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Equity Markets Begin Correction

Today, equity markets continued to show signs that at least a mild correction is underway as the S&P 500 Index closed at its lowest level since May 1st. After reaching an intra-day high of 956 on June 11, the S&P 500 has declined nearly 8% through the close of today's trading at 881. From a technical perspective, the S&P closed below its downward sloping 200-day moving average of 885, a potential warning of more downside to come. In addition, commodities have begun to roll over as the reflation trade has lost momentum.

I see two major factors driving the recent declines. First, the "green shoots" crowd is losing more and more supporters due to the ugly June employment report released last Thursday. In a significant disappointment to those expecting a V-shaped economic recovery, 467,000 jobs were lost in June compared to an expectation of -350,000 jobs, and the unemployment rate ticked up to 9.5%. The economy has lost 6.5 million jobs since the recession began, and employment is now back to August 2004 levels. Over the weekend, Vice President Biden even admitted that the recession and resulting job losses were worse than the Administration expected, sparking some calls for a new economic stimulus package.

Those that have seen "green shoots" of less bad economic data have strongly argued that employment is a lagging indicator. It is true that traditional recessions - those sparked by the manufacturing sector or inventory corrections - often end months before the employment figures turn positive. However, in recessions caused by a financial crisis, job losses add to the vicious cycle of home price depreciation and loan defaults. In such a recession, employment is likely to become a coincident or leading indicator. For more detail on this concept click on this article in the Financial Times.

The second major factor driving recent declines is concern over the upcoming second quarter earnings reporting season. For the strong rally off the March lows to continue, investors will likely require fundamental improvement in corporate earnings. As the green shoots whither, suggesting a weaker than expected second half recovery, earnings improvement will be muted. While we expect many companies will meet or exceed pessimistic earnings estimates for the second quarter, the future guidance provided by these companies should drive market action over the coming weeks. With the major equity market indices sitting near important support levels, the earnings reports over the next couple of weeks should determine whether the rally regains its footing, or a deeper correction ensues.

Stock Market Correction Ahead?

In my May 22nd post, I talked about the S&P 500 Index approaching its 200-day moving average, an important level that would inspire confidence if the index could close above it on strong trading volume.  Well, the S&P 500 did close above the 200-day moving average on June 1st, but volume was lackluster, and has remained so ever since.  To us, the low volume suggests a lack of conviction on the part of investors, as well as a potential exhaustion of the monster rally off the March 9th lows.  This monster rally has been driven by confidence that massive stimulus by the world's central bankers and treasury authorities, on a scale never before seen, has averted a systemic collapse of financial markets and has produced the "green shoots" of economic recovery.

While we agree that the financial system has stabilized - for example, credit markets have improved to pre-Lehman bankruptcy levels, and the banks have successfully raised billions of dollars of capital - many critical questions remain unanswered, casting doubt on the sustainability of the equity market rally.  Market action over the past two days suggests the answer to one of those questions won't be pretty - the question being, what happens when the Federal Reserve eases off the gas pedal? 

Since the financial crisis began, the Fed, Treasury, and central banks around the world have devised ever more ambitious plans to revive the credit markets, including guarantees, asset swaps, and outright purchases of debt.  Since September 2008, the Fed has increased the monetary base by almost $1 trillion, an amount that dwarfs the increase following 9/11 by a factor of 10.  All of this stimulus and printing of money has led to fears of hyperinflation.  The bond market has suddenly begun to question who would be willing to buy the $2 trillion in debt to be issued by the Treasury over the next twelve months, sparking a rise in Treasury yields that threaten to derail the "green shoots".

With interest rates rising and investors bidding up the prices of traditional inflation hedges, such as oil and other commodities, it was disclosed over the weekend that the G8 is exploring ways to scale back central bank support of the markets.  In addition, the Fed appears reluctant to expand purchases of mortgages and Treasuries.  Predictably, stocks sold off sharply to start the week.  The bottom line: for much of the global credit market, governments are the only game in town.

We continue to believe that stocks have enjoyed a massive rally within an ongoing bear market, expecting at least a mild correction to begin soon.  For the markets to advance much higher from here should require substantive signs that point to growth, not merely a slower pace of contraction.  We see three important events to watch over the next several days: stock option expiration this week, the Fed meeting next week, and end-of-quarter maneuvering by money managers.  Today's S&P 500 close at 912 places the index right at the downward-sloping 200-day moving average.  A close below 900 could provoke more selling, while a move above 950 could spark a run higher as investors get a dose of "performance anxiety" into the June 30 quarter end.

Is The Rally Over?

Is the monster rally that took the S&P 500 up 39% from the March 9th low to its 2009 high of 929 on May 8th over?  Recent market action is clearly warning that a near-term top may be at hand.  Look at the chart of the S&P 500 below.  The red circles indicate a "double-top" that failed just below the downward-sloping 200-day moving average.  The 200-day moving average represents very strong resistance, and the market's inability to break through that level on two attempts signals that the rally is exhausting itself.

After a nearly 40% rally in two months, it's hardly surprising that the market is having difficulty breaking above this key level.  Furthermore, as we've written for weeks, the rally was built on economic and corporate earnings data that was rather ugly, but certainly better than most investors expected.  So while the banking system has stabilized, investors are beginning to question bullish assumptions of when economic growth will return, and how strong and sustainable that growth will be when it does return.  After all, consensus earnings expectations for the S&P 500 this year are less than $30, implying a current P/E ratio of over 30 times.  If recovery is delayed, or not as robust as the $60 in earnings expected in 2010, then stocks are rather expensive at these levels.

Yesterday's market action demonstrated the inherent risks.  Standard & Poor's cut the outlook for Britain's sovereign debt to "negative" and warned that the country's triple A rating could be cut.  Some in the U.S. warned that this country's debt could be at risk of a downgrade, given multi-trillion dollar deficits as far as the eye can see.  As a result, bond prices declined along with stock prices.  In addition, weekly new claims for unemployment were reported to be down slightly, but still at a high level of 631,000.  As the Financial Times said this morning, "Investors who have piled back into risky assets such as equities on the assumption of growth should ponder America's job losses, lest they also find themselves all at sea."

The next week or so should be critical to the equity markets.  We expect bullish investors to mount another assault on the 200-day moving average.  If a breakout on strong volume is not achieved, we recommend reducing equity exposure.  At this time we're not convinced that the market will fall to its March lows, but a correction on the order of 10% should be expected.

One final thought: if I had told you in early March that the market was poised for a monster rally of 30%-40% in two months, what would you expect me to do with your money after that rally occurred?

Free Market Capitalism?

Last week, I mentioned that a fair market value for the S&P 500 was around the 900 level, based on $60 of earnings in 2010 and a price-to-earnings multiple of 15 times.  However, I suggested that the multiple of 15 times earnings might be too high, meaning that earnings need to surprise to the upside to drive further significant equity market gains.  This week I highlight one of the main reasons that investors may pay a lower multiple on future earnings: government intervention in private markets.

A couple of weeks ago I attended the 6th annual PIMCO Institute for Wealth Managers.  The largest fixed income manager in the world with nearly $750 billion under management, PIMCO is known for its in-depth analysis of critical investment issues.  The conference was an opportunity to hear from PIMCO portfolio managers on the outlook for the global economy, asset allocation, and risk management in the new world we appear to be moving towards in the wake of the financial crisis.

PIMCO's co-founder, Bill Gross, has been referring to this new world as one characterized by de-levering, de-globalization, and re-regulation.  Given the intense focus lately on government intervention in private markets (while on deck for a CNBC interview this week, I listened as other guests shouted about the "criminalization of capitalism"), I'd like to focus on Gross' idea of re-regulation.  Since this financial crisis began, many have questioned free market capitalism and self-regulation.  Government is increasingly gaining control of vital industries, such as banking and the automakers, with huge implications for investors.  The recent Chrysler bankruptcy announcement, during which the President sharply criticized a group of bondholders for adhering to their fiduciary duty to their own investors, is but one of many worrying examples of government intervention. 

To read Bill Gross' thoughts on this topic, please click here.

All Clear Signal?

Stock markets worldwide extended the monster bear market rally last week amid a favorable response to the bank stress tests and better than expected employment numbers.  After a 40% rise in equities since March 9th, many believe the bear market is over.  So has the market issued the all clear signal? While huge government stimulus, coordinated across the globe, has cutoff the Armageddon scenario, we believe it is too early to expect a healthy recovery any time soon.

Let's start with the much-cheered April employment report released on Friday.  The economy lost only 539,000 jobs compared to the expectation of over 600,000 job losses.  Of course, 539,000 job losses in one month is a big number, and the number of job losses in this recession has reached 5.7 million.  But digging a little deeper, the April report was not nearly as rosy as the market took it on Friday.  First, the losses for February and March were revised lower by 66,000 jobs from the original reports, and the April numbers may be revised lower as well.  Government added the most jobs, including over 60,000 hired for the 2010 census. Temporary jobs declined by over 60,000, typically not a good sign for a budding recovery.  A government statistical adjustment that projects jobs added through imaginary new business creation, added 266,000 jobs. Finally, remember that a healthy, growing economy typically adds 250,000 jobs per month, yet this economy continues to lose jobs at a stunning pace.  So while we may have seen the peak in terms of monthly job losses, the economy has a long way to go before we give it an all clear.

The bottom line in our view is that stocks have run too far, too fast.  The credit markets, while showing some improvement, have not confirmed the equity market strength.  Looking at valuations, stocks are no longer cheap, considering that a price-to-earnings multiple of 15 times 2010 expected earnings of roughly $60 for the S&P 500 results in an index level of 900, a little below Friday's close (later this week, we'll discuss why a P/E multiple of 15 is likely too high).  As a result, we think the market is at risk for a correction in the weeks ahead, although the substantial cash on the sidelines in many portfolios is likely to prevent a retest of the March lows.  For investors who are overweight equities, we would view this 40% rally as a gift that should be cashed in.

Stocks Get a Dose of Reality

After a six week rally that took the S&P 500 up 28.5% from the March 9 bear market low, stocks endured a 4% selloff on Monday.  Financial stocks led the decline, as Bank of America's earnings report and concerns over upcoming results of the bank stress tests sparked an 11% loss in the S&P Financials Index.  But the declines were widespread, with declining stocks outnumbering advancers 17 to 1, and declining volume exceeding upside volume by nearly 30 times.  Stats such as these are not what one would expect in a "bull market". 

Is this the start of significant correction?  Interestingly enough, the S&P 500 closed Friday right at the level from which the index began to plummet to new lows back on February 10th.  What happened on that day?  It was the infamous Treasury Secretary Geithner speech that was long on general principles but short on meaningful details.  Of course, Geithner's subsequent speech in March was better received by investors and helped add fuel to the recent rally. 

In any event, the market was bound to run into trouble after the strongest and swiftest advance since the 1930s.  As we have been writing over the past few weeks, the rally has been based on a string of "less bad than expected" earnings reports and other economic news.  If you step back and look at the so called "green shoots" from a distance, the surrounding dead trees dominate the landscape.  For example, the "strong operating earnings" reported by big banks in the first quarter were heavily distorted by accounting gimmicks.  Secretary Geithner has said that there is a "$2 trillion hole in the banks", yet the banks tout their strong first quarter earnings?

Whether a larger correction is upon us remains to be seen.  The next two weeks will be dominated by earnings reports, including a good one tonight from IBM.  The S&P should find good support at the 800 level absent materially worse news.

Market Update - April 13, 2009

The current bear market rally (or new bull market, if you appear on television), continues.  For the fifth consecutive week, stocks finished higher.  As of today's close, the S&P 500 has shot up 27% in 25 trading sessions, a buying panic sparked by a string of news that is "less bad".  Last week's positive surprise came from Wells Fargo, which pre-announced much better than expected earnings on a day of light, pre-holiday trading.  With the steep yield curve, allowing banks to borrow from the Fed at 0.25% and invest in Treasuries and agencies north of 2.5%, one would think the banks could mint money.  But, at least until recently, investors expected loan losses to overwhelm these earnings.  With ongoing distress in the credit markets, it seems premature to assume the worst of the banks' problems have passed.

The rally has carried the markets to the best five-week run since 1938.  The rally has been broad, with 85% of NYSE stocks above their 50 day moving averages.  Yet the rally has been led by many of the worst performers during the bear market, including banks and homebuilders, indicating that much of the rally has been driven by short-covering.  With the bulk of first quarter earnings set to be reported over the next three weeks, the market advance has left little room for error should companies fail to deliver upside surprises.

This rally has many of the characteristics of a bear market rally: a buying panic; led by the most heavily-shorted stocks; and embraced by many market participants proclaiming that the bottom is in.  We are highly skeptical of the sustainability of the rally, but of course are happy to take advantage of it.  In previous posts, we stated that long term investors with a moderate tolerance for risk should target close to a 30% allocation to equities.  This rally is affording the opportunity for those overweight equities to reduce exposure.  For those that have missed the rally, we recommend awaiting a correction from these overbought levels prior to committing capital to equities.

Market Update - March 29, 2009

As winter slowly gives way to spring, a positive change in confidence among investors has quickly emerged.  Equity markets are enjoying a strong relief rally on a pace that is the fastest since 1938.  In the 13 trading days since the S&P 500 Index closed at a new bear market low of 676 on March 9, the index rocketed 23% to close Thursday's trading at 833.  So, do these strong gains suggest the bear market is over?  We remain highly skeptical that this rally is sustainable beyond the next few weeks, but we examine below both sides of the debate and suggest an investment strategy in this environment.

The initial spark for the rally was extreme oversold readings coupled with expectations for Congress to change mark-to-market accounting rules.  Since Treasury Secretary Tim Geithner's ill-received speech on February 10th, stocks fell 15 out of 19 trading sessions, setting the stage for a technical bounce.  On March 23rd, investors cheered as the Treasury released details of its plan to deal with toxic assets on bank balance sheets.  Adding further fuel to the rally, the government released economic data that was better than expected, including home sales, durable goods orders, and consumer spending.  Finally, with the end of the first quarter of 2009 fast approaching, some portfolio managers may have experienced "performance anxiety", buying stocks so as not to miss the rally.

To this writer, the recent rally looks dangerously similar to each of the previous bear market rallies that have failed over the past year.  At the beginning of March, few people believed a rally was possible, and it seemed everyone was convinced the S&P 500 was headed to 600 at best.  Now, with stocks 20% higher and economic data that is "less bad", the media seems dominated by those expecting a new bull market driven by a second half economic recovery.

Perhaps the market has seen the lows and a cyclical bull market can continue.  Yet to endorse this view, investors must make the aggressive assumption that actions by the country's leadership have solved the financial and economic crisis such that this heavily indebted economy can return to growth later this year.  This is an extremely tall order, especially considering the weaknesses of the plans.  For example, the Treasury's Public-Private Investment Plan to buy up to $1 trillion worth of bad assets leaves critical questions unanswered, including what price will be offered for the assets, and whether banks will be willing to sell at that price.  Most disturbing, the plan relies on more debt to solve a debt-induced problem, which is akin to solving a drinking problem by ordering another round.  Fundamental problems still remain, including weak bank balance sheets, too much debt, and too little capital.  Our fear is that the plan will have limited success, and at a great cost to taxpayers.

The bull case lies in the growing confidence that trillions of monetary and fiscal stimulus dollars will gain traction.  The Fed and other central banks around the world are pulling out all the stops, keeping interest rates low and buying mortgage-backed and Treasury securities.  To be sure, the pace of the decline in economic activity appears to be slowing, as seen in this week's housing data.  The recent rise in crude oil and other commodities also supports this case.  This improvement is likely just a bounce from the truly horrendous data from the fourth quarter of 2008, but nevertheless we must watch for signs of a sustainable trend.  Finally, if we can make the argument that earnings are close to the trough for this cycle, valuations are attractive.

So while we continue to believe this is a bear market rally, we are watching several indicators as a signal to change our view.  First and foremost, the credit markets are not confirming the rally in equities, so we would like to see corporate credit spreads to Treasuries narrow.  Second, outperformance by emerging market equities, cyclical stocks, and commodities would signal a return to global economic growth and an improved appetite for risk.  Finally, we would like to see the rally extend to broad groups of stocks and a decline in measures of volatility.

What is an appropriate investment strategy amid this market uncertainty?  Our recommended allocation for long term investors who can tolerate risk is 30% equities, 30% high quality fixed income securities, 30% alternative investments, and 10% cash.  Due to our expectation that the market will remain in a broad range and stock selection will be critical, we are biased towards active managers rather than indexing.  Given the strong rally, we prefer to average in to the equity allocation on weakness.  Should some of the aforementioned indicators materialize, we would become more aggressive with respect to the equity allocation.

Weekly Market Update - March 2, 2009

The S&P 500 Index broke to a new bear market low on Friday as the U.S. government took a 36% equity stake in Citigroup, and an updated GDP report showed the U.S. economy contracted at a stunning 6.2% annual rate in the fourth quarter of 2009.  The decline on Friday was the ninth in ten days, and the month's 11% loss marked the worst February since 1933.  More worrying, the losses occurred during an important week for the Obama Administration, which included the President's first address to a joint session of Congress, and the unveiling of his first budget.  It seems that few investors are tuned in to the high approval ratings of the new president.

We have been cautiously optimistic that November 20, 2009 marked a short term low for the market.  Although we feared the hangover from years of a debt-induced spending binge would ultimately take stock prices lower, we were mindful of the fact that some of the biggest rallies in history occurred within the context of secular bear markets.  On the bright side, signs have emerged during the recent retest of November lows that the market remains in a bottoming process.  For example, much fewer stocks are breaking to new lows compared to the November decline, and declining volume to advancing volume is much improved relative to the extreme levels seen last fall, indicating a lack of panic selling.  The better relative performances of the NASDAQ, as well as growth stocks and emerging markets, are consistent with historical tendencies around past market bottoms.

However, the current political environment and the health of banks around the globe create substantial risks that equity prices decline further.  While we all knew the Obama Administration would bring sweeping change, the anti-growth provisions of the 2010 budget are breathtaking, considering this is the worst recession since the Great Depression.  Examples: raising dividend and capital gains tax rates to 20% from 15%; reducing the mortgage interest deduction at a time when housing prices are collapsing; introducing a cap and trade system for carbon emissions which will raise energy prices for consumers; and increasing marginal tax rates on incomes over $250,000.

We continue to advise clients to maintain a defensive posture until the market exhibits more definitive signs of improvement.  Our current recommended portfolio includes just 30% in equities, with the balance in high quality fixed income securities and alternative investments such as gold and managed futures.  Investors with higher allocations to equity should look to reduce exposure should the markets continue to break down in the days ahead.

Weekly Market Update - February 22, 2009

Increasing fears that the U.S. government will soon move to nationalize some of the country's largest banks drove stocks to near their November lows.  The Dow Jones Industrial Average, at 7,365, now sits nearly 200 points below its November 20 low, and many foreign stock markets reached new lows last week.  The S&P 500 is just 2% above its low, while the NASDAQ is a surprising 9% above its low.  Gold is up 10% in two weeks, demonstrating the lack of confidence on the part of investors.

We have been very cautious this year as we expected a retest of the November lows.  Given the unprecedented amount of global monetary and fiscal stimulus applied to the financial crisis and recession, we believed stocks had a good chance of holding the lows.  In fact, we have noticed several positive developments during the retest, including the lack of widespread panic selling, and many stocks outside the financial sector holding well above their November lows.  However, misguided actions by the new Administration have increased the risk of another significant decline for stocks.

At this time of crisis, investors crave more clarity and decisive action, yet the government seems to turn a deaf ear.  While Treasury Secretary Geithner outlined broad principles in his speech two weeks ago, his lack of detail led the stocks of Citigroup and Bank of America to visit the $2 level.  And after signing a $787 billion stimulus package full of pork barrel spending and entitlement programs, the President unveiled a $275 billion foreclosure prevention plan that was widely panned by observers as a waste of money and a bailout for bad behavior.

In any event, the week ahead shapes up as a critical one for the equity markets.  Should the S&P 500 break decisively below 752, the risk of an additional 10% to 20% decline becomes acute.  As a result, investors should remain defensive and prepared to further reduce equity exposure.