poohIt’s hot, too hot for my liking.  I’m sleeping in my basement with my dogs, while my hometown enjoys a record heat wave.  While laying awake at night stewing in my own juices I began running through some old blog posts in my head and thought it might be worth revisiting the status of the financial markets.

Over the past three weeks, we have seen another unprecedented run in the DOW and S&P 500.   On July 10th, I began to ask myself if we were headed back into the abyss as the DOW seemed intent on testing the 8,000 barrier once again.   On its way there, it apparently got spooked and went the other direction, breaking through 9,000 with ease.   On a percentage basis, the DOW ran 12.6% from July 10th to July 31st.   This move is rather consistent with the way stocks behave during significant economic contractions, in that they are prone to high levels of volatility and can swing excessively.

To understand the reason why that is, we need to review what a stock price really is.  We know it is the discounted value of all the future earnings associated with that ownership instrument.   Those projected streams are subject to two main risks — macroeconomic risk and company execution (let’s exclude investor sentiment for the moment), to be revisited in another entry).  When stocks as a herd run down, the causation is usually macroeconomic uncertainty, as opposed to company specific factors.   Since the impact of macroeconomic conditions on forward earnings is a science lacking a high level of precision, corrections can be significant as clarity increases.   Said differently, as our financial system was melting down with great rapidity last winter you had an over correction to the downside as equity analysts predicted a massive impact of our structural problems on forward corporate earnings.   As second quarter (2009) earnings were released these past two weeks they came with a number of “positive surprises”.  However, these were not surprises at all in my estimation, but rather poor forecasting to begin with.   Coupled with some positives on the consumer confidence (consumer confidence index has doubled off the lows; new home sales increased 11% in June), treasury spreads have increased (spread between 10-year and 3-month increased nearly a full percentage point, meaning people were beginning to favor longer term instruments) , unemployment (job loss increased, but the pace of job loss slowed), economic growth (ISM manufacturing index topped 50, above which means growth) and banking system stability, the market ran quickly to its current position — aided of course by the media.

With that explanation behind us, we can no turn our attention to where does the DOW go from here.   The truth is, I don’t know, but my inkling is that we don’t have much room for upside right now.   My basic premise rests upon the reality that corporate earnings surprises were largely based on the realignment of costs with revenue opportunities; there was no real growth of the top line.  As such, we continue to contract, albeit at a slower rate.  Until we can truly rightsize consumer sentiment, we will struggle with generating real growth.

Further, there are significant structural hurdles.

  • Industrial Production.  Based on Federal Reserve disclosures, nearly one-third of our manufacturing capacity remains idle.   This is the lowest rate of production since the Fed started to record this data.  The last parallel we can find was 70.9% in December 1982.   The picture is just as bleak on a global level.  Such excess capacity cannot be rationalized quickly and is more likely to result in price based competition, which can only lead to further calamity.   On the plus side there appears to be very little inventory in the channel, as companies have moved aggressively to cut cost.  However, until trade and inventory credit loosens further, it will not rebound.
  • Tax Base.   Across the board the domestic economic system is facing an economic shortfall of catastrophic proportions.  The U.S. government has spent nearly $2.7 trillion this year, versus collections of $1.6 trillion.   In cumulative, state government deficits total $120 billion.   Forty nine states require balance budgets however. (Vermont is your holdout).  Personal income taxes have dropped by over 25%, with no quick path to renewal.   Yet, we somehow need to find ways to underwrite huge government programs and keep the lights on at the local level.  The imbalance is massive and budget gaps will result in further market disruption.
  • Consumer Sentiment.  As the consumer goes, so goes the economy given our asset lite service based model.   The problem is the consumer is underwater and expected to remain so for some time.   Jobless rates have reached double digits and it will take years for reabsorbtion.   Over 4 million Americans have been looking for work for more than six months, an unprecedented level.   Retails sales were down a further 5.1% in June versus a projected 4.5%.    We have yet to experience the wave of personal bankruptcies that will surely arrive as people walk away from their mortgages and face the music on their mountain of personal credit card debt.
  • Banks.  The banking system remains unhealthy, though the risks of a full scale collapse remains unlikely.   Deep skepticism with respect to real estate will result in regional and local market lending dislocation.   Rather than facing loan losses head on, banks are preferring to extend and pretend on the consumer level.   Without dependable credit consumers and businesses cannot grow.

Net net, it is not at all clear where growth is going to come from.   However, it is clear that we have found bottom, as evidenced by the slowing declines.  More than likely we are in for an extended period of sideways, with growth coming from stimulus and government programs (e.g., cash for clunkers, health care reform).     This will be jobless recovery with  companies surviving on lean diet of capital expenditures.   No one is forecasting robust growth.   In short I can’t see much upside.  Further, if this downturn has fundamentally changed consumer behavior, than the market will continue to shrink and stock prices will follow it down.

/bryan

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