Getting bearish again
You have probably noticed a change in tone at Credit Writedowns since about June, but a lot more in the past month or so. Once mildly bullish due to the deeply oversold levels this Spring, I have become increasingly alarmed at the unjustified strength of the recent market rally.
My most recent post explaining my concern, “Major selloff coming?” kind of gives you the timeline. I really would like to be bullish, but I have major issues with this rally on both a technical and fundamental basis:
- The technicals all point to stock markets in the U.S., Europe and Emerging Markets as being overbought. This has been the case for at least two months now. As the market continues up without a pullback, you have to be concerned that any pullback will be violent.
- There has been an enormous multiple expansion, which is usually what occurs in the middle to latter stages of a secular bull market, not in the beginning of one. It certainly makes one think this is a bear market rally and not a secular bull move.
- I have said that the massive liquidity dumped into the system is not going to fuel inflation when capacity levels are at historic lows in the U.S. There is absolutely no pricing power, either for businesses or workers. But, all that money is going somewhere eventually. Right now, it looks like it’s going into asset prices. Liquidity is seeking return.
- If you look at the deflationary pressures, they are almost all still at work: poor employment markets, producer price inflation at record low levels (Germany down 7.8% through July y-o-y for example), overcapacity in Europe, China and Asia, back breaking debt levels, etc, etc.
- But, then, where is the demand? It’s not there. The consumer is not going to be jumping in here. A lot of the uptick in the economy is inventory-related, not consumption-driven. So either former exporters, government or business will have to pick up the slack.
- And let’s not forget my favourite whipping boy, the financial sector. In the U.S., there are a lot of toxic assets on balance sheets, while leverage and equity capital ratios are still poor. That speaks to the need for continued deleveraging and low loan growth in the financial services sector.
So while a snap-back rally was inevitable given how oversold things had become in March, this rally has been a bit over the top. I am not alone in this assessment. The Wall Street Journal has pointed to Jeremy Grantham and a few other March bulls who are now speaking in more cautious tones.
…Jeremy Grantham, penned a note on March 10 entitled “Reinvesting When Terrified” that encouraged investors to buy, suggesting stocks were 30% undervalued.
Since then, the market has roared ahead, without stopping for a correction of 10% or more. Standard & Poor’s 500-share index ended last week at 1026.13, up nearly 52% from its 12½-year low on March 9 and its highest close since Oct. 6. The Dow Jones Industrial Average is at 9505.96, up 45% since its March low.
Now, the chairman of Boston asset-management firm GMO and his colleagues say the S&P 500 has zoomed right past what they consider fair value of about 880, based on earnings estimates and historical price-to-earnings ratios.
Notice the part about not having had a correction, which I see as a contrarian indicator. Back in May, Grantham said a leap up to 950 and then a sideways move between 950 and 1050 on the S&P meant the market was modestly overpriced. That is not a sell signal. This is where we are right now. But, at 1026, we are dangerously close to breaking out of that range to the upside – which would be a sell signal.
With the City and Wall Street ready to return to full speed soon, we will get a better taste of what is to come due to higher trading volumes. But, for now, I am mildly bearish on shares.
To add a bit more evidence to your mildly bearish stance let’s not forget the CRE collapse hitting malls and shopping centers that were built at a frantic pace over the last decade in the US. The recent demise of CIT is just one symptom of this collapse. Add to this continued housing weakness and loan defaults eating into the Prime loan sector to the tune of 7.8% last I checked. One out of four loans in the US is in default or seriously delinquent. Even though the massaged housing numbers show a slight improvement in sales I find these figures highly dubious when surrounded by sky-high default levels and near 10% unemployment.
Add to the above shaky fundamentals a global trading market that is nearly frozen, if the Baltic Dry Index is any reliable indicator, and consumers around the world are simply not consuming. This also explains the record production capacity drop you mentioned.
So where does the recent record rally come from? The financial markets seem utterly decoupled from fundamentals. I remember a similar time in the mid-1980’s when economist Peter Drucker wrote a piece in Foreign Affairs magazine about a decoupling of real and financial markets. He opined that this was a new and sustainable trend. Then we had the crash of 1987 and folks discovered, yet again, that the rules of business and finance are age-old and flex from their traditional bounds only temporarily. Their snap-back return to historical norms catches many off-guard and can be violent and sudden.
Guess this view makes me “mildly” bearish too!
Link to Peter Drucker’s article from 1986:
“The Changed World Economy”
Bulls vs Bears or is the S&P simply repricing itself to reflect the ongoing and perceived downward spiral of the US dollar as Obama and crew drop money from helicopters?
Barry Ritholtz’ analogy of this market to 1975 “works” for me, with the twist that the trend then was to higher interest rates. a trend that was to last for about 40 years, from the early 1940s to 1982. The nominal Dow low of 574 in Dec. 1974 was not pierced, but of course 1982 undercut it in real terms.
If the ongoing secular trend remains deflation/lower Treasury rates, nominal stock prices may not have peaked, unlike in 1974.
I am interested in your thoughts on this analogy, as well as on gold as a store of value through ownership of an ETF.
doctorx, I just posted a funny little SNL skit a friend sent me about a weak dollar that kind of puts my thoughts on this in perspective:
I didn’t ad-lib any commentary on it because I’m not sure where the dollar is headed these days. But, it definitely is related to Barry’s thoughts about 1975.
I question whether the fed can create any inflation in this environment. I certainly think they want to. If they can, you’re looking at some serious problems down the line. What seems likely to me is that, at a minimum, the US currency loses value vis-a-vis hard assets like gold, oil or commodities. That would certainly put some cyclical inflation into the system, but from a secular perspective, we need to get rid of a lot of capacity before inflation comes back in a secular way.
So, I certainly like gold as a store of value i.e. as a hedge part of a larger portfolio. I know people like Buffett do not and physical demand for gold is declining right now. So, perhaps oil is a better ‘store’ of value.
Thanks, Ed, for the coments and the rapidity of the response.?
Regarding your (mild) turn to the bearish stock tilt, here’s some contrarian support.? I have a bearish stock broker who gave up fighting the tape about 2 weeks ago.? And I work with a bond broker who’s very astute, went long stocks at the bottom in his personal account and predicted about 2 weeks ago that the S&P would peak in the 1000-1100 range and then have a significant downward move.? And in case you didn’t see Afternoon Tea with Dave (Rosenberg), he’s sort of throwing in the bearish towel for the near-term stock trend as well because he is tired of fighting the tape.?
Gold is acting like quite the “flation” hedge these days.? Am I correct that the yen depreciated in gold terms throughout Japan’s deflationary ZIRP time?
Thanks for the link.? Am getting into a meeting and will look at it when relaxed.? In the meantime, I posted positively over the weekend on the long T-bond (specifally “TLT”), and would be honored if you would read it:
And by the way, being mildly bearish means I expect a pullback, not a crash. Whether the rally continues after a brief pullback depends on the fundamentals. Right now, the longer-term fundamentals don’t support much more upside from here. But, it’s not like we are partying like it’s 1999 here.
I saw the Rosenberg thing. He still seemed bearish, but if you were bearish all the way from March, you took a beating. Not what one terms outperformance.
Agreed it’s hard for stocks to crash as the economy turns up.
Your comments are greatly appreciated.
Please keep up the truly fine work.?
The difference in objectivity and predictive accuracy between what you and the high-quality bloggers do vs. what comes out of the MSM (and forget the brokerages) is amazing.?
I’m with you on the write-downs.
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