Do you believe what everyone is saying about a second half recovery? Do you think the worst is behind us? Do you think we are out of the woods? Not so fast!
In early March, when the stock market bottomed, everyone was talking about how Armageddon was upon us. Now, just two and a half months later, everyone is talking so optimistically about how the economy is recovering nicely.
This bear market rally – yes, we are still in a bear market and will be for some time – was caused mostly by short covering. That is, people who were betting stocks would fall reversed their bets when the market turned higher after Citigroup said it was “profitable” the first two months of the year (I’ll touch on the banks’ false profits later). Some of the worst performers from 2008, which were the most heavily shorted stocks, have led the market higher.
I am not a buyer of this false rally and all the economic “green shoots.” Right now, the path of least resistance for stocks is lower because all the “good” news has been priced into stocks. Everyone is a little too optimistic about a recovery in the near term (I think we will be trending sideways for a long time) even as some economic indicators are worsening.
The stock market has rallied 31% from its recent low, but it will not go much higher. Current earnings estimates for the S&P 500 are $56.94 for 2009 and a whopping $73.37 for 2010. (source: Thompson Reuters) Is it realistic that companies will improve their earnings 29% over the next 18 months? I do not think so! Earnings estimates will come down; therefore, stock prices will come down too. Here’s why:
1) Companies are selling assets to raise cash (especially banks) and they will not have the same earnings power going forward.
2) Unemployment is expected to go to at least 10%. Even though initial jobless claims are “stabilizing,” continuing claims hit a new record every week. As more and more people lose their jobs, spending will decrease causing corporate earnings to decrease.
3) Taxes will go up to help offset the government’s massive debt. Obama already said this is going to happen; it is a matter of when not if. As personal income taxes go up, the consumer will get pinched and decrease spending. Corporate taxes will also go up which will cause companies’ bottom lines to shrink. To offset decreased profits, price increases (inflation) are very likely which will also hurt the already ailing consumer.
Also, who wants to invest when the government keeps changing the rules and intervening? First were restrictions for financial companies that took (or, rather, were forced to take) TARP money. Next were the automakers. The government should just cut its losses and forget about setting up a government-owned auto company that will buy GM’s “good” assets when it files for bankruptcy. Ridiculous if you ask me. Government cannot run government. How is it going to run an auto company? Now it is the credit card companies and new legislation preventing rate hikes when people miss their payments (in no way, though, am I saying what credit card companies were doing was right).
Let me briefly touch on the banks’ “false” profits. Goldman Sachs (GS) reported better than expected earnings because it shifted its fiscal calendar so December results were not included in its most recent earnings release. GS had a $780 million after-tax loss in December that will go largely ignored. (source: nytimes.com) Citigroup and Bank of America were profitable because they were able to book “gains” (thanks to mark-to-market accounting rules) as their CDS spreads deteriorated. Basically, they lowered the value of the liabilities on their books and this reduction was treated as a gain on the income statement. (source: Portfolio.com)
That is enough negativity for now. Let’s focus on some positives. Below are some recent fundamental improvements in the economy.
1) Banks have been able to raise capital successfully in the equity market to meet the government’s stress test requirements. Many of these offerings have been over-subscribed – a sign that investors have a higher appetite for risk. Most notably, Bank of America raised $13.5 billion, Wells Fargo raised $8.6 billion, Morgan Stanley raised $4 billion, and U.S. Bancorp raised $2.5 billion. (source: Bloomberg.com)
2) Banks are not afraid to lend to one another anymore. The overnight LIBOR rate currently sits at 0.46%, down from its high of 4.82% after the collapse of Lehman Brothers. (source: Bloomberg.com)
3) Corporations have been able to issue debt. Recently, Microsoft issued $3.75 billion and Wal-Mart issued $1 billion. However, only companies with the most pristine balance sheets have been able to access the debt market. (source: Bloomberg.com)
4) IPOs have started to pick up again after being non-existent for some time. There were 296 IPOs in 2007, 57 IPOs in 2008, and eight so far this year. Seven of the eight IPOs this year have taken place after the market bottom in early March. (source: MSNBC.com)
5) Mortgage rates are still near historic lows even as yields on longer term Treasurys have steadily risen. The average 15-year fixed rate mortgage is 4.64% and the average 30-year fixed rate mortgage is 5.00%. (source: Yahoo! Finance)
6) Commodity prices are rebounding with the biggest gains coming in the energy complex. Gasoline futures are up 132% from their late-December low of $0.785 and crude oil futures are up 89% from their mid-December low of $32.40. Demand from the emerging markets remains strong as they avoided a lot of this financial mess, and OPEC is talking about cutting production again. There is also talk that the “evil” speculators are back and they are the reason prices have rallied so strongly. (source: Barchart.com)
Even though there may be signs that the economy is “not as bad” as before or that it is “stabilizing” (two phrases that I hate and hear way too often on television), there are many fundamental problems that remain. Do not get caught up in the media’s effort to talk-up the stock market or the economy. If you turn your head to the problems that still exist, like the media is doing, you will get burned when everyone finally realizes we are not out of the woods just yet.
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