Last week, we observed a significant deterioration of market internals. On the slightly brighter side, from a valuation perspective, the pullback in the market has modestly increased our estimate of likely 10-year S&P 500 total returns from about 3.4% at the market's peak to about 3.9% presently. That's an improvement, but the muted extent of that improvement should provide some indication of the extent of market losses that would be required to restore meaningfully attractive prospective returns.
From the standpoint of market action, we presently see two lines of critical support. The first is right here at current levels. A week ago, I noted that "one or two more reasonably sloppy weeks would significantly damage market internals." Last week's market action was more than sloppy, with the result that even another modest down week would signal a measurable shift of investors toward risk aversion - and if history demonstrates one thing, the worst periods for the market are those where risk premiums are thin and risk aversion is increasing. A second line of support corresponds to the March lows, where a deterioration would throw a great number of technical trend-following methods simultaneously into sell mode. Whatever one thinks of those methods, investors should probably not ignore the prospect of a speculative liquidation in a market too overvalued for fundamentalists to be interested.
My guess (which we don't trade on and neither should you) is that after several weeks of declines, the market has a good chance of stabilizing and possibly advancing from the present line of support, as investors try to "buy the dip" despite weakening economic data, divergent market internals, and limited prospects for further government stimulus. This is also the general picture for various ensembles of market conditions we examine - relatively neutral short-term (improved from quite negative a few weeks ago), but still with a negative average return/risk profile looking out more than a few weeks. For our part, our overall range of flexibility remains between a tight hedge and about 10-20% exposure to market fluctuations, with a strong line of downside protection still essential in any event. Again, this is because a break of various nearby support levels here would likely prompt an exodus by a large trend-following contingent of speculators, in an environment where value-conscious investors would not have much interest except at substantially discounted valuations.
In recent weeks, and particularly in last week's ISM, employment claims and unemployment reports, we've observed a substantial weakening in measures of economic growth. At present, the evidence of economic deterioration is not severe - as I noted in 2000, 2007 and last summer, recession evidence is best obtained from a syndrome of conditions, including the behavior of the yield curve, credit spreads, stock prices, production, and employment growth. While all of these components have weakened, they have not deteriorated to the extent that has (always) accompanied the onset of recessions.
To a large extent, the current softening of economic conditions is really nothing more than the recrudescence of the deterioration we saw last summer. Basically, we're coming up on the can that the Fed kicked down the road when it initiated QE2. While the Fed was successful in releasing a modest amount of pent-up demand, and was certainly successful in provoking speculative activity, there was never a realistic prospect of creating a beneficial "wealth effect" for the economy as a whole. The historical evidence is emphatic that people consume off of perceived "permanent income" - not off of volatile dollars. Wealth is driven by the creation of long-term cash flows through productive investment, not by boosting the valuation of existing cash flows by encouraging speculation. There was no reason for people to take much of a permanent signal from fluctuations in a stock market that has lost more than half of its value twice in a decade (and is likely to lose a good chunk of its value again if history is of any indication).
So while the Fed has been successful in fostering speculation, further impoverishing the world's poor through commodity price increases, and subsidizing banks by driving funding costs to zero (at the expense of the risk averse and the elderly), QE2 has clearly failed from an economic standpoint. This failure is not because we haven't given it enough time, or because monetary policy works with a lag. Rather, the policy has failed because it focused on easing constraints (bank reserves, short-term interest rates) that weren't binding in the first place. Very simply, neither the Fed's policy, nor the fiscal policy initiatives to date, address the central challenge that the U.S. economy faces, which is the debt burden on households.
The salient problem in the U.S. economy isn't the precise level of already low mortgage rates. It isn't "uncertainty" about taxes or health care. The problem is that people aren't spending as they did in recent decades, because that spending was largely debt-financed, and the pressures now run in the opposite direction. We still haven't restructured mortgage debt on millions of homes that are underwater. Property values are hitting new lows. Hundreds of thousands of properties are delinquent and yet the mortgages are being carried by the banking system at face value. Banks, knowing this, are clearly reluctant to extend their balance sheets further. Government deficits of nearly 10% of GDP are presently required to cover the gap in private incomes and spending. Indeed, most of what we observe as personal income growth is attributable to transfer payments from government.
To be clear, I believe that about 90% of the economy is functioning reasonably well (in the typical range of what is experienced over an economic cycle), but 10% of it is in extreme difficulty well outside what is seen in the normal cycle, and is only floating thanks to deficit spending that is unsustainable in the long-term and increasingly under pressure in the short-term. The problem is that we measure severe recessions as declines in GDP on the order of 2% or so. Without addressing the central problem of household indebtedness and underwater mortgages, the economic growth we get may not be robust enough to avoid more frequent recessions and near-recessions.
