Comstock Partners, Inc.March 29, 2012
The Market Sweet Spot Is Ending
A growing number of indicators suggest that the market is running out of steam. Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3. This is a contradiction. If the economy were indeed as strong as they say, we wouldn't need QE3. The fact that market observers eagerly look forward toward the possibility of QE3 is itself an indication that the economy is weaker than they think. We can have one or the other, but we can't have both.
At the same time the problems in Europe have been put on the back burner, giving the market some temporary relief----and we do mean temporary----from the relenting dire headlines that have often dominated the financial news. This, too, is not likely to last very long.
The U.S. economy has benefited over the last few months from the inability of seasonal adjustment factors to account for an exceedingly warm winter and the distortions introduced by the fact that the worst of the recession in 2008-2009 occurred in about the same months. Although it is difficult to put a number on this, we suspect that the seasonal adjustments made the economy appear much stronger than it actually was, and that the payback is about to come.
Adding to these distortions, Fed Chairman Bernanke recently pointed out that Okun's Law may have been a factor in the improving unemployment numbers. Okun's Law, based on empirical observation rather than theory, states that for every 2% change in GDP, unemployment changes 1% in the opposite direction. Bernanke stated that at the worst of the last recession, unemployment increased by far more than it should have based on the decline in GDP. Recently, however, unemployment dropped by far more than it should have in relation to the increase in GDP, and that this was payback for the prior distortion. The takeaway is that the unemployment rate will not improve much in the period ahead, an assumption that is undoubtedly a major reason for the Fed's continued caution on the outlook and promise of near-zero rates into 2014.
In just the last two weeks it has been noticeable that expectations have become so high that a number of indicators have started to disappoint. The list includes core durable goods orders, the Richmond Fed Manufacturing Survey, the Chicago Fed National Activity Index, initial weekly unemployment claims, pending home sales, new home sales and existing home sales. In addition, corporate earnings also show signs of peaking. The recent ratio of negative to positive earnings revisions is the highest since the first quarter of 2009. First quarter S&P 500 earnings growth is now estimated at only 0.7%, significantly down from the 16% estimated about a year ago and the 5% estimated as late as January. We think that when first quarter earnings are reported in a few weeks management guidance will take estimates down even more for the full year.
The economy is also facing the so-called "fiscal cliff" beginning on January 1, 2013. This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester. Various estimates placed the hit to GDP as being anywhere between 2% and 3.5%, a number that would probably throw the economy into recession, if it isn't already in one before then. At about that time we will also be hitting the debt limit once again. U.S. economic growth will also be hampered by recession in Europe and decreasing growth and a possible hard landing in China.
Technically, all of the good news seems to have been discounted by the market rally of the last three years and the last few months. The market is heavily overbought, sentiment is extremely high, daily new highs are falling and volume is both low and declining. In our view the odds of a significant decline are high.