, as federal government spending becomes a larger part of the nation’s economy, the added borrowing will eventually push up interest rates, hurting the spending capability of businesses and consumers.

Put these forces together and a grim picture emerges.  Even if our nation manages to avoid another financial crisis, the economic growth rate will structurally slow down.  This means that corporate profit growth will also slow down and that the ratio of corporate profits to GDP will drop.  Lower earnings and lower earnings growth mean that valuation multiples ought to come down as well. 

And lower P/E multiples together with depressed earnings strongly suggest that the S&P will have a hard time surging much further.  In fact, if the markets discover that these secular forces will prevent the return of the Goldilocks economy, then the S&P could correct sharply.

It might take a while, but the odds are fairly high that these headwinds will espress themselves eventually.

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