In our view the market, at current levels, is highly vulnerable to a major downturn as a result of negative fundamentals and high valuations. Following is a summary of important factors likely to impact stocks in the period ahead.
ECONOMY---The economic fundamentals remain weak. Following the deepest recession since the 1930s the recovery has been extremely slow and too heavily dependent on an inventory turnaround and government transfer payments. The usual catalysts for self-sustaining growth have largely been absent, including consumer spending, employment, housing and credit availability. As we would expect after a major credit crisis, debt deleveraging has offset most of the massive fiscal and monetary stimulus undertaken by the Administration, Congress and the Fed. Growth has been slogging along at an annual rate of 2 percent or under and threatens to go even lower as stimulus efforts wind down. In addition the dire financial condition of numerous state and local governments is already leading to sharply reduced spending (see Cisco for example) and the possibility of state defaults. The economy is between a rock and a hard place as further stimulus would threaten to send the budget deficit out of control while austerity would send the economy careening lower.
QE2----This is a desperate effort with little potential gain and a lot of risk. The bet is that QE2 can reduce interest rates in the 2-to-10 year range, boosting the economy and jump-starting asset values. But mid-range interest rates are already historically low while asset values are unlikely to respond much more than they already have on the anticipation of the move. At the same time expectations have resulted in a weakening dollar and soaring commodity prices that could help ignite a global trade war and squeeze the profits of companies that will have problems passing through price increases to deleveraging consumers.
SOVEREIGN DEBT----We've stated in previous comments that the Greek debt problem in the spring was merely papered over and was still simmering beneath the radar. Now it's Ireland's turn in the spotlight. This will probably be papered over as well, but the problem is that a number of the weaker EU members are essentially insolvent and will eventually have to be restructured with severe damage to European banks that hold the debts, particularly in Germany, France and England. This will continue to be a drag on economic growth in the EU.
CHINA-----With inflation threatening to get out of control, the Chinese authorities are trying to tighten monetary policy gradually to engender a soft landing together with lower inflation. A few weeks ago we described how home building had gotten so out of control that there were at least a dozen huge ghost towns with empty houses and unused roads. Now food prices are soaring leading to popular discontent to the chagrin of the Chinese leaders who fear the possibility of widespread rioting that imperils the regime. With the leading economies of the U.S., the Eurozone and Japan in such weak condition, China has been the major catalyst for global growth. Any slowdown in China would therefore put the entire global economy at risk, and we all know from experience that once a nation starts tightening, recessions are the outcome much more often than the occasional soft landings.
VALUATION----In addition, don't believe the story that stocks are cheap. This misconception is based on the year-ahead forecasts of S&P 500 operating earnings. The use of operating earnings is a contrivance that began in the mid to late 1980s to make earnings look better than reported earnings according to generally accepted accounting policy (GAAP). Prior to the bubble period that began in the late 1990s the S&P 500 sold at an average P/E of about 15 times trailing GAAP earnings (not forward operating earnings) with a range of 22 to 7 going back 1926. Based on our 2010 trendline GAAP earnings of about $65 the S&P 500 is now at 18.2 times the average and far closer to the top of the range than the bottom. Secular bear markets have typically bottomed at 7 to 10 times earnings. Similar calculations by Robert Shiller and John Hussman indicate even higher valuations.
All in all we think think that the stock market is discounting far better results than the economy can produce in the period ahead. As was true at the market tops in early 2000 and late 2007 the market is once again misreading the negative signals that are evident all around us.