Zeller Kern’s Weekly Investment Monitor
An Oversold Market With Lots of Uncertainty September 1, 2010
Last week, we experienced a little more volatility in the markets that, so far, is within a continued sideways direction - a pattern that gives no indication as to whether we will begin to break out to higher stock prices, or, begin the next stage of notably lower stock prices. The good news is that the level of bullish sentiment among investors, which are investors that think the market will head higher, reached down to levels not seen since March of 2009 when the stock market bottomed. This is often seen as a contrarian indicator, but the cruel reality is that the market will very often move in the direction that hurt the most market participants. Just as the investment "herd" thinks the market is about to crash, very often, it turns right around and takes off to higher levels.
However, this investor sentiment exists within a world of massive uncertainty. Perhaps, investors are so pessimistic because they are beginning to look at the future conditions and challenges within our economic system and are concluding that a bit of risk and volatility could be on the horizon. Our technical models within our investment discipline continue to be in a defensive posture which has been the case since May of this year.
Of course the current environment is much different than it was back in 2008. So far, the market activity hasn't been about economics for about the past 18 months, if it were we would still be at 600 on the S & P 500. The reality is that corporations are more efficient and able to adjust to risk and enter into austerity strategies than governments are, thus keeping corporate profitability increasing in spite of declining or flat revenue growth. Corporations are unloading their debt at an amazing rate and are reducing their issuance of bonds at an unprecedented $355 billion annual rate - which brings us to the discussion of our Federal government and the Federal Reserve.
With the recent meetings at Jackson Hole last week, Ben Bernanke and company made it clear that they are willing to take Keynesian theories to the limit and bailout, spend, and even expand the balance sheet through monetization, whatever it takes to float the economy. However, it seems like they are not worrying about the consequences of their actions until it is too late. Through the first quarter of 2010, the Federal Reserve printed approximately $1.5 trillion of paper money which was used to buy mortgage bonds, Treasury bonds, and government agency bonds. The concerning thing about all of this is, even with these actions the economy is showing signs of slowing and the banks are still closing. While they continue to print massive amounts of money and take on incredible levels of debt, the private sector is undergoing a massive contraction in debt which includes corporate bonds, bank loans, mortgages, and consumer credit. This is painting a picture of what our firm has been expecting since early 2008 - deflation. And it is looking more and more like Ben Bernanke knows this, which is why he is making statements like the one he made last week in Jackson Hole, Wyoming.
As we have argued for a few years now, the trend will eventually be deflationary. We argue deflation because it will be driven by a massive contraction of credit - a contraction that aggressively removes money that once used to be injected into the economy and provided growth. When it contracts, it flows out decreasing economic growth and demand for goods and services. So what are the trends? If we include both the government and private sectors, the total new credit in 2007 was $4.5 trillion. Now, it's running at about a zero percent annual pace. This is a cycle that has to work itself out and we will get through it eventually, presenting us, we think, with unprecedented opportunities. But, in the meantime, if you don't get out of the way when the bus finally arrives, you could get clobbered.
Although, we do see some potential good news for the markets. While there is little real growth likely to happen in the economy there is a shift in sentiment if a change in the control of Congress takes place. If you don't think politics count, think again. Very often politics and taxes are major factors that can affect the markets. It will be very interesting over the next several months to see how this all plays out, which may end up providing a positive trend for the markets.
The Markets
The major indices closed the week with only modest declines after Bernanke fueled a large rally on Friday, helping to offset some of the growing concerns regarding the pace of the economic recovery by making sure that everyone knows that he is committed to Keynesian strategies. At least for the day, the market participants liked what they saw.
The S&P 500 declined to a loss of 2.3% before rebounding by the end of the week to show just a 0.7% decline. While only three of the 10 sectors were up the tech sector was the main laggard showing a decline of 2.1%.
Stocks rallied 1.7% on Friday after Ben Bernanke said that he is ready to use "unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly."
Unfortunately, economic data continued to trigger more negative sentiment as the housing industry remains in depression as it recorded the worst stats in history. This was evidenced by the release of existing home sales which plummeted 27.2% to a 3.83 million. Even more troubling, July is typically one of the strongest months for home sales, but the possible tax credits pulled sales into the earlier part of the year.
New home sales numbers declined to 276,000 in July, the lowest level since records began in 1963. When comparing these stats with current population versus 1963 when there was over a third less folks in the country, these numbers are beyond dismal. It is possible that new historical sales lows will be broken each month through the remainder of the year.
The latest revision of second quarter GDP was revised to 1.6% from the prior reading of 2.4%. The rate, however, was better than expected. We expect the market is likely to remain in the current trading range for at least the next 2 to 3 weeks.