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  Posted on: Thursday, September 12, 2013
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Stocks Are Vulnerable To a Severe Decline

   
 
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The stock market appears to be hitting a wall, as an increasing number of negative catalysts are on the horizon at the same time that the positive catalysts, that have propelled the market for more than four years, are fading.  Economic growth remains disappointing, the Fed appears set to cut back stimulus, earning growth is decelerating and Washington is beset by uncertainty over the Mid-East and budget and debt limit problems.

The economy is still plodding along at barely above “stall speed”, falling short of forecasts by the Fed and most Wall Street strategists and economists.  Employment has increased by an average of only 160,000 a month over the last six months with an unusually high proportion of new jobs in low paying segments of the economy.  Although initial unemployment claims have dropped significantly, businesses are still reluctant to hire.

GDP grew at an average annual rate of 1.8% in the 1st half, and, according to Moody’s Analytics, is tracking at a rate of only 1.4% in the 3rd quarter, based on results released to date.  In addition, with wages rising at a tepid rate, and household savings rates historically low, the ability of consumers to spend remains restrained at best.  Capital expenditures are also being held back by continuing excess capacity and too much vacant office space.

Despite the economic weakness, the Fed appears committed to start the process of tapering back quantitative easing (QE).  Journalists close to the Fed’s thinking now believe that the FOMC is likely to begin the tapering process at next week’s meeting, although the cutback may be minimal at the start.  The key takeaway, though, is that a stimulus program that was previously open-ended, with an implied “put” under the market, now appears to have a finite end.  That makes a big difference in the way investors perceive the program, as is evident by the soaring yields in bond rates since Bernanke first mentioned the possibility of tapering in May.

All of this is happening at a time of unusual political uncertainty.  Although the market has breathed a sigh of relief over Putin’s proposal to defuse the Syrian crisis, the outcome is still in great doubt as both Russia and Syria are attaching conditions to their plan, and the process of eliminating chemical weapons and verifying their removal are exceedingly difficult.  In addition the rest of the Mid-East is still a tinder box ready to explode at any time.

Washington is also facing a standoff between the White House and the Republican base over the Federal budget and the debt limit that, once again, threatens to shut down the government or result in further spending cuts in a fragile economy.  The market is assuming that the impasse will be settled at the last minute.  While that is more probable than not, whatever compromise gets us to a solution is also likely to have negative consequences for the economy and market.

In sum, with the market already selling at close to 20 times cyclically smoothed reported earnings, the vulnerability to a severe decline seems similar to that of early 2000 and late 2007.

        

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