The Insightful Trader

If this is the Bull Case, Count me Skeptical

by on Jun.22, 2009, under Editorials

 Although the S&P  has  stalled out for the moment it had quite a rebound from the March 9 bottom. And until June 12 or so the market shrugged off bad news quite regularly. It’s easy enough to understand a rebound from a panic low, but are we really in a new secular bull market?  The recent Forbes article, “The Real Suckers are in Cash”  tries to prove that case, but comes up short.

  Forbes’s case: the March 9 bottom was THE bottom, the recent stock market strength tells us that that the end of the recession “is plainly in sight.” Housing is bottoming, autos are bottoming, commodities are booming, credit markets are healing, and stock earnings yields provide ample competition for bonds. It looks so good that the cash on the sidelines will have to come in, mostly to stocks but maybe also to commodities, which can keep going as the economy rebounds or if inflation expectations rise.

    Regarding their case for rapid economic recovery the Forbes article  contains at least one outright misstatement: “The U.S.  manufacturing Institute for Supply Management  Index (ISM)  rose to 42.8%S in  May, which usually signals that gross domestic product is expanding rather than  faltering.”  No, it usually  doesn’t. According the ISM, readings lower than  50  on  the  Index  signal contraction.  Forbes reporter  Robert  Lenzner  should  know  this.  I think Lenzner meant to tell us that  GDP was contracting  at  a decreasing rate,  but  that’s not  what he  wrote. Furthermore, the Index measures activity in the manufacturing sector rather than GDP as a whole. While expansion in manufacturing would be good news for the economy, our shrunken manufacturing sector accounts for only about 20% of total US economic activity. 

    Increased home construction traditionally helps boost a recovering economy. Since residential construction is not recovering yet, Lenzner reaches for the bright side and notes  April’s  6.7%  jump  in  pending  home sales when compared with April 2008, as measured by the National Association of Realtors (NAR) Index. There is less to this one than meets the eye. Even though pending sales are up home prices continue to fall, according to economists at BMO, who seem to have provided Lenzner with much of his data. In other words, the housing market shows falling prices on higher volume— not exactly a healthy market yet.  In addition NAR says that April’s strong data may reflect a desire to get home purchases consummated by November in order to qualify for the the $8,000 first time home buyers’ tax credit. Therefore NAR implies that current data may reflect a boost in current sales at the expense of future sales.

     Moreover, as of now, most of the sub prime loans with that originally came with introductory teaser rates have already reset — but the alt-A schedule of loan resets is about to pick up steam. Alt-A loans are supposedly of higher quality than subprime, but more likely to default than prime loans. When these loans reset, many homeowners in higher price brackets, who often got alt-A loans, will be squeezed as the sub primers were, forcing some to default and place more distressed inventory onto the market. Increasing unemployment is forcing more prime mortgage borrowers to default as well.  Housing isn’t just “in the tank” as Lenzner says, it continues to deteriorate. Finally I find it odd that Lenzner actually missed the one positive sounding data point in April’s housing numbers, an increase of spending on improvement of existing residences of  8.9% year on year as reported by the Census Bureau. 

   Another industry that often helps lead us out of recession is automobiles, and Forbes correctly notes that auto sales improved in May by about 100,000 vehicles over April to the best performance of the year. Is this a big deal? Too early to tell, in my view. Sales are down year on year, as one would expect, and they remain anemic, below a seasonal adjusted annual rate of 10 million. No doubt auto sales could rebound off their lows, but what concerns me is the consumption pattern going forward. Does anyone expect the average middle class homeowner to finance a second or third car from a home equity loan (as was often the case in California and Florida?). As I understand it, the industry was geared to produce 16 million units annually before the recession hit; in his March CNBC interview Warren Buffett forecast that 13 million would be the new normal rate going forward, but felt he had to argue with those who forecast that rate rather than 11 million. The difference between 16 million and 13 million: the people who have lost their jobs so far in Detroit’s bankruptcies, and perhaps more to come, especially if the 11 million number should become accurate.

    Still… a rebound to 13 million would be great news. And… much more of that rebound will have to come from savings, not borrowing, because consumers are tapped out and forced to raise their savings rates. They certainly have less home equity to borrow against, too. My verdict: an auto sales rebound should happen, eventually, but a strong rebound is not something to bank on heavily any time soon. I expect consumers, especially those with secure jobs or who need cars to get to work,  to replace cars that need replacing, but less frivolous consumption, especially financed by imprudent borrowing, will be less common than in previous cycles. New employment will have to come from a new industry in this recovery, maybe from green technology if we are lucky, but that too will take time.

    Lenzner asserts that the recent increases in commodity prices imply that the economy ” is about to turn the corner,” presumably because higher commodity prices signal  industrial raw materials demand. That’s a hard case to prove because, not only is the US manufacturing sector continuing to contract, as noted above, but our trade partners such as China, Germany, and Japan, are contracting too since their exports to the US are down year on year. Forbes does not tell us, who is making more of what? I suspect, few companies are actually making much more of anything: as London based portfolio manager and financial blogger Macro Man writes, China has been buying commodities heavily but putting them into storage rather than using them in manufacturing.  The Chinese business magazine Caijin (h/t, Naked Capitalism) adds descriptive color to Macro Man’s charts and statistics. Caijin notes that China has increased bank lending by six trillion yuan since year-end 2008, and that many of these loans have gone into commodities speculation.  Caijin’s writer Andy Xie fears this margin financed commodity buying could come to a bad end. Having said that, I am bullish on commodities longterm, though they may have gotten ahead of themselves here. I agree with Lenzner, that commodities could rise over time with inflationary expectations.

   Forbes also states that there is a large repository of cash sitting on the sidelines that is feeling left behind. Lenzner even says that this sum equals half the market cap of the S&P500. It’s hard to analyze this statement fully, since Lenzner does not name his source. However, veteran money flow analyst Charles Biderman of  Market Trimtabs  told CNBC on June 18 (h/t, Zero Hedge) that sideline cash is nearly spent. Based on his funds flow analysis, Biderman rates the market a sell and is in fact short banks, consumer discretionary, and retail stocks among others. He stated that companies are selling stock “as fast as they can.” According to Biderman, 7 of the 8 times when, by his measures, companies have have sold large amounts of new stock to the public while company insider trading activity is simultaneously bearish, the market has subsequently declined.

    Although Lenzner thinks the ability of the credit and equity markets to absorb new supply is positive, and that has certainly been true up to a point, one might also remember the old Wall Street adage, “When the ducks quack, feed ’em.” Wall Street can only sell stock when markets have been strong, but the new supply soaks up at least some of the available buying power.

   Speaking of funds flows, Forbes (along with many others) claims that compression in key short rates and spreads (such as LIBOR and the TED spread) proves that the money markets have healed. As stated two weeks ago, I believe these spreads are now misleading indicators. No one knows just how high these rates would be, absent the trillions of dollars that the Fed has lent under its new, extraordinary programs such as TAF, TSLF, PDCF, and so on. In addition, we have Treasury’s explicit guarantee of money market funds, and its de facto guarantee on all liabilities of major banks. One suspects that without these programs, money market rates would be significantly higher. Of course the right thing to do would be to use these guarantees as a temporary shield to forestall panic while the FDIC shut down insolvent institutions and forced banks to mark tradable assets to market. Until that is done, we effectively have a nationalized money market whose indicators tell us how much confidence lenders have in the US government, rather than how much confidence they have in institutions that stand on their own.

   Forbes puts a great deal of store in the comparison of earnings yields with bond yields, in effect relying on the “fed model” to show that stocks are cheap. For those of you who need a refresher, the fed model compares earnings yields to bond yields and says in effect that when earnings yields on stocks are greater than bond yields, investors buy stocks. Given  the earnings estimates Lenzner is apparently using, he says that the yield on bonds provides stocks with room to move to 9,000 or even 10,000 by summer’s end.  I would make three points here.

   First of all, the “fed model”relationship is not set in stone. Up until the late Fifties, investors demanded a higher yield on stocks than on bonds, to compensate for the inherent uncertainty that stocks provide. Later, in the Sixties, investors became more willing to pay up for the growth prospects that stocks also provide, and Lenzner seems to assume this behavior will continue. Could the relationship between stock and bond yields shift again? Value investors, at least, have talked about that in the past year.  Second, I have never liked the fed model with bond yields below 5% or so. Like it or not, if you use the fed model then you are forecasting P/E ratios in excess of 20. That may be reasonable in a stable environment with great growth prospects, but it would be hard to argue that we are back in Nirvana now.  

    Thirdly, Lenzner’s argument says that we can dismiss inflation concerns for the next 2-3 years, and so we need not worry that bond yields will rise and provide more competition for stocks. I would actually agree with the first part — inflation feels tame for now in this environment. The Fed’s extraordinary programs have replaced vaporized assets on bank balance sheets rather than increase the money supply as much as might appear,  and banks are not eager to lend out the money they have. That keeps demand for goods, and hence inflation, low. The real trouble as I see it, is the increasing supply of bonds to finance the government’s fiscal deficit. Seemingly every week the bond market faces an an auction with trepidation. Is this really the time to buy stocks because you are confident that bond yields will stay low? I have trouble with that.

   Of course Forbes covers itself by listing the usual worries: increasing unemployment, decreasing consumer spending, inflationary expectations. Fair enough.  But when I read through the Forbes case, I just don’t see a cogent reason to buy stocks here. And to go higher, we need, not just holders who keep holding, but also, new buyers to push the price up.

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