Comstock Partners, Inc.June 21, 2012
The Fed Is Shooting Blanks
Today's significant market decline most likely marks the end of the oversold bounce from the June 4th lows. The rally was based on little more than the hope of central bank rescues around the world in the face of what has now become a widely recognized global slowdown that threatens the onset of another recession. In our view the market faces a number of major headwinds including deteriorating economic conditions, a dimmer outlook for corporate earnings, the European solvency crisis and a major slowdown in China and other emerging nations.
While some have called today's decline a severe over-reaction to a Goldman short recommendation and the sharp drop in the Philadelphia Fed index, the slowdown started becoming evident to us almost three months ago and has been accelerating ever since. In our comment of March 29th, entitled "The Market Sweet Spot Is Ending", we noted that, "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". Since that time the majority of key economic indicators have continued either to fall short of expectations or show actual declines. Therefore, the sharp decline in the Philadelphia Fed index reported today, far from being an outlier, is in line with the weight of the evidence that has been developing over the last three months.
In addition to the deteriorating economic conditions, cracks have also started to develop in the corporate earnings picture, which has been the major strong point for the market over the last three years. We have recently seen either disappointing earnings or lower management guidance for a number of major companies such as Proctor and Gamble, McDonalds, Phillip Morris, Pepsi, Caterpillar, Bed, Bath & Beyond and many others. The drop in commodity prices along with the slowdown will adversely affect cyclical and energy companies as well. With earnings season coming up in just a few weeks, it is likely that this will the most disappointing earnings period since the end of the recession. We believe major markdowns in corporate earnings estimates will be a key market feature for the rest of 2012 as well as 2013.
The European sovereign debt crisis will also be a continuing story in the period ahead, and has the potential to be a "Lehman" type situation. The markets will not give the EU the time it needs for any permanent solution such as full political integration, and anything else will just have the effect of papering things over. A significant bailout of Spain and Italy will require huge amounts of funds that only Germany can possibly provide, and it is understandable why Germany would be unwilling to place itself in financial and economic jeopardy.
China and the rest of the emerging nations are also slowing down significantly. While the Chinese government, unlike the Western democracies, can order plants to be built and can force banks to lend, the result would be only more idle plants or factories that produce items that cannot be sold. The key point is that China and the emerging nations are export-based economies that are highly dependent on Europe and the U.S. to buy their goods.
In the midst of the U.S. economic slowdown, the ability of the Fed to do much more is doubtful. Despite the Fed's reduction of its growth estimate and its increase in the unemployment projection, the action it took is minimal and unlikely to help. As we wrote in last week's Special Report, ".the easiest and most reliable measures have already been taken and any remaining weapons are unorthodox, untried and subject to unknown negative side effects".
Chairman Bernanke essentially confirmed this at yesterday's press conference, when in answer to a reporter's question, he said, ".the types of unconventional programs that are now available.we know less about them.they have various costs and risks, and for that reason, we might get a different amount of financial accommodation in this kind of regime than one where short-term interest rates can be varied freely". He added that a larger Fed balance sheet would be harder to reduce later, could impair markets or foster financial instability. Although Bernanke did say that the Fed was not out of ammunition, we got the impression that the Fed had done pretty much all it can and that factors such as Europe and the U.S. "fiscal cliff" were beyond the Fed's control.
In the face of the current economic and financial situation, it is notable that the stock market rally that started in October topped at 1422 (S&P 500) on April 2nd. After dropping 11%, the subsequent oversold bounce retraced 62% of the decline, and has now turned down once again, re-confirming the downtrend. In our view the April 2nd peak marked the top of the entire three-year rally dating back to March 2009, and a new cyclical decline has begun.