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  Posted on: Thursday, July 23, 2009
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Tailwinds and Headwinds

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Although the potential head and shoulders top we thought we sighted two weeks ago has been obliterated, we feel strongly that the tailwinds propelling the market will soon be over whelmed by the significant headwinds working against it.  Since the March bottom the market has been sparked by the following.  First, the global financial and economic system did not collapse.  Second, the worst of the economic free-fall is over, and the economy is showing signs of stabilization.  Third, second-quarter earnings for companies reporting so far have generally exceeded expectations.  Fourth, a large number of economists and strategists are now forecasting an imminent and significant economic recovery.

We agree that the global system has not collapsed, and have felt since late last year that the massive monetary and fiscal stimulus put in place world-wide would prevent such a disastrous outcome.  We also agree that the worst of the economic free-fall is over, since it would be difficult to keep declining at that pace  for much longer.  However, as we have stated previously the economy is "less worse", but still declining.  As for second-quarter earnings, exceeding the beaten-down estimates was no great feat and was due mainly to cost-cutting, while revenues have still been dropping for the majority of companies.  In addition disappointing results after today's close by Microsoft, Amazon and American Express indicate that upcoming reports may not be as encouraging as earlier reports that were probably overly hyped.  For instance, strong gains by some banks were based on one-time trading profits while Intel's results were likely based on market-share gains and not reflected in comparable strength by end users such as Dell and other computer companies.  Caterpillar's results were said to be encouraging despite sales dropping by 41% and earnings by 66%.

At the same time there are significant headwinds working against the economy and the market.  Consumers are still restrained by historically high debt levels, low savings rates and a subdued housing industry.  In addition consumer credit card delinquencies in June reached a record 10.4%, not a harbinger for renewed spending growth.  This is being exacerbated by increasing unemployment, the lack of real wage increases and a drop in hours worked per week.  State and local tax revenues declined 11.7% in the first quarter and are in line to drop by 20% in the second.  Across the country states and cities are drastically cutting spending and raising taxes to overcome massive deficits, thereby offsetting large parts of the Federal stimulus.  Commercial real estate is also in trouble with delinquencies on commercial mortgages held by banks doubling to 4.3% in the second quarter from a year earlier.  Since consumer spending, state and local governments and commercial real estate account for some 80% of GDP, it is hard to see the economy making much progress without these key sectors.

The housing industry,too, is not out of the woods.  New and existing home sales have stabilized, but at extremely low levels.  According to RealityTrac foreclosure filings were started on 336,000 homes in June, the fourth straight month over 300,000.  Second quarter filings were up 20% over a year earlier.  At the end of the first half one out of every 84 homes in the nation were in foreclosure.  This is adding greatly to the supply of homes on the market and sales of foreclosed houses are accounting for about a third of existing sales.  According to RealityTrac's CEO, "Unemployment-related foreclosures account for much of this increased activity and the higher number of borrowers owing more on their mortgages than their homes are worth represent a potentially significant further risk."  Inventories of existing homes still amount to a high 9.4 months of sales, and a large portion of foreclosed homes do not even appear in the numbers.  The inventories of new homes is a high 10.2 months of sales.

The labor situation remains a serious problem for the economy.  Although weekly initial unemployment claims are running a bit below earlier numbers, this is a result of misleading seasonal adjustments as normal auto shutdowns that usually occur at this time of the year took place earlier.  Continuing claims have declined recently only because employee benefits are running out.  Unemployment is likely to rise for some time to come with negative feedback into housing, spending and further credit losses for financial institutions.
Today UPS, an excellent barometer of the economy stated that while economic conditions have not been getting "dramatically worse", things have not improved.  They said few signs of an imminent turnaround were evident.  The company expects average daily domestic volumes to be down about 4.6% in the third quarter and average daily international export volumes to be down 4% to 6%. Fedex issued a similar warning last week, and almost every company involved in moving goods has expressed similar sentiments.

All in all, the headwinds facing the economy do not bode well for a continuation of the rally depite the strength seen to date.  Stocks have already discounted "green shoots" and stabilization while serious problems are being temporarily overlooked or forgotten.  The market now needs more fuel to power the rally, and this is not likely anytime soon.



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