Last week’s breakdown from a consolidation top looks more
and more like a significant change in market trend to the downside on both a
fundamental and technical basis.
Technically, the sharp move down was a classic definition
of a breakaway gap, typified by a daily high that was lower than the prior day’s
low in a direction opposite to the previous market trend. In addition, the August
2nd peak in the S&P 500 was not accompanied by a new high in
breadth while the 10-day average of new daily NYSE highs was only 400, compared
to 800 during the period of the May highs in the market. It is also significant that the decline occurred
from the top of an aging bull market that had gained 156% in four years and
Fundamentally, as well, the market appears to be reacting
to some important changes in comparison to the last few years. The Fed, in posing the strong probability of
a finite limit on quantitative easing (QE), has changed the nature of the game. The market climbed strongly during QE1 and
QE2, only to correct when they ended. To
avoid that pitfall, the Fed made QE3 and QE4 open-ended, and the market
accordingly responded with a strong bullish move. Now that period is over, and whether tapering
occurs in September or December or early next year doesn’t matter as much as
the fact that the market focus has been changed toward anticipating a finite ending
as illustrated by the sharp rise in the 10-year yield.
This is happening at the same time that corporate
earnings growth is slowing down after rising rapidly since the end of the
recession. It was this factor combined
with the QE programs that kept the market going higher despite an extremely
sluggish economic recovery. From 2008
through 2011 S&P 500 earnings increased 95%, but only 2% annualized since
then. In addition forward-looking
estimates are being revised down, and still appear to be too high. This is confirmed by recent disappointments
at key companies such as Wal-Mart, Macy’s, Cisco, IBM, Amazon and Google.
The market is continuing to receive minimal support from
the economy, which has been slogging along at about a 2% growth rate for the
last three years. Real disposable income
has risen by an average of only 0.5% year-to-year over the first six months of
2013, and retail sales have been accordingly tepid with little room left to
reduce an already low consumer savings rate. Job growth remains inadequate with
an unusual proportion of employment gains coming in low-paying industries and
part-time jobs. Now, the sharp increase
in mortgage rates threatens the growth of the housing industry as well, with
monthly payments on a $300,000 mortgage rising by 14% or close to $200. Add to that mix an escalating crisis in the Mid-East,
the likelihood of a 3rd Greek bailout and the coming conflict in
Washington over the budget and debt limit.
In sum, it appears to us that the character of the market
has taken a significant turn for the worse, and that the period ahead will be far
more difficult than the years since 2009.
Now selling at 19.5 times trailing reported (Gaap) earnings on the
S&P 500, the market is highly overvalued compared to the long-term norm of
15 times and its bear market lows under 10.
In our view, the potential downside for the market is unusually high.