A confluence of important factors that have propelled the
market higher seem to be in the process of reversing, indicating that the
cyclical bull market that started in March 2009 is most likely at an end. Here is the way we see it.
QUANTITATIVE EASING (QE)----Ever since the beginning of
QE1, the market has expanded when QE was in force and corrected when it
ended. Each time, the market ended its
correction only when it became apparent that there would be additional QE. During periods when QE was on, the S&P
500 rose a total of 127%. When QE was
off, the market fell by a total of about 27%.
Now the Fed has given strong indications that they would begin tapering
QE over the next few months, and a survey of investment managers and economists
show that 65% think the tapering will start with the September FOMC meeting. In response, the 10-year note yield has
soared from 1.6% to near 3% in a short period of time, and stocks have come
down from their peak. We think that with
a finite end to QE now in view, the pressure on the market will be to the
downside.
LACK OF DEMAND IN THE ECONOMY----The economy has been
unable to break out of its annualized 2% growth trend despite QE, and now seems
to be weakening further. Although recent
economic data releases have been mixed, consumer spending, which accounts for
about 70% of GDP, remains constrained by debt-heavy household balance sheets, a
tepid jobs market, barely rising disposable income, lack of wage growth, and a
low savings rate. Real disposable income
in July was down from two months earlier and up a meager 0.8% from a year
earlier. Real median household income is
at its lowest level since 1995. That is
why real consumer spending has increased only 1.7% year-over-year.
In addition the labor market is weaker than it
appears. Jobs paying wages in the lowest
quintile accounted for 30% of new jobs since the end of the recession and
workers in this group work less hours. A
high proportion of new jobs involve part-time workers who would rather work
full-time, while large part of the drop in the unemployment rate has resulted
from workers leaving the labor force. Furthermore,
core capital expenditures declined 4% in July, while the sharp rise in mortgage
rates has resulted in recent signs of weakness in housing starts, new home
sales and pending sales. Estimates for 3rd
quarter GDP growth have slipped to about 1.5%, barely at “escape velocity”.
CORPORATE EARNINGS----Corporate earnings growth, a
powerful factor in the stock market rise along with QE, has decelerated with 2nd
quarter S&P 500 earnings growth coming in at about 3.7% over a year
earlier. Even this amount was mostly accounted
for by a 27% increase in financial earnings as profits declined in industrials,
telecom, technology, materials and energy. Earnings estimates for the second
half seem far too high, and are likely to be slashed in coming months.
VALUATION----The market is now significantly
overvalued. Based on today’s close, the
S&P 500 is selling at about 19 times trailing 12-month reported (GAAP)
earnings, the high end of the range established before the serial bubbles of
the last 14 years. The long-term average
multiple is about 15, with major lows at 10 or below. Normalized for cyclicality, the P/E ratio is
20 times.
THE COMING SHOWDOWN IN WASHINGTON----The next couple of
months will feature a showdown between the White House and Congress over
budgeting authorization and the debt limit, reminiscent of the turmoil in
2011. Both sides seem adamant in their
positions, and are not likely to settle until the last minute, if then. In the meantime the headlines will look
pretty scary.
TECHNICAL---The breakout of the S&P 500 above the
1687 level reached on May 22nd petered out at 1709 on August 2nd
and quickly fell back below the May high. , The NYSE averaged about 800 new
daily highs around the May top and only 400 at the August, indicating a
significant divergence. In our view this
is pointing to a major change in market trend in response to the reversal of
bullish support from infinite QE and soaring corporate earnings as well as the likelihood
that the economy will not soon transition into the long-awaited self-sustaining
recovery.
All in all, we believe that the market is in the process
of topping out and entering a major downturn.
