As Bullishness Returns to the Market: Can the Rally Continue? (SPY, QQQ, DIA, GOOG)

The S&P 500 is up about 5% since I changed my stance on the stock market from bullish to bearish back on November 19th and all of the fundamental reasons for the change are still intact (although I’m neutral on a technical basis). Recent news has been mixed or negative and not helping the situation is the announcement over the weekend from Chinese Premier Wen Jiabao that the yuan is not overvalued and that there is a chance of a double dip recession in China.

Many of China’s trading partners (including the US) have been upset with China’s handling of their currency during one of the most devastating economic period in recent history (China had been gradually appreciating the yuan but stopped in 2008). Adding to protectionist issues, Google said over the weekend that is 99.9% sure it will be closing it’s China.cn web portal and China made a warning to Google’s Chinese partners that they will be responsible for any search related problems on their own website.

Despite all this negative news flow, investors has been hanging on to hope with the tired lines of “things are getting less worse”. Bulls are still reciting facts about recoveries in past recessions as if the more they repeat them, the more they will apply to the current crises. Unfortunately they do not.

It would seem that people are ignoring fundamentals and the more the stock market rises, the more bullish they will become. The downside to this strategy is that most people who are bullish are already invested. It is almost always short sellers covering their positions that launch the market into it’s final peaks before coming down and this is certainly how it feels to me.

The chart above from Bloomberg gives some good color to the situation. There is no “clear” indication that we are topping out right now but there are definitely more (and better) reasons to be cautious than to be optimistic. The rally over the last month has been strongly moved by short sellers having their stops hit (trust me, I’ve been trying), and I fear that a few months from now we will be looking back at this point in the stock market as a double top and possibly the highs for the year. Be careful everybody.

-MJB

Disclosure: Net-long the stock market with over 35% assets in cash

A Look Back at 2009 and Outlook for 2010 (AA, GLD, DJIA, SPY)

There has been much to celebrate during 2009 as the stock market ended its’ free-fall and set off on one of the biggest single year gains since the Great Depression. We have seen continued improvements in many economic indicators and their second derivatives such as temporary hires, corporate earnings, initial unemployment claims, and even the more comprehensive measure of U-6 unemployment registered a slight improvement in November. However, the improvements have been very slow coming and I do not anticipate any radical improvements in the near term that would justify additional sudden upside in equity markets.

Despite the improving flow of news, I remain cautious because of many structural issues  carried over from the last few years that remain to be dealt with and because of the significant caveats that apply to much of the good news we have had. For example, the big recent fall in initial unemployment is to be expected at the end of the year because companies usually try to avoid the bad PR of laying off employees going into the holidays. Also, the slight improvement in U-6 unemployment during November is more likely to be a statistical blip than the emergence of a new trend considering that it is still above the reading from September and December’s reading ticked higher as well.

At the end of the fourth quarter, the S&P 500 was sitting at the 50% Fibonacci retracement line from the July 2007 market highs to 2009 lows following more than a 64% move from the March bottom. At 19.9, the  projected 2010 price/earnings ratio of the market is certainly above the historical average of approximately 16 but it is still well within normal ranges during the beginning of a recovery.  Although I do not feel that the market is significantly over-valued at current levels, I see few catalysts for significant additional gains and after pouring over historical data, I believe there is a relatively high likelihood that the market will correct moderately to the downside as the previously mentioned issues play out and the following headwinds begin to manifest themselves:

Tepid Employment Outlook

Although the initial unemployment claims number has been declining recently, a disturbing trend in the data has been emerging in which continued unemployment has been rising in an almost inversely proportional way. This indicates that a growing number of people have been and are being disconnected from the labor market for almost a year. These people will lose their unemployment benefits soon, depressing their ability to contribute to the economy while also subtracting from the spending power of those people who remain employed because many people are now using discretionary income to support family members and friends who have fallen on hard times.

To make matters worse, many of the jobs that have not yet come back (such as manufacturing, financial services, automotive, etc.) are not likely to return to pre-crash levels of employment and sectors that are growing such as health care are not hiring as much as they normally would be because of persisting uncertainty regarding regulation in the sector. Also, the longer someone stays out of the labor market, the more their skills become obsolete, diminishing their long term productivity and earnings potential. I’m also beginning to factor in a slight chance of a double dip recession similar to 1937 if the Government and Fed are forced to begin withdrawing stimulus and liquidity before the labor markets can fully stabilize.

Withdrawal of Monetary and Fiscal Support

A large part of the recent rally has been due to strong fiscal and monetary policies enacted over the past two years that I mentioned previously in my October 20th Buffett vs. Bullion post. However, these will be disappearing relatively soon as the Troubled Asset Relief Program (TARP) expires in 2010 and liquidity is withdrawn from the market by the Government and Fed to prevent inflationary pressures from building into another asset bubble. The U.S. Government hasn’t even come close to issuing all of the debt that is required to fund its’ growing deficits but now that a complete financial meltdown is off the table, investors are already demanding higher yields to make purchasing the treasuries worthwhile considering the balance sheet problems facing our country. If yields continue to rise, it will eventually put serious pressure on an already strained credit market and economy.

Hobbled Banks and Declining Credit

Commercial banks are the backbone of the worlds’ credit markets and they have been badly injured over the past few years by and are still being held together by unprecedented levels of legislative (termination of mark-to-market), monetary (lowering Federal Funds Rate below 0.25%) and fiscal (TARP) support. The banks are still being hobbled by a multi-year build up of toxic “assets” and unprecedentedly high default rates on a wide range of consumer and commercial loans which has significantly curtailed the ability of banks to loan out new funds in the market which would spur further economic growth.

In recent past recoveries, credit has always continued to expand and the savings rate has continued its’ long term downward trend. However, the most recent recession seems to have fundamentally changed things. The weakened banks can no longer increase the credit they give (in fact, credit has been contracting), and Americans have begun rejecting their debt-loving nature sending the national savings rate average above 4.5% in 2009 for the first time since 1998. The markets rejoiced and rallied on the news that many of our nations’ major banking institutions had returned to profitability. Unfortunately, the opposite reaction could take place when/if investors realize that the return to profitability was heavily aided by taxpayer support and that normalized bank earnings will be lower in the near future because of the previously mentioned reasons and lower levels of lending.

Persistent Market Uncertainty

Certainty in and of itself is not necessarily a good or bad thing, however a lack of certainty is the breeding ground of volatility in the stock market which tends to reduce realized returns over shorter time frames. There continues to be a great deal of uncertainty concerning the Federal Funds Rate over the next several years and Government intervention in the market as we mentioned in our newsletter from the Third Quarter. There are also other issues which have been temporarily swept under the rug which could come back to haunt during 2010 such as health care reform, regulation of the financial industry, changes to the tax code and taxes on greenhouse gases. I feel that these are important issues which must be tackled comprehensively and in a timely manner. This will almost ikely continue to be a challenge for the current Congress and could become even worse following the 2010 midterm elections. Every day that goes by without there being solid laws on the books is another day that executives will delay hiring or expenditures because of uncertainty over what the business and economic landscapes of the U.S. will look like five years from now.

For example, (1.) Should healthcare companies hire more people to meet growing demand from regulation that would increase the pool of customers, OR should they fire people because the industry might get regulated to death instead? (2.) Should financial institutions begin putting money back to work in the economy, OR should they be divesting certain assets because of a possible return of Glass-Steagal? The answer barely matters in this case; CEO’s just need to know what the rules of the game will be so they can plan for it. (3.) Should employers like General Electric continue to take advantage of our skilled labor force as well as our great technical and legal infrastructure, OR should they relocate to a more fiscally responsible country for fear of draconian tax rates being employed to sustain Congress’ out of control spending habits? (4.) Should companies continue investing in green and other sustainable technologies to improve our planet, OR should they shut down because they won’t be cost competitive with fossil fuels unless carbon emissions are taxed appropriately?

Maybe Congress could answer these questions for us when they are done squabbling over who gets the most pork barrel money.

All this being said, I continue to maintain a positive long term outlook because there are still many exciting areas which I feel offer favorable risk/reward fundamentals and will take advantage of longer term shifts in the global economy. I will continue to revisit my investment thesis regularly throughout the next quarter and I am very interested to hear what executives will have to say about their outlooks on the conference calls during the upcoming earnings season which Alcoa (AA) just kicked off.

We have just emerged from one of the worst financial crises since the Great Depression and I use this comparison because of the great similarities between then and now. The Great Depression began in 1929 when the market fell steeply following years of greed and financial excess (sound familiar?). Market sentiment quickly recovered and stocks experienced one of their greatest runs in history over the next several months as investors covered short positions and began to anticipate a strong recovery (sound familiar?). The rally took the market all the way to the half-way back point (right about where we are now) but investors began taking profits as they waited for the projected fundamental economic improvements to materialize and the market proceeded to dive, not truly bottoming until almost four years later in 1933.

Mark Twain once said “History doesn’t repeat itself, but it does rhyme” and with this in mind I plan on returning to a more defensive posture than I was in the beginning months of 2009 when prices as well as expectations were much lower.

Words of Wisdom for 2010
“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
– Warren E. Buffett

“The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
– Warren E. Buffett

Happy 2010 everyone!

-MJB

Changing Intermediate-Term Stance on Market from Bullish to Bearish (SPY, DIA, QQQQ)

I brought up some long term technical issues regarding the market in my post from October 30th and although we broke over the downward trend line, I am now changing my overall intermediate-term stance on the stock market from slightly bullish, to moderately bearish.  I will outline my reasoning below:

Unemployment and continued joblessness
The unemployment number have been slightly improving of late but they cant seem to stay under the 500,000 mark. The number of continuing jobless claims are falling faster but Jon Ogg from 24/7 Wall St. aptly points out that the number needs to fall to 400,000 from the current 5,611,000 for the unemployment to stop growing.

We haven’t even felt the real pain from unemployment yet
Thus far, the majority of the unemployed have been receiving jobless benefits under the American Recovery and Reinvestment Act which provides extra unemployment assistance  so that they can continue to spend and contribute to the economy. This runs out in January, 2010 (only a bit more than a month from now) and nobody is even talking about it (more on this here).

Holiday retail sales may do well after having consumers save for it all year, but this is almost certainly a case where current demand will be coming from future purchasing power. Retail and discretionary sales are down hugely so far in 2009 and instead of getting better, it’s very likely to get substantially worse in 2010. Are people really going to have the same gusto to spend when they have homeless relatives staying with them at home? This is very troubling to me because of the potential negative feedback loop it could cause with additional layoffs.

Congress hates Americans
Whatever happened to all that infrastructure and education spending that was going to create jobs? Oh that’s right, congress and Nanci Pelosi had to pay off all of their supporters and donors before the real economy got any money. Too bad there isn’t much left that hasn’t been appropriated already…

All I see when I watch hearing is a bunch of stunningly uninformed (or plain stupid) grandstanding by our representatives in Congress and it doesn’t seem like the issues of financial regulation, energy independence or health care overhaul are going anywhere.  The government has succeded in changing the playing field and rules of the game, unfortunately, the new playing field and rules seem to change whimsically on a quarterly basis. I believe that all the the uncertainty created by the Government is a large contributor to the lack of investment in capital and workers because there is no way to effectively forecast and plan.

Reading Obama’s tea leaves
By now I’m sure many of you have noticed that President Obama has been pretty on the money with a lot of his recent ‘hunches’ and ‘expectations’ of the economy and the unemployment situation. He talked about how job losses would likely continue in 2010 and a few days later the unemployment numbers came out with the first reading above 10% since the 1980’s.

President Obama also recently broke with the presidential tradition of being the economies cheerleader by saying “It is important though to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the US economy in a double-dip recession”.

I think that the only reason he mentioned the deficit was to give lip service to the Chinese (who had been pressuring him over the falling Dollar) while he was on tour in Asia, but the fact that he brought the phrase “double-dip recession” into things was a little scary. This is especially eerie because of all the things that could put us into a double-dip recession, our deficit is probably not even in the top three. My interpretation is that President Obama is hinting at a double-dip recession in GDP in 2010 and using the deficit as cover.

I feel that people would need to be very greedy and imprudent for the market to be pushed up much from here. Just some food for thought…

– Michael J. Burns

Disclosure: I am net long the market with slight exposure to gold though GLD

http://247wallst.com/2009/11/19/one-million-american-face-lose-of-jobless-benefits-in-january/#more-53948