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When the Music Stops

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Forget about all that talk concerning the Mayan calendar and December 21, 2012.  The date you should be worried about is January 1, 2013.  I’ve been reading so much about it that I decided to try a Google search using “January 1, 2013” to see what results would appear.  Sure enough – the fifth item on the list was an article from Peter Coy at Bloomberg BusinessWeek entitled, “The End Is Coming:  January 1, 2013”.  The theme of that piece is best summarized in the following passage:

With the attention of the political class fixated on the presidential campaign, Washington is in danger of getting caught in a suffocating fiscal bind.  If Congress does nothing between now and January to change the course of policy, a combination of mandatory spending reductions and expiring tax cuts will kick in – depriving the economy of oxygen and imperiling a recovery likely to remain fragile through the end of 2012.  Congress could inadvertently send the U.S. economy hurtling over what Federal Reserve Chairman Ben Bernanke recently called a “massive fiscal cliff of large spending cuts and tax increases.”

Peter Coy’s take on this impending crisis seemed a bit optimistic to me.  My perspective on the New Year’s Meltdown had been previously shaped by a great essay from the folks at Comstock Partners.  The Comstock explanation was particularly convincing because it focused on the effects of the Federal Reserve’s quantitative easing programs, emphasizing what many commentators describe as the Fed’s “Third Mandate”:  keeping the stock market inflated.  Beyond that, Comstock pointed out the absurdity of that cherished belief held by the magical-thinking, rose-colored glasses crowd:  the Fed is about to introduce another round of quantitative easing (QE 3).  Here is Comstock’s dose of common sense:

A growing number of indicators suggest that the market is running out of steam.  Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3.  This is a contradiction.  If the economy were indeed as strong as they say, we wouldn’t need QE3.  The fact that market observers eagerly look forward toward the possibility of QE3 is itself an indication that the economy is weaker than they think.  We can have one or the other, but we can’t have both.

After two rounds of quantitative easing – followed by “operation twist” – the smart people are warning the rest of us about what is likely to happen when the music finally stops.  Here is Comstock’s admonition:

The economy is also facing the so-called “fiscal cliff” beginning on January 1, 2013.  This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester.  Various estimates placed the hit to GDP as being anywhere between 2% and 3.5%, a number that would probably throw the economy into recession, if it isn’t already in one before then.  At about that time we will also be hitting the debt limit once again.   U.S. economic growth will also be hampered by recession in Europe and decreasing growth and a possible hard landing in China.

Technically, all of the good news seems to have been discounted by the market rally of the last three years and the last few months.  The market is heavily overbought, sentiment is extremely high, daily new highs are falling and volume is both low and declining.  In our view the odds of a significant decline are high.

Charles Biderman is the founder and Chief Executive Officer of TrimTabs Investment Research.  He was recently interviewed by Chris Martenson.  Biderman’s primary theme concerned the Federal Reserve’s “rigging” of the stock market through its quantitative easing programs, which have steered so much money into stocks that stock prices have now become a “function of liquidity” rather than fundamental value.  Biderman estimated that the Fed’s liquidity pump has fed the stock market “$1.8 billion per day since August”.  He does not believe this story will have a happy ending:

In January of ’10, I went on CNBC and on Bloomberg and said that there is no money coming into stocks, and yet the stock market keeps going up.  The law of supply and demand still exists and for stock prices to go up, there has to be more money buying those shares.  There is no other way in aggregate that that could happen.

So I said it has to be coming from the government.  And everybody thought I was a lunatic, conspiracy theorist, whatever.  And then lo and behold, on October of 2011, Mr. Bernanke then says officially, that the purpose of QE1 and QE2 is to raise asset prices.  And if I remember correctly, equities are an asset, and bonds are an asset.

So asset prices have gone up as the Fed has been manipulating the market. At the same time as the economy is not growing (or not growing very fast).

*   *   *

At some point, the world is going to recognize the Emperor is naked. The only question is when.

Will it be this year?  I do not think it will be before the election, I think there is too much vested interest in keeping things rosy and positive.

One of my favorite economists is John Hussman of the Hussman Funds.  In his most recent Weekly Market Comment, Dr. Hussman warned us that the “music” must eventually stop:

What remains then is a fairly simple assertion:  the primary way to boost corporate profits to abnormally high – but unsustainable – levels is for the government and the household sector to both spend beyond their means at the same time.

*   *   *

The conclusion is straightforward.  The hope for continued high profit margins really comes down to the hope that government and the household sector will both continue along unsustainable spending trajectories indefinitely.  Conversely, any deleveraging of presently debt-heavy government and household balance sheets will predictably create a sustained retreat in corporate profit margins.  With the ratio of corporate profits to GDP now about 70% above the historical norm, driven by a federal deficit in excess of 8% of GDP and a deeply depressed household saving rate, we view Wall Street’s embedded assumption of a permanently high plateau in profit margins as myopic.

Will January 1, 2013 be the day when the world realizes that “the Emperor is naked”?  Will the American economy fall off the “massive fiscal cliff of large spending cuts and tax increases” eleven days after the end of the Mayan calendar?  When we wake-up with our annual New Year’s Hangover on January 1 – will we all regret not having followed the example set by those Doomsday Preppers on the National Geographic Channel?

Get your “bug-out bag” ready!  You still have nine months!


 

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Stock Market Bears Have Not Yet Left The Building

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The new year has brought an onslaught of optimistic forecasts about the stock market and the economy.  I suspect that much of this enthusiasm is the result of the return of stock market indices to “pre-Lehman levels” (with the S&P 500 above 1,250).  The “Lehman benchmark” is based on conditions as they existed on September 12, 2008 – the date on which Lehman Brothers collapsed.  The importance of the Lehman benchmark is primarily psychological — often a goal to be reached in this era of “less bad” economic conditions.  The focus on the return of market and economic indicators to pre-Lehman levels is something I refer to as “pre-Lehmanism”.  You can find examples of  pre-Lehmanism in discussions of such diverse subjects as:  the plastic molding press industry in Japan, copper consumption, home sales, bank dividends (hopeless) and economic growth.  Sometimes, pre-Lehmanism will drive a discussion to prognostication based on the premise that since we have surpassed the Lehman benchmark, we could be on our way back to good times.  Here’s a recent example from Bloomberg News:

“Lehman is the poster child for the demise of the banking industry,” said Michael Mullaney, who helps manage $9.5 billion at Fiduciary Trust Co. in Boston.  “We’ve recovered from that.  We’re comfortable with equities. If we do get a continuation of the strength in the economy and corporate earnings, we could get a reasonably good year for stocks in 2011.”

Despite all of this enthusiasm, some commentators are looking behind the rosy headlines to examine the substantive facts underlying the claims.  Consider this recent discussion by Michael Panzner, publisher of Financial Armageddon and When Giants Fall:

Yes, there are some developments that look, superficially at least, like good news.  But if you dig even a little bit deeper, it seems that more often than not nowadays there is less there than meets the eye.

The optimists have talked, for example, about the recovery in corporate profits, but they downplay the layoffs and cut-backs in investment that contributed to those gains.  They note the recovery in the banking sector, but forget to mention all of the financial and political assistance those firms have received — and are still receiving.  They highlight signs of stability in the housing market, but ignore lopsidedly bearish supply-and-demand fundamentals that are impossible to miss.

In an earlier posting, Michael Panzner questioned the enthusiasm about a report that 24 percent of employers participating in a survey expressed plans to boost hiring of full-time employees during 2011, compared to last year’s 20 percent of surveyed employers:

Call me a cynic (for the umpteenth time), but the fact that less that less than a quarter of employers plan to boost full-time hiring this year — a measly four percentage-point increase from last year — doesn’t sound especially “healthy” to me.

No matter how you slice it, the so-called recovery still seems to be largely a figment of the bulls’ imagination.

As for specific expectations about stock market performance during 2011, Jessie of Jesse’s Café Américain provided us with the outlook of someone on the trading floor of an exchange:

I had the opportunity to speak with a pit trader the other day, and he described the mood amongst traders as cautious.  They see the stock market rising and cannot get in front of it, as the buying is too well backed.  But the volumes are so thin and the action so phony that they cannot get comfortable on the long side either, so are buying insurance against a correction even while riding the rally higher.

This is a market setup for a flash crash.

Last May’s “flash crash” and the suspicious “late day rallies” on thin volume aren’t the only events causing individual investors to feel as though they’re being scammed.  A recent essay by Charles Hugh Smith noted the consequences of driving “the little guy” out of the market:

Small investors (so-called retail investors) have been exiting the U.S. stock market for 34 straight weeks, pulling almost $100 billion out of the market. They are voting with their feet based on their situational awareness that the game is rigged, and that the rigging alone greatly increases the risks of another meltdown.

John Hussman of the Hussman Funds recently provided a technical analysis demonstrating that – at least for now – the risk/reward ratio is just not that favorable:

As of last week, the stock market remained characterized by an overvalued, overbought, overbullish, rising-yields condition that has historically produced poor average market returns, and consistently so across historical time frames.  However, this condition is also associated with what I’ve called “unpleasant skew” – the most probable market movement is actually a small advance to marginal new highs, but the right tail is truncated and the left tail is fat, meaning that there is a lower than normal likelihood of large gains, and a much larger than normal potential for sharp and abrupt market losses.

The notoriously bearish Doug Kass is actually restrained with his pessimism for 2011, expecting the market to go “sideways” or “flat” (meaning no significant rise or fall).  Nevertheless, Kass saw fit to express his displeasure over the degree of cheerleading that can be seen in the mass media:

The recent market advance has spurred an accumulation of optimism.  S&P price targets are being lifted by many whose memories are short and who had blinders on as the equity market and economy entered the last downturn.  Bullish sentiment, coincident with rising share prices, is approaching an extreme, and the chorus of bullish talking heads grows ever louder on CNBC and elsewhere.

Speculation has entered the market.  The Iomegans of the late 1990s tech bubble have been replaced by the Shen Zhous, who worship at the altar of rare earths.

Not only are trends in the market being too easily extrapolated, the same might be true for the health of the domestic economy.

On New Year’s Eve, Kelly Evans of The Wall Street Journal wrote a great little article, summing-up the year-end data, which has fueled the market bullishness.  Beyond that, Ms. Evans provided a caveat that would never cross the minds of most commentators:

Still, Wall Street’s exuberance should send shudders down any contrarian’s spine.  To the extent the stock market anticipates growth, the economy will have to fire on all cylinders next year and then some.  At least one cylinder, the housing market, still is sputtering.  Upward pressure on food and gas prices also threatens to keep a lid on consumer confidence and rob from spending power even as the labor market continues its gradual and choppy recovery.

The coming year could turn out to be the reverse of 2010:  decent economic growth, but a disappointing showing by the stock market.  That’s the last thing most people expect right now, precisely why investors should be worried about it happening.

The new year may be off to a great start  . . .  but the stock market bears have not yet left the building.  Ignore their warnings at your own peril.


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