With global equity markets continuing to move higher in recent weeks, media pundits and economists have now begun to proclaim an end to the “Great Recession”. US stock indexes are now firmly in positive territory for the year with the S& P 500 up 11.9% year to date, and the Nasdaq Composite up by 27% year to date. Although it’s tough to argue with the impressive rally we have seen in equities since the devilish low of 666 was set on the S&P 500 in early March, we are maintaining our stance that this rally has little to do with improving economic fundamentals. In our view the upward surge in stock prices is nothing more than a technical bounce off of a major low which has now turned into speculation fever and quite possibly the beginning of another asset bubble, this time in equities themselves. Given that interest rates are currently at 0%, and the government has now resorted to giveaway programs for everything from loan modifications to used cars, it shouldn’t be a surprise to anyone that the stock market would be higher in the short term. The nature of recessions is that they clear the system so that capital can move freely to enterprises that offer products or services that have actual demand. Ben Bernanke was recently quoted in saying that he did not want to be the Federal Reserve Chairman that presided over the second Great Depression. By injecting the economy with an exponential amount of monetary stimulus as compared to other previous recessions, Mr. Bernanke may have gotten his wish. Just like his predecessor, Alan Greenspan, who held interest rates too low for too long and helped fuel the housing bubble, Mr. Bernanke may have stabilized the economy in the short term, but will leave the next Federal Reserve Chairman and the US taxpayer with a mountain of debt and liabilities that will have to be faced at some point. With interest rates already at 0 %, the next Fed Chairman will not have the same luxury of cutting rates that his predecessors enjoyed. This next crisis will be bigger and may prove to be the one that will finally clean out the system and allow a true recovery to begin.
Recent readings on the economy point to a mixed picture at best with businesses cutting costs wherever possible. The US consumer, who is widely believed to be the most important piece to the global recovery, is still dealing with high debt, along with a house that is worth at least 20% less than it was last year, and a stock portfolio that is almost half of what it was last year at this time. About 70 percent of the country’s GDP comes from consumer spending, so in order for a sustainable recovery to begin we are going to have to see that major sector of the economy do better. Sales at U.S. retailers unexpectedly fell in July by 0.1%, the first drop in three months. Economists were expecting a rise of .8 % which just shows how far ahead some analysts’ expectations are of the actual economy. Confidence among US consumers unexpectedly fell in August as concern over jobs and wages grew. While economists were expecting a rise to 69.0 in the University of Michigan Sentiment Index, the number actually decreased to 63.2, the lowest level since March. A rise of almost 50% in the S&P 500 has turned some of the most bearish analysts into bulls. Going forward, we expect to see more misses on readings of the economy which will surprise the markets to the downside and will force analysts and economists to adjust their estimates down.
A closer look at the S&P 500 shows just how out of sync the stock market is from the actual economy. After a 50 percent rebound from a 12 year low in March, the index is now trading at 18.6 times earnings, which is the highest valuation since 2004. The fundamental differences between today’s economy and 2004 couldn’t be clearer. Back in 2004, we were in the midst of the biggest credit expansion in history, with banks lending to anyone with a pulse, which resulted in the housing bubble. Today, the opposite holds true with banks that are hesitant to lend, and a consumer who is looking to pay down debt. As much as we would like to see a return to prosperity, we do not see how today’s stock market could be valued at the same level as 2004. With an unemployment rate almost double what it was in 2004, consumer demand simply isn’t there (unemployed people do not usually buy homes, cars, etc) and we think the market will figure this out very soon. Recent earnings have had little to do with revenue and more to do with companies cutting costs.
History shows that US investors lose the most in September as compared to any other month (a loss of 1.3% on average since 1928). After the run-up we’ve seen in the market we think the same will hold true for this September and we caution investors to take profits and keep tight stops on positions going into the 3rd quarter. We are sticking to our thesis that due to the massive monetary and fiscal policies that governments around the world have chosen to take, we will at some point very soon (possibly as soon as this fall) see one or more currency come under severe selling pressure. While the US Dollar is the obvious candidate, the contrarian view tells us that it will be another major currency. Unfortunately, we have a plethora of countries with vulnerable currencies to choose from starting with Western Europe (Spain and England come to mind) who have undertaken massive stimulus programs of their own in an attempt to fight off deflation. All things being equal, governments can only spend what they take in through tax revenues. During boom years, governments should spend wisely and save for a rainy day. It is now raining and Western governments are continuing to borrow and spend without discretion and at this rate will literally spend their respective countries into poverty. One thing is for sure: currency traders understand what is happening in regards to government spending even if equity markets haven’t gotten the idea yet. Along those lines, although flawed, the US Dollar remains to be the world’s reserve currency, thus, we expect the dollar to move higher over the next couple of months with inflows returning to the greenback as volatility returns to the markets. Dollar strength will reverse much of the gains we have seen in the markets which are centered on commodities, metals, and emerging markets. Just how strong this fall’s correction will be is anyone’s guess as it is nearly impossible to predict just what will trigger the selling, but given that equity markets have risen almost 50% over the past 4 months, and these things tend to overshoot on the downside, we would caution patience when putting on any new long positions. What will be interesting to watch for is just how traders react to some kind of currency shock. Most traders, outside of currency traders, have never seen what a currency crisis looks like and just how it will affect their positions. Will traders continue to hold positions after knowing that the market is up 50 % in three months with the possibility of a return to recent lows? Will the lack of liquidity return again forcing the Fed to move even more aggressively or will they step aside this year now that the banks are “out of the woods”. Just like last fall, we believe that there are just too many unknowns right now to make any big bets in the market and believe that holding cash for a clearer market picture going forward is the best strategy. Fortunes have been made and lost during volatile markets such as we have seen over the past year and this time will not be any different.
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