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August 29, 2005 |
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Oil is rigged firmly above $60 a barrel, US consumers are not saving a dime, house affordability (index) is at its lowest point since September 1991, and the US yield curve is threatening to invert. Those that live in Pleasantville could argue that the US economy is not as dependent on oil as it used to be, that the US savings rate is misleading because stocks and real estate are not included, that the yield curve is a barbaric relic, and that anyone can afford a house with no money down. Those with common sense know better.
Why will the bear resume? The obvious reason why the bear is about to make a come back is because the S&P 500 is trading at more than 20 times core earnings and yielding less than 1.8%. If you back out the 1990s these valuation levels have rarely been seen in history, much less sustained. And while FirstCall notes that since 1950 there has only been four periods when corporate earnings have registered 10+% growth over eight quarters in a row - and that we are in such a period today – it should be noted that stocks do not follow the earnings trend verbatim: the markets crashed when earnings were running at 10%+ before (3Q87), and severe bear market developed at the end of another historic earnings streak (3Q74). In short, with the 2-year earnings recovery threatening to slow down the prospect of the fundamentals catching up with stock prices is remote. The less obvious reason why the bear is near is that rising interest rates are giving investors an attractive alternative to stocks. When the Fed was aggressively cutting interest rates – to the point wherein savers were essentially being taxed - money piled out of many fixed investments and (back) into stocks. The exact opposite situation is threatening to happen today: the Fed is raising interest rates and ‘safe’ investments (MMs, CDs) are becoming increasingly attractive. It may only be a matter of time before the 30-month trend of outflows in MM and related investment flows reverses, thus draining liquidity from stocks.
The final reason why the bear may be near is because with so many crisis type situations developing it is difficult to conclude that a crisis will be avoided. The US current account deficit, the housing bubble, record oil, Fannie, GM/Ford (debt markets), record bankruptcies, hedge funds, derivatives nightmares…The list of deeply concerning issues goes on and on. In fact, the list is so long that the US stock market bubble barely receives any coverage at all. Granted, the contrarian could argue that since fears of crisis are so strong that this means no crisis is near. However, ask this contrarian if he wants to buy real estate in Florida, invest in a hot new unregulated hedge fund, write naked Fannie puts, and leverage long on the US dollar. Fed Optimism Not Warranted If tempted to believe that the Fed can quickly remedy any crisis or economic slow down, what should be remembered is that the Fed had a difficult time stimulating the US economy after the 2001 recession; that many feared the Fed would be ‘pushing on string’ up until mid-2003 (or when the refi mania really kicked off and Greenspan started taxing savers). Point being, the last 2-years of relative calm in the financial markets arrived only after 3-years of angst. News that the Fed is cutting interest rates – perhaps as early as next year – should be of little comfort to the investor. Conclusions There is no scenario wherein after the next three Fed meetings that the asset dependent US economy will be in better shape than it is today. Rather, and to reiterate, common sense says that either the curve is going to invert, long-term interest rates are going to rise, or the Fed is going to stop tightening soon. None of these scenarios is an appealing prospect to the investor, and yet one of them will come to pass within the next 17-weeks! An inverted yield curve is a negative force on the lending/borrowing dynamic, rising long-term interest rates equals bad news for the US housing market, and if the Fed stops tightening it will be because of a slow down in either the economy and/or housing market. The US economy has surprised the pessimists before and could, albeit temporarily, do so again. However, with investors having immersed themselves in riskier investments since 2003 and consumers – although quite willing – unlikely to find the means to support a significant increase in spending, the odds of a slow down are rising. In fact, even if the US housing market can continue to support the US economy for a little while longer, housing price gains have been so sensational that further advances would only harden the conclusion that a day of reckoning is near. In other words, there comes a point when the short term economic benefits of the booming US housing market no longer outweigh the potentially devastating impact of a housing crash. And although no one can be certain exactly when this point will arrive, rhetoric and policy actions from the Fed suggest that it already has passed. In short, a recession/bear market in 2006 looks increasingly likely. This is the case not only because of record oil, 0% savings, and a potential peak in corporate earnings, but also because Greenspan and company will not take their foot off of the brake until the ‘froth’ in the US housing market dissipates. The real danger for the US economy arises when the housing mania finally cools and investors potentially seek degree of safety not found in stocks and real estate. Quite frankly, beyond housing and equities there is no readily identifiable asset class than can be artificially stimulated with cheap money to usher in another round of unsustainable growth in America. This realization could quickly make the mad crowd of speculators hunting for a positive investment return angry.
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