For those of you who missed my article last week after the disruption of Financial Sense, I’d recommend reading it as today’s article is a continuation of my thoughts from my prior article. You can click on the link below:
"Da Bulls versus Da Bears... Daaaaa Bears"
To briefly recap, I stated that the greatest risk I face is missing the turn in the markets due to my strong bearish leaning over the past two years, and that I needed to keep my opinions open and search for signs of stabilization. The first figure in last week’s article highlighted that we have indeed witnessed one of the first signs of economic stabilization, which it has, and that is the negative contribution from housing to GDP bottoms. While the bottoming of the negative contribution of housing is clearly a positive development, I dug deeper into the details of GDP for the bigger picture, looking at housing from various angles.
One of the key tip offs that housing was in a bubble and likely to correct was by viewing the size of residential real estate relative to GDP, which peaked near the upper historical range of 6%, and has now declined to its long run historical bottom. Thus, it is no surprise to see the drag on GDP from residential real estate abating.
Source: BEA
However, we are far from being out of the woods in relation to housing. While residential fixed investment (think new home building) may be near a bottom as home builders slash projects, there is still a MASSIVE glut of homes still on the market that will depress home values well into next year. While the supply of new homes for sale relative to the number of US households is nearing a bottom, existing homes for sale relative to the number of US households is nowhere close to a bottom, far from it! Home builders are the first to respond to economic conditions as they slash prices to clear inventory, while homeowners hold out on the belief that housing prices will rebound and become forced sellers well into a housing correction when they capitulate. This relationship can be seen below where existing homes for sale relative to households lags new home sales by roughly 18 months. Also bear in mind that the size of existing homes for sale is nearly 4 times the size of new homes for sale. Thus, we can expect housing prices to continue to decline until the inventory of existing homes can be brought down, with the negative wealth effect of falling real estate prices to continue to weigh on the consumers psyche for the foreseeable future.
Source: BOC
Furthermore, while the slump in residential real estate is nearing the end in terms of its drag on GDP, the decline in nonresidential real estate is just getting started. Nonresidential real estate construction typically lags residential real estate by roughly 2 years, indicating that the slide in nonresidential real estate is still in the early innings and likely to weigh on GDP to nearly 2011. In the past few years the growth in nonresidential real estate went a long way in helping to offset the negative decline in residential real estate. Now, nonresidential real estate is likely to significantly weigh on GDP, and it is highly unlikely for there to be positive growth in residential real estate to offsetting the decline nonresidential real estate.
Source: BEA
In addition to the role of nonresidential real estate depressing GDP growth will be consumption. Many wise analysts have pointed out that when the US consumer does tap out, it won’t be with a whimper but a bang as personal consumption expenditures make up roughly 70% of GDP. This is exactly what makes a large retrenchment in consumer spending so significant, as residential real estate made up ONLY 6% of GDP at its peak while personal consumption is roughly 70%. To show how significant the impact of a retrenchment in consumer spending means for GDP growth, look at the figure below. You can see that the decline in consumption nearly shaved off 3% of GDP growth in the last two quarters, and to add insult to injury, nonresidential real estate shaved off more than 2% to GDP growth in the recent quarter.
Source: BEA
Like nonresidential real estate, the decline in consumption relative to GDP has a long way to go to return to historical norms. As seen in the figure below, while residential real estate is now back to trough levels, the retrenchment in personal consumption is just getting started and will weigh on GDP for years to come, with possible positive contributions here and there along the way as it returns to average levels.
Source: BEA
I believe the retrenchment in consumption will take place well into the next decade as consumers learn they can’t count on stock and home appreciation as savings. It will take years to restore their balance sheets to more comfortable levels and actually begin to save. For this reason the U.S. economy faces major headwinds that will not likely abate until the next decade. For those interested I have written several pieces over the last year to support this conclusion, with articles listed below for reference. Interestingly enough, we appear to be following the path of the Japanese market post their bubble in 1989, as the chart below illustrates, which would support my view for an end to this secular bear market ending some time in the middle of the next decade.
- 02.27.2008–Change We Can Believe In: The Slow Decline of the U.S. Consumer
- 03.05.2008–The Slow Decline of the U.S. Consumer/Economy - Part II
- 10.15.2008–Secular Sign Posts: The View from 30,000 Feet
- 12.17.2008–Turning Japanese?
Source: Bloomberg
What is vital for people to understand is that deleveraging is not an event, it’s a process. The unwinding of massive debt levels that consumers have wracked up is going to take time, lots of it. The deleveraging that took place during the Great Depression lasted for more than a decade with the government stepping in to support the economy and play a larger role. This can be seen below in the following figure that shows the respective GDP weights for consumption (C), fixed investment (I), government expenditures (G), and net exports (NE).
Source: EconompicData
While some maintain that the develeraging by households will be shallow, I beg to differ and believe the market is telling us to bet on a significant contraction in the role of consumption in the economy. The huge secular bull market in stocks that began in the early 1980s was primarily based on a massive accumulation of debt that fueled consumption and corporate earnings. The primary beneficiaries of this credit boom/bubble were the consumer discretionary and financial sectors. This trend can be seen below that shows a well defined trend of the combined share of the S&P 500 for the consumer discretionary and financial sectors, which rose to more than a 35% combined weighting in the S&P 500. Interestingly enough, the break of this well defined trend broke late in 2007 when the stock market peaked. The destruction in financial and consumer discretionary stocks has been an absolute waterfall collapse, with their combined weighting falling to roughly 17% currently, and well on its way to retrace the entire advance from the early 1980s. I believe the massive market cap destruction in these two sectors is telling us a loud and clear message as stocks discount future economic events, and that is to expect a significant consumer retrenchment ahead.
Source: Standard & Poor’s
Because I expect nonresidential real estate as well as personal consumption expenditures to weigh on GDP growth for several quarters to come, I believe that the low seen this week is not “THE” low for this bear market. If it was “THE” low, then the stock market is expecting an end to the recession by September as the stock market bottoms roughly 6 months prior to a recessions end. I see that as HIGHLY unlikely with an end to the current recession not likely to be seen until early 2010.
For this reason I think we will see new lows ahead for the markets. One index that I have been tracking with greater interest than the S&P 500, the NASDAQ or Dow Jones Industrial Average is the AMEX Institutional Index. One flaw I see with the DOW is that it is a price-weighted index such that the movement in IBM with a current price of .62/share has a greater influence on the DOW than the combined movements of Disney, Intel Corp., Pfizer, American Express, General Electric, Alcoa, Bank of America, General Motors, and Citigroup combined! With the S&P 500, the financial sector represents roughly 10% and plays a major role in its price action. What is attractive about the Institution Index is that it is a market cap-weighted index of 75 stocks most widely held among institutional equity portfolios, designed to reflect their core stock holdings. It basically makes up a great basket of the some of the biggest households names and is well diversified.
Interestingly enough, while the S&P 500 made a new all-time high in 2007, the Institutional Index did not, and actually peaked at nearly a perfect 61.8% Fibonacci retracement of the 2000-2002 bear market, with the 38.2% and 50% retracement levels acting as key resistance levels for 2006 and 2007. The clear break through support at the 2002/2003 lows now indicates the most likely level of support resides at the 94/95 lows, which would correspond to a price target of roughly 440-480 on the S&P 500. A decline to the 94/95 lows would also mark a test of the lower declining trend line that has been in place since the 2000 market top. The figure below is an excellent example of what a secular bear market looks like, punctuated with cyclical bull and cyclical bear markets within the overall secular bear market trend.
Source: StockCharts.com
Many prominent analysts such as Jeremy Grantham and John Hussman believe 600 on the S&P 500 is clearly possible, and while the company is sparse of those that believe numbers below 600 is possible, they are there. For example, Bennet Sedacca, CEO of Atlantic Advisors, believes that not only is 450 possible, but numbers below that can not be ruled out. His recent thoughts are posted below:
A Beatles' Guide to the Bear Market (03.09.2009)
My price targets over the past few years were for an initial stop of the S&P 500 at 750, then 600-650, then 500, then the eventual 450 level. Despite my expectations of miserable earnings and global deleveraging, I’m sad to say that my ultimate targets may have actually been a bit too optimistic. My price target now for the S&P 500 is in the 350-400 range, which is still a decline of 40-50% from current levels.
While numbers such as the above are hard to fathom, how many believed more than a year ago that we would breach the 2002 lows? One of the things I tried to stress in last week’s article was the level of volatility and stress that we are witnessing in financial markets hasn’t been seen since the Great Depression. Some have maintained that comparisons to the Great Depression are ridiculous, with famed investor Steve Leuthold being one of them. His comments from a Bloomberg interview last week are provided below (emphasis added).
Leuthold Says Stocks Will Surge, Depression Avoided
Steve Leuthold, whose Grizzly Short Fund returned 74 percent last year betting against U.S. stocks, said now is the time to buy equities because investors are too fearful about the economy.
"These comparisons people make with the Great Depression are totally out of touch with reality, and pretty stupid," he told Bloomberg Television in an interview today. "We’ve been in much worse, much more panicked and more scary situations in the U.S."
The economy isn’t as bad as it was in 1974, when stocks began rebounding, said Leuthold, who oversees .2 billion at Leuthold Weeden Capital Management in Minneapolis. He predicted the Standard & Poor’s 500 Index will surge to at least 1,000 in 2009, representing a gain of 44 percent from yesterday’s 12-year low of 696.33.
I respectfully disagree. What I commented on last week that has me gravely concerned is the level of stress in the currency markets, as current stress levels make the Asian Currency Crisis pale in comparison, and we can not rule out that we could see an Eastern European Currency Crisis. This can be seen in the figure below that shows my Currency Market Stress Index at levels nearly three times those seen in the Asian Currency Crisis.
Source: Bloomberg
The volatility and stress we are seeing in other financial markets like the bond market clearly support the notion that we are in the most serious situation since the Great Depression, and I’d argue with Mr. Leuthold that the degree of financial stress seen in 1974 can’t even come close to comparing to the current situation, and one truly does have to go back nearly 80 years of history to find a relevant comparison. There are others who are not as sanguine and still cautious as they listen to what the currency markets are telling us, with Martin Armstrong, former Chairman of Princeton Economics International, one of them. His commentary from a recent article is provided below.
Is it The Time To Turn Out the Lights? (02.19.2009)
The greatest concern that we should have is that the sheer degree of volatility is off the charts. We are looking at nearly an outside reversal to the downside of the Euro on an annual basis! This degree of sheer volatility is truly amazing on an annual level. We have not seen this type of volatility on an annual level since 1933. Just look at the previous chart of the Pound. Note that in 1933, the Pound fell to new lows, but then reversed and even exceeded the level, due to Roosevelt’s 60% devaluation of the Dollar and the confiscation of gold domestically. The sheer level of volatility is clearly back to the days of the Great Depression…
I cannot stress enough that the level of volatility that we are experiencing during this financial crisis is just well beyond even that experienced during the early stages of the Great Depression and is more akin to the collapse of Rome. That is a stark comparison that tells me this is nothing to fool around with and try to gather political power and install the life-long dreams of socialization. I find it extremely ironic that the nation poised to explode as a rising star of the new age of capitalism is China. The likelihood of either Europe or America doing the prudent economic policy to save our free economies is about as likely as myself running for President.
I simply can not turn bullish until I see some signs of stabilization in the currency markets, and thus believe that the current rally is only working off the markets oversold condition, with new lows in our future, not behind us. A possible Elliott wave principal interpretation applied to the AMEX Institutional Index hints that there is more pain ahead. We look to have completed the first two major waves of this bear market, with wave 1 being completed at the March 2008 lows, wave 2 completed at the July 2008 peak, with the index now working off the last count of wave 3.
Source: StockCharts.com
The November 2008 lows would constitute minor (red) wave 3 of intermediate (green) wave 3, with the January 2009 high representing minor wave 4. Breaking down minor wave 5 (red) of intermediate wave 3 (green) shows that we have completed minute waves (blue) one through 3, and the current rally appears to be minute wave 4, with a potential price target using a 38.2% and 50% Fibonacci retracement levels of ~385-400, or roughly 750-775 on the S&P 500.
Source: StockCharts.com
If the market stalls there and turns down, then we would be minute wave 5 of minor wave 5 of intermediate wave 3 that could carry us to new lows, which would then mark a significant intermediate term bottom that could lead to a multi month rally representing intermediate wave 4. This pattern would resemble what we saw last year, with a bottom in March and a multi month rally into May. We could then be in store for a next top with the “sell in May and go away” seasonal pattern. A May top could then lead into an intermediate wave 5 decline that could take us below 600 for the ultimate low to this bear market, with the bottom in the second half of the year, with September to October being historical months for bear market conclusions.
The above is highly subjective but does at least help provide a roadmap for what we could see. If I am far too bearish then I will have only missed out on opportunity, NOT CAPITAL. A move by the S&P 500 above 800 would tend to invalidate the above analysis and I could be proven to be far too bearish. Until the markets and my stress indices tell me otherwise, I continue to believe the path of least resistance remains to the downside, and the current rally could be nothing more than a sucker's rally, eating away at long term investors capital.
