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Thursday, 6 August 2009

etfguide Is This Rally Out of Sync with the Economy?

By Simon Maierhofer

In the good old days, farmers knew better than to yoke a bull and an ass together to plow the field. The yoke would be uneven and no good would come from it. How about a bull and a bear, would those two harmonize?

We shall find out soon. Unknowingly, investors have been watching a bull and bear work together simultaneously. We have a stock market bull and an economy bear. How so?

For nearly five months, the major U. S. indexes such as the S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC), along with international stocks (NYSEArca: EFA - News) have been climbing higher and higher. Simultaneously, economic numbers continue to disappoint. In other words, the stock market bull is thriving, while the economy bear is diving.

Full of confidence, the stock bull is vivacious and obvious to all while the economy bear is ashamed of its dark existence. It thus makes sense that bad news is hardly broadcasted, in some instances one even has to search for it.

Just because the bad news hasn't been presented with neon lights doesn't mean it isn't there. In fact, the prevalence of bad news would ironically be good news, because as we know, new bull markets climb a wall of worry. The fact that worrisome data isn't making it to the front page of newspapers and prime financial television should worry the stock market bulls.

Doing the dirty work

Since few others are doing it, we will do the dirty work and lay bare the economy's Achilles heel. Knowing the bull and bear can't cohabitate the same economic turf, we will discuss the resolution of this conflict.

Disappointing earnings

As earnings season nears its end, it is eye-opening to take a look at the composite results. Even though a good portion of companies have beaten their earnings estimates (Intel, Goldman Sachs), we shouldn't forget that those estimates were low-ball estimates. Profits were not the result of new sales; they were the result of cost-cutting, or Chinese stimulus money. Of course, cost-cutting equates to employee cutting and a higher unemployment number.

Despite their cost reduction efforts, low-ball forecasts, stimulus money, and incentives like cash for clunkers, 39% of companies (according to Standard & Poor's data) were not able to meet their forecasts. Revenue of S&P component companies is down more than 10%.

Dismal jobless reports

The 9.5% unemployment rate does not reflect the 4.4 million people who've been unemployed for more than 27 weeks, or the employees who've been forced to work less and make less. As part of the above mentioned cost-cutting efforts, companies cut the hours worked by a record 2.3% to an all-time low 33 hours. The 'all-inclusive' unemployment rate published by the Bureau of Labor Statistics is 16.4%.

For a moment, suppose you are a company executive. If the economy gains momentum (that's a big if), would you hire new employees or simply increase the hours worked by current employees back to a normal level. There is no light at the end of the tunnel when it comes to better unemployment numbers.

Bank lending

An unemployed consumer doesn't spend or borrow money. This is the essence of a Wall Street Journal article which reported that the total amount of loans held by 15 large U. S. banks shrank by 2.8% in the second quarter. More than 50% of total loan volume came from refinancing mortgages and renewing credit to existing businesses.

Banks have realized that there is no benefit in lending out more money. As credit worthiness decreases, loan defaults increase. For once, financial institutions (NYSEArca: XLF - News) and banks (NYSEArca: KBE - News) are actually doing what's right, even though it seems wrong.

Consumer sentiment

The most recent University of Michigan Consumer Sentiment Survey revealed the following:

Confidence slipped from 70.8 to 66

Income expectations fell from 113 to 120 (50% of consumers fear losing their job)

Home-buying intentions melted from 157 to 147

Car-buy intensions faltered from 139 to 133

This sentiment is perfectly understandable considering that wages and salaries have declined at a record pace.

No more help from baby-boomers

The hopes for a continued bull market, or a bull market resumption, has often relied on the financial stamina of the baby boomer generation. Baby boomers were responsible for nearly 80% of the spending growth from 1995 to 2005. Needless to say, plunging prices courtesy of Dow Jones (NYSEArca: DIA - News) and S&P 500 (NYSEArca: SPY - News) have not helped their retirement plans. In fact, nearly 70% of baby boomers around age 60 now say they are financially unprepared for retirement.

Those hoping for retirees to come and buy stuff' may soon find that retirees are competing for jobs. The 100,000+ monthly new entrants into the labor market will soon be competing against seasoned veterans.

Valuation metrics

Looking at Wall Street and trying to figure out the fair value of the Dow Jones reminds me of KPBS's 'Antiques Roadshow.' Many analysts own all kinds of stocks, all believed to be undervalued until it turns out that they paid way too much. On December 16th, 2008 for example, Morningstar ran the article, 'We Think the Dow is Trading at a 30% Discount' pegging the Dow's real value at around 12,500.

On the same day, TheStreet.com featured the piece, 'You're witnessing the Stock Sale of the Century' claiming that the bear market that ended on November 20th was phony and shouldn't have happened. It didn't happen and it was far from over at the time.

In contrast, the ETF Profit Strategy Newsletter considered financial companies a 'downward spiral with no stop-loss provision' before the real meltdown actually started and recommended short ETFs in September 2008, and once again in early January 2009.

Discerning the true value for stocks is actually quite simple, if you are humble enough to stick with a simple concept. During prior bear market bottoms of historic proportions, P/E levels, dividend yields, and mutual fund cash reserves have always reached levels indicative of a market bottom.

Unless those indicators provide their stamp of approval, the market is overvalued and any rally will turn out to be short-lived. Based on those indicators, the market is grossly overvalued, still.

What fuels this rally?

During the Great Depression, the stock market declined in steps. A 48% decline was followed by a 48% rally. The next 47% decline was followed by a 23% rally. This process continued until the Dow Jones lost over 89% of its value.

Investors who jumped back in after the initial 48% decline saw their portfolios dwindle by yet another 60%. Investors who thought they were 'bargain hunters' after the second rally, found out that their bargains were a money pit. The cycle continued until the market had destroyed the financial existence of many.

This rally is simply here to relieve investors' pent-up urge to buy and recreate an environment that will drag the maximum amount of money back into the losing vortex.

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