Global equity markets have run up too fast, leading us to believe that the recent rise in share prices is nothing more than a bear market rally. At best, we believe that the market will move sideways for years as households struggle with a weak job market, credit card debt, and increasing payments on mortgages. In a recent interview, Warren Buffett, who made some impressive moves in 2008 during the height of the financial crisis, said that “we are not out of problems yet.” He added,” we have to get the sputtering economy back so it’s functioning as it should be”. We agree with Mr. Buffett’s assessment of the economy and believe that the odds that the markets will break the lows which were set in March of this year are increased due to reckless government spending and a banking system which is unwilling and unable to lend (rightfully so, since the economy is still very weak). Stock markets and equities in general can disconnect from reality for months and sometimes years, as the NASDAQ did in 2000. While a 50% rise in the S & P 500, for example, is impressive we believe that it is way too early to proclaim that the recession is over and a recovery is underway, especially with consumers slowly losing access to credit. If the first quarter of this year was marked by companies cutting payroll and expenses at a rate not seen in over 30 years, then the second quarter can be characterized by consumers finally starting to feel better about their economic prospects and very cautiously heading back out to spend. The consumer who is not mired in debt is now able to purchase everything from homes, to cars, to clothes at deep discounts adding to the GDP. While recent economic data does paint a picture of a shallow recovery, the massive amounts of debt and leverage that the majority of consumers took on over the past 10 years will take years to pay down. Additionally, as the unemployment rate remains elevated, the odds that the consumer retrenches are even higher than they were a year ago, increasing the probability of a double dip recession as consumer spending accounts for almost 2/3 of US GDP. Additionally emerging markets such as China are down over 20% (the official mark that brings them back into bear market territory) so any hope of a commodity-lead recovery (inflation) have been put on hold.
The current market, economy and government response have been very similar to what happened in late 2001 and early 2002 after the NASDAQ bubble implosion. In an attempt to revive the economy, Federal Reserve Chairman Alan Greenspan lowered rates to historic lows and the Bush administration encouraged Americans to “shop till we dropped.” The auto industry took its cue from the government and began to offer 0% financing rates on cars. Consumers were quick to take advantage of the cheap rates pushing auto sales to an impressive 65% annual rate. The brief spike in sales pushed GDP higher to an annual rate of 3.5% making most economists and market analysts believe that the recession was over and strong recovery was underway. The similarities between then and now are evident in both the markets rise and the government’s attempt to kick start the economy. The only difference between the two periods is that we can substitute the 0% auto financing programs offered in 2001 for the recent “Cash for Clunkers” program. Today we hear media and analysts alike proclaiming that the stock market’s rise and improving economic numbers are forecasting a strong recovery. While we are hopeful that this will be the case, the lessons from 2001/2002 tell us otherwise. The S & P 500 topped out in late 2001 and subsequently fell 34%, through the lows it set a year earlier.
A quick look at the current state of the housing and mortgage markets will give more insight to the overall economic health of the country. We have known for years now that the US government’s economic data must be dissected to get the full picture. For example, summer and fall are the seasonally strong periods for the housing market and this proved to be the case again when US existing home sales posted a gain of 7.2% in July. A closer look at these numbers show that 31% of those sales were either distressed sales or foreclosures. This level of foreclosure activity simply cannot be so high if housing is truly going to stabilize. Foreclosures only soften the prices of homes, keeping buyers on the sidelines prudently waiting for the price declines to stop. A recent analyst note predicted that as many as 48% of all US mortgages will be underwater (where the mortgage is larger than the value of the house) by 2011. Many of these mortgages will also adjust to a higher rate over the next two years putting more pressure on the market. As the supply of homes increases, prices will continue to drop. Adding to the supply of homes is the so -called “shadow inventory.” These are homes that banks have taken back after foreclosures. In normal times, the bank will immediately put the house back on the market, but in this environment banks are holding on to the homes to not flood the market and put further pressure on prices. It is estimated that the shadow inventory consists of as many as 700,000 homes being held by banks. This shadow inventory will add pressure on the housing market for years to come, as banks will sell into markets that they believe are stabilizing, further increasing the supply of homes and holding prices down.
As we previously mentioned, stock markets can disconnect from the true economic fundamentals for months and years in some cases. One of the biggest factors that can drive a market higher (or lower) is the amount of money in the system. We already know that the Federal Reserve has instituted one of the most aggressive money printing campaigns in history and this will undoubtedly create dislocations in the economy. The dollar for example, is continuing its race to the bottom, with the US Dollar index falling to its weakest level in 2009. And with a push for universal healthcare, a program which would immediately be put to the test if passed as companies will rush to save on employee health care costs, the current administration is making it clear that the US will continue to borrow and spend its way through this tumultuous period. One natural place all the excess liquidity can flood into is equities themselves causing yet another bubble. With the latest unemployment reading coming in at a 26 year high of 9.7%, we believe that the bond market (where most of the investors are institutions and not individuals or day traders who can bid up prices) is a better gauge to forecast the overall health of the economy. The bond and equity markets have diverged since early May, and bond yields are currently still trading at the level they were during that month. If the economy were truly getting better, bond yields would have moved higher. This divergence will have to be addressed sooner rather than later. The S & P 500 was trading at around 850 in May, and for this reason, along with recent cautious outlooks from investing legends such as Mr. Buffet, we believe that at minimum, a 15% correction back to those levels over the next couple of months is warranted.
