The factors that have moved the market up for the last
five years are eroding. Contrary to
popular conception, the economy shows no sign of entering a new phase of more
robust growth. Quantitative Easing (QE)
is being gradually withdrawn, and on its current schedule, will end by
November. Technically, the market has
shown significant signs of topping out.
In the absence of stronger economic growth, corporations will have a difficult
time increasing earnings. The market is
substantially overvalued by historical standards.
A number of key economic indicators have now been
reported for March or April, and is not encouraging for investors expecting a
big bounce back from the cold winter.
The housing market was particularly disappointing. New home sales in March
were down 14% from February, and down 13% from a year earlier. Mortgage purchase applications in April are
off 16% year-over-year. Existing home
sales were about flat in March, and down 7% from a year earlier. The pace of sales was about the same as in
June 2012. Housing starts were up 3% in
March, but off 6% year-to-year. The
March NAHB Housing Index crept up to 47 from 46, near its lowest level in a
Industrial production for March rose 0.7% from the previous
month, but only 3.8% from a year ago, well within the prevailing range of the
last three years. Although investors cheered a March increase in retail sales
of 1.1%, the year-over-year gain was a weak 3.8%, compared to 4% before the
extreme cold weather set in, and nowhere near the recovery peak of 8.5% in July
2011. The March jobs increase of 192,000
was 1.66% above a year earlier, but was up 1.82% on an annual basis in November. In prior economic recoveries, jobs typically
rose from 3%-to-5% annually for months at a time. New orders for durable goods ex the volatile
transportation and defense sectors were up 3.5% year-over-year, down from an
annual rate of 8.8% in September.
If the Fed sticks to its current plan, QE will end in
November. In the last few years QE has
been started and stopped a number of times.
A study by Bianco Research found that the S&P 500 rose 117% during periods
when QE was in effect and declined 27% when it ended. Although QE is being ended gradually this
time instead of suddenly, we believe that the winding up of the program will be
a headwind for the market in the period ahead.
In the last five years corporate earnings have soared
despite weak revenues that have mirrored the tepid growth in GDP. This feat was accomplished largely through
keeping a lid on new hiring, holding down spending on new plant and equipment,
and buying back stock, mostly with funds raised through new debt issuance. This
is not a recipe for sustained earnings growth.
In addition, the S&P 500 is selling at 21 times cyclically-smoothed
earnings, a level exceeded in the last 90 years only in 2000 and 2007.
As we pointed out in recent comments, the market has also
taken a turn for the worse on a technical basis. The momentum stocks that led the market have
declined sharply and bounced back weakly.
Many of these stocks have no earnings while those that do are selling at
nose-bleed valuations reminiscent of the 2000 and 2007 market peaks. The S&P 500 has flattened out while
Nasdaq has broken a ten-month rising trend line. The partial bounce back has
still left it below its 50-day moving average.
Sentiment is still heavily bullish and the number of stocks making new
daily highs has been dropping.
In our view, the upside potential for the market is exceedingly
limited and the downside risks are high.