Market Temperature Update

The S&P500 rose 1.8% last week on declining volume. Volatility dipped slightly. And the percent of stocks, in the S&P, that are above the 150 day moving average inched up but barely.

What’s interesting is that the US stock market—unlike most every other major stock market in the world—is rising in the face of deteriorating macro data. Lately, the worse the macro news, it seems, the better the US stock market performance. Why? Because in the US, investors have been conditioned to believe that the Fed will always “be there” to save the day, with more quantitative easing, another operation twist, or whatever it takes. So when the economy stumbles, the markets cheer because surely the Fed will print more money and make everything OK. Of course, should the economy roar back to life—something it has NEVER done since the Great Recession supposedly ended in mid-2009—then the stock markets would love that too.

Investors have been trained to believe that they simply can’t lose.

Apparently, the 2008-09 meltdown must have been an aberration, something that is best not mentioned. Because today, of course, something like that could never happen. This time is different.

We’ll see.

In the meantime, back to the macro numbers. The Case-Shiller home price index was disappointing. Home prices fell more than expected in the 20 city index. New home sales fell from last month. Durable goods orders—both headline and ex-transportation—were a disaster, both falling far more than expected. Initial jobless claims were far worse than consensus estimates. And finally, real GDP rose far less than expected. And that’s with a generously low deflator that boosted even this disappointing figure; using a more honest (larger inflation deflator) would mean that real GDP did not grow at all.

Technically, the S&P500 is still below the highs reached in late March, and as long as that remains true, the downtrend is still in effect. Breadth has not jumped, despite last week’s price rise. And many other correlated markets are pointing down—industrial metals, Treasuries, and international equity markets.

So where do we stand at the end of April?

US stock markets are overbought and overvalued. Not coincidentally, this is almost exactly where they were in the spring of 2010 and 2011. What happened then? In each prior spring, a Fed easing program ended……and markets promptly tanked.

This year, another easing program is scheduled to end in June: Operation Twist. And there is very little reason why this year US equity markets will behave differently.

In fact, one can argue that there are several new dangers that lie ahead…..dangers that did not exist in either 2010 or 2011.  First, in the US, there’s a fiscal cliff that’s fast approaching. At the end of 2012, several major spending programs are scheduled to end; and several key tax rates will be going  up. Second, the European situation is fast deteriorating. While the crises over the last two years revolved around relatively small periphery states (think Greece), the crisis is now spreading to the larger states (think Spain and Italy). And it will be almost impossible to sweep Spain’s problem under the rug, as was done with Greece. Third, China is rapidly slowing. And this time—unlike the 2008—China may not be able to respond with a massive credit stimulus that kept the economy on its super-fast rate of growth. Finally, Japan, with its ever-growing government debt load, is even closer to tipping over into a credit and currency crisis.

Also, let’s not forget raw valuations. The Shiller (cyclically adjusted) PE ration for the entire S&P500 is now at 23x. This is FAR above its long-term historic average, which is closer to 16x.

Simply put, the US stock markets are overvalued. They will correct. And unless this time is truly different (highly unlikely), the correction may be severe.


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