Comstock Partners, Inc.August 16, 2012
The Market Is Not Discounting The Bad News
Global growth continues to slow. Of the major economies, the Eurozone is in the worst shape, with output dropping 0.7% in the second quarter. Even the German economy has been plodding along with a rise of only 1.1%, while business confidence declined for the 4th straight month. New orders declined by the largest amount in three years. France's output was down 0.2% with unemployment over 10%. Leading retailers have reported declining sales while auto manufacturers have been cutting production. 2nd quarter output fell 2.9% in Italy and 1.7% in Spain. Greece continues to be a disaster. The news from Europe has been in one of its periodic quiet periods, allowing the memory-challenged U.S. market to temporarily ignore it once again. It will probably not be long before the stresses and strains hit the headlines again with usual dismal results.
The U.S. economy has continued its extremely slow growth pattern, looking good only by comparison with the EU. July retail sales picked up after three consecutive down months. With weak employment, low savings and the need to deleverage debt, consumer spending is likely to remain weak. The Philadelphia Fed Survey was negative for the 4th straight months and the New York Empire state survey was below zero for the first time since October. The important small business survey was down for the 4th time in five months with particular weakness in revenues and profits. Although there has been a lot of talk about a housing rebound, the mortgage purchase index declined for the 5th consecutive week, and is down 8.6% over the last four weeks and 11.3% over the past year. We previously pointed out that existing home sales are at their lowest level since October and that pending home sales declined in June.
China's growth has been slowing even according to the suspect official figures. 2nd quarter GDP growth of 7.6% was the weakest since the 2009 global crisis and industrial production was up 9.2%, the lowest rate since May 2009. A number of economists who are familiar with Chinese economics, politics and culture believe that the actual rate of growth is much lower than the official figures show. Both China's exports and imports have been falling, thereby impacting growth of many other nations as well.
Despite the underlying malaise, the market has been undergoing a low volume rally that has carried the S&P 500 close to its April 2nd peak on the grounds that the central banks of the major nations would implement easing measures that would prevent any recession and that ,since the bad news is well known, it is most probably discounted. In our view, this is the typical denial we often see at market tops. With interest rates already so low and central bank books loaded with assets, there is not much more they can do except attempt non-traditional remedies with uncertain and, perhaps, unwanted outcomes.
We also doubt that the market has discounted the bad news at a time when the S&P 500 is up 112% over the past 42 months. Just because bad news is well-known, it doesn't mean that it is automatically discounted. Take October 2007 for instance.
At the October 2007 market peak there was also plenty of bad news out there that didn't matter until it did. By October 2007, investors already knew that 1) the housing industry was collapsing; 2) various mortgage lenders such as H&R Block, Countrywide, Impac Mortgage and Accredited Home Lenders had come public with their serious problems; 3) Washington Mutual revealed improper loans totaling $30 billion; 4) large numbers of loans were adjustable-rate, interest-only, not backed by documentation of assets and income and topped with a home equity loan granted at the same time; 5) we had learned how mortgages were sold and packaged, sliced and diced and sold throughout the globe; 6) we learned about an alphabet soup group of securities few had ever heard of before; 7) large numbers of mortgage companies were taking huge write-downs and going out of business; and 8) two big Bear Stearns hedge funds came close to collapse.
Despite all that, Wall Street still didn't get it. In August 2007 a typical guest on financial TV casually referred to all the market turmoil as "financial gamesmanship" as opposed to what he termed "solid economic fundamentals". He was far from alone in his thinking.
In our view the same sort of denial is going on now. Investors are overly reliant on central bank action that has a good chance of being ineffective or worse. The bad news, despite being well-known, is essentially being ignored. Rather than concerned, the market seems to be unusually complacent. The S&P 500 volatility index (VIX), commonly known as the "fear index" is now down to 14.6, compared to 15.6, 14.1, 15.6 and 17.4 seen at the respective market peaks in April 2012, April 2011, April 2010 and October 2007.