As we enter the New Year the changing rationale for a continuing bull market is the supposed long-awaited hand-off from a market dominated by Quantitative Easing (QE) to one driven by a burst of economic growth.  Although the reasons are changing, this will be the 4^th straight year that economists and strategists are looking for a pick-up in economic strength.  In each of these years the economic results were disappointing, although the support of QE was enough to propel stocks higher.  We think that the economy once again will grow far more slowly than the consensus believes, and that the overly-strong sentiment favoring a continuing robust market will prove to be mistaken.

Optimism about stocks is near a fever pitch that has preceded major market downturns in the past.  In an illuminating statement in the New York Times, columnist James Stewart recently wrote: “In the many years I’ve been surveying experts for their predictions for the coming year, I cannot recall another time when optimism about the stock market, the economy and corporate profits was so widespread.”  The Investment Intelligence Survey showed bullish sentiment among advisors at 60%, even higher than at the 2000 and 2007 highs, with bears at a low of 15%.

In addition, the National Association of Active Investment Managers points to the highest allocation to stocks since they began collecting the data in July 2006.  The Hulbert Newsletter Stock Sentiment Index is at its highest level ever, dating back to January 1996.  The data is supported anecdotally as well. Strategists and economists seem almost unanimously bullish, and it is hard to find a bear anywhere.  Margin debt, too, is at record highs, exceeding the levels of 2000 and 2007.  History indicates that whenever the overwhelming sentiment toward the market is extremely bullish or bearish, it is nearly always wrong, and that is likely to be the case this time as well.

Furthermore, the case for a breakout to a significantly higher level of economic growth is weaker than it appears.  The stronger growth in 3^rd quarter GDP was largely due to inventory accumulation, as may be the case for the 4^th quarter as well, which is also being given a boost by a lower trade balance. 

Consumers, accounting for about 70% of GDP, are still not in good shape, while housing is also weakening.  The pace of income growth is the worst of the recovery period, with real disposable income up only 0.6% from a year earlier.  The labor force was down year-over-year in both October and November.  The termination of emergency unemployment benefits leaves 1.4 million people with no income.  A lot of the increased inventories were accounted for by retailers, and was not justified by the tepid results of the holiday season.  According to ShopperTrak, year-over-year holiday sales rose by the lowest percentage in four years.  Of the last nine years, only 2008 and 2009 were worse.  Although hopes are high for increased spending by business, this is highly correlated with consumer spending.

The housing industry has also turned down.  Existing home sales for November were down year-over-year for the first time in three years.  The mortgage purchasing index has been declining, indicating further weakness ahead, while mortgage rates are rising.

In sum, we think that the pace of economic growth will once again prove to be disappointing at a time when the market can no longer count on QE to bail it out.  With the market also significantly overvalued, as we have pointed out in past comments, the long overdue market downturn may be close at hand.