In addition to the economic slowdown, the continued housing crisis, the endless turmoil in Europe and the deceleration in China and India, we are moving closer to the period where the so-called 'fiscal cliff' will become more of a threat to the market.  The fiscal cliff refers to the near-simultaneous January 2013 expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits and the sequester established in last summer's debt limit agreement.  Various estimates have indicated that the hit to GDP could be as high as 4%.  Many on Wall Street dismiss these concerns on the grounds that Congress and the administration will simply extend everything and, once again, 'kick the can down the road'.  That may eventually happen, but it won't be easy.

Various members of the Federal Reserve Board, including the Chairman, have been concerned enough to make their worries publically known.  Bernanke, at his last press conference, said that the size of the fiscal cliff was so large that "I think there's absolutely no chance that the Federal Reserve could or would have any ability whatsoever to offset the effect on the economy".

Chicago Fed president Charles Evans added that "The cliff at the end of this year is just that writ large.  Whether or not calm heads will prevail and avoid this or do something useful, you know that's as big an uncertainty as I can imagine anybody facing."  Atlanta Fed president Dennis Lockhart stated "Congress and the administration understand that the perception is growing that if a transition isn't engineered that works well, that you're going to end up with a lot of Mojo taken out of the economy in a very brief period of time."

The prevalent Wall Street take seems to be that Congress and the administration will settle the matter in some way or at least extend the period of expiration.  Although that may turn out to be the case, that is certainly not the lesson of the last four years, particularly 2011, when Congress held the administration hostage to the possibility of a U.S. default on its debt during negotiations over the debt ceiling.  If anything is done, it is highly unlikely to happen before the elections, and, as usual in these cases, will not be settled until the last possible minute, or even beyond.  The looming battle, likely to be nasty, is almost certain to upset the market, particularly with so many other factors looking negative at the same time.

In any event, it seems to us that the three-year cyclical bull market is in the process of topping out, and that the secular bear market will resume.  At today's close the S&P 500 was at the same level as February 16^th of this year and about 12% below the peak reached more than 12 years ago in early 2000.  This year's top was at 1422 on April 2^nd.  The number of Daily new NYSE highs is diminishing on every rally, and a lot of the speculative leaders of the last two or three years are collapsing.       

According to extensive research by Reinhart and Rogoff, past credit crises were invariably followed by many years of below average growth, high unemployment, sluggish economic expansions and numerous recessions.  In practice their studies were recently reinforced by Japan's two-decade period of sluggish growth and the current tepid recovery in the U.S.  In our view, working our way out of the mountain of debt, both private and public, that was incurred during the boom will take many years to come and will keep a solid lid on overall gains in the stock market. 

The current economic recovery remains in sharp contrast to any other expansion of the post-war period, and is now showing definitive signs of petering out once more.  The recently reported first quarter GDP is a mere 1.3% above the amount reached at the peak of the last cycle in the fourth quarter of 2007.  In eight previous post-war expansions, GDP had increased by an average of 13.3% in the 17^th quarter following a peak, with the lowest being 10.5%.

Now, even this tepid recovery is slowing down once more.  In the last two months the overwhelming weight of the evidence supports this view, as the following indicators have either come in below expectations or suffered an actual downturn: core durable goods orders, the Chicago Fed National Activities Index, new home sales, existing home sales, payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index, the Kansas City Fed Index, the Philadelphia Fed Survey, industrial production, the Empire State Manufacturing Index, the NAHB Housing Index, the ADP payrolls, auto sales, real consumer spending and the GDP.  Weekly initial unemployment dropped this week after rising for three weeks, although the four-week moving average remains high.  The only real outlier appears to be the ISM manufacturing Index, which came in above expectations.

At most, we think the economy will be disappointing in the period ahead.  Consumers, who account for about 70% of GDP, are hamstrung by debt.  In addition they have kept up their spending only by running their savings rate back down to 3.8% of disposable income, only the fifth month below 4% since 2007.  Other limiting factors are low wage growth, high unemployment, the large numbers of workers who have dropped out of the labor force, declining home prices, higher tax payments and a flattening out of transfer payments.  It is therefore no wonder that consumer confidence still remains at recessionary levels. 

Still ahead is the so-called fiscal cliff, another conflict as we approach the debt ceiling again, a contentious election, and the continued inability of a dysfunctional congress to get anything done.  All in all this is not a political outlook that is likely to give investors any confidence.

Adding to the headwinds is the worrying state of the global economy.  Europe is plunging into recession with the fragile consensus unraveling with the fall of the Dutch government, this Sunday's French election and the upcoming election in Greece.  China is dealing with a speculative housing boom and a major political scandal prior to a major change in leadership to a new generation.

Although the stock market is not yet down much from its highs, the technical picture is already reflecting the upcoming problems.  The S&P 500 closed at 1395 over seven weeks ago on March 13^th, and at 1391 today.  The interim high was at 1422 and the low 1357.  The bulls' only hope for a further advance is the reliance on the prospect of QE3 rather than on real growth.  We think the market is in a topping process and will break 1357 on the downside on the way to significantly lower levels.              

The overwhelming weight of the evidence over the past four to six weeks is that economic growth has peaked and is now slowing down.  In that period we have seen either disappointing results or actual declines in the following important economic indicators: core durable goods orders, the Chicago Fed National Activities Index, initial weekly unemployment claims, new home sales, existing home sales, payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index, personal income, the Kansas City Fed Index, the Philadelphia Fed Survey, industrial production, the Empire State manufacturing index and the NAHB Housing Market Index.

These indicators cover most of the U.S. economy and generally provide a good idea of where activity is headed.  In this regard we point out that the Chicago Fed computes and puts out a little-followed monthly indicator called the Chicago Fed National Activity Index (CFNAI), a weighted average of 85 monthly economic indicators covering production, income, employment, hours worked, personal consumption, housing sales, orders and inventories.  The CNFAI has declined for three consecutive months and entered negative territory in March.  From what we see so far in the current numbers, another drop is likely in April as well.

The significance of the above data is reinforced by ECRI Weekly Leading Indicator.  On December 10^th the ECRI dropped to 5.25% below a year earlier, a level that indicates a high probability of recession.  In fact, since 1968 the ECRI leading indicator has declined to that level or below only six times, and each time a recession began either a few months before or a few months after.  There has never been a false call, and this is the first negative call since January 2008.

Since most serious investors follow the same economic releases that we do, they must be aware of the fragility of the current recovery, particularly given the household debt burdens and the problems in Europe and China as well as the so-called "fiscal cliff" awaiting the U.S.  That is why they slice and dice every single word in the FOMC monetary statements, minutes and speeches of Chairman Bernanke and every other Federal Reserve Board member, hoping to get a hint that QE3 is coming to the rescue soon.  Yesterday was a good example where the FOMC and Bernanke basically said nothing new, yet were subject to all kinds of interpretation by the "experts" who do that sort of thing for a living.  The market has been moving up on the liquidity provided by central banks around the world and is deathly afraid of going it alone. 

All in all, the economic recovery is not sustainable, and we doubt that the Fed can do anything more. Although QE1 helped prevent the economic and financial system from collapsing, each easing move after that has had less and less effect.  We believe that the stock market is in for a rude awakening.

The growing optimism on housing is not justified.  Not only is the recent data disappointing, but the overhang of shadow inventories threatens to keep the housing market depressed for some time to come.

We'll begin with a look at the data.  Existing home sales were down 2.6% in March, the second straight monthly decline.  Sales remain depressed, and are still 37% below the peak during the boom.  The purchase index for the latest reported week was down 11%, and is down 15% from a year earlier.  New housing starts dropped for the second consecutive month to a paltry 654,000.  It topped out at 2,273,000 in January 2006.  The NAHB housing index for April dropped back to its early January level.  It remains at 25, compared to a peak reading of 70. The latest Case/Shiller report show year-over-year national average price declines of 4%  To find anything encouraging in these numbers is quite a stretch.

In addition to the data already reported, it is difficult to be optimistic about the period ahead.  Although the bulls talk a great deal about the decline in inventories of homes for sale, keep in mind that the official inventory numbers include only homes that are now on the market, and ignores the importance of the so-called "shadow inventories" that loom over the industry like the sword of Damocles.  The shadow inventories include houses that are not now on the market, but are either delinquent on mortgage payments, in default, owned by banks or are in some stage of the foreclosure process.  Estimates of the number of houses in this category vary anywhere between 2 million and 10 million.

Foreclosures have generally declined over the past year as a result of the well-known robo signing scandal that caused banks to voluntarily stop most foreclosures pending some kind of settlement.  This has now been accomplished by an overall settlement between the states' attorney-generals and the major bank mortgage holders.  As a result, the significant number of potential foreclosures that were held back by the scandal will now begin to be processed and show up in future inventories.  It is highly likely that the vast number of distressed houses coming into the market will depress prices even more in the period ahead.

Importantly, the shadow inventories do not include homes that are under water, but where mortgage payments are up to date.  This group includes homes with mortgages that are now worth at least 5% less than the amount of their mortgage.  About 25% of all homes with mortgages now fall into this category, and as prices decline even more under the weight of the shadow inventories, the number of underwater homes will increase, putting even more pressure on prices.  Experience indicates that the more a mortgage is underwater, the greater the chances are that owners will stop maintaining their property and quit paying their mortgage. 

The bullish argument that houses are now generally affordable also does not hold up on closer examination.  As we have repeated ad infinitum the average household has too much debt and is in the midst of deleveraging rather than taking on more debt.  Furthermore, households, on average, do not have enough cash for a down payment or a high enough credit score to qualify for the more stringent credit standards put into effect following the credit crisis.  Neither do they have enough income.  According to Ned Davis Research the ratio of median home prices to median household income is still about 5% above the 36-year mean.  It is notable that following all bubble periods, ratios not only decline back to the mean, but fall significantly under it. 

 All in all, it seems that it will be some time before the massive number of actual and shadow inventories are cleared from the system.  Until that happens, home prices will remain under continued pressure.                   

Over the past two weeks even more evidence has emerged that the "sweet spot" the market has been enjoying in the last few months is coming to an end.  (See "The Market Sweet Spot Is Ending", March 29, 2012).  The European sovereign debt problem has emerged in the headlines once again, more key economic indicators have fallen short of expectations and the S&P 500 dipped below its 50-day moving average for the first time since December.

The market started to decline from its peak level when the latest FOMC minutes hinted that an imminent implementation of QE3 was not on the table.  The problem is that there was always an inherent contradiction between celebrating the advent of a sustainable recovery, while, at the same time, expecting the initiation QE3.  This didn't make much sense.  If the U.S. economy were truly in a sustainable recovery QE3 would not be necessary.  In itself, the hope for a new quantitative easing program indicated that investors really believed, as we did, that the economic recovery was almost completely dependent on massive doses of liquidity, and incapable of going forward on its own.

We pointed out at the time that economic expectations had become so optimistic that a number of key indicators started to disappoint.  These included core durable goods orders, the Richmond Fed Manufacturing Survey, the Chicago Fed National Activity Index, initial weekly unemployment claims, pending home sales, new home sales and existing home sales.  Since then, other indicators that have fallen short include payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index and personal income.

The U.S. economy has also benefitted from the inability of seasonal adjustment factors to account for an unusually warm winter and the distortions introduced by the fact that the worst of the 2008-2009 recession occurred in about the same months.  Since this made the economy appear to be much stronger than it actually was, the payback is likely over the next few months.

The economy is also facing the now well-known "fiscal cliff" beginning in January 2013.  This includes expiration of the Bush tax cuts, the payroll tax cuts, emergency unemployment benefits, the highway bill, the farm bill, and the sequester established in last summer's debt limit agreement.  Various estimates have indicated that the hit to GDP can be as high as 4%.

The European sovereign debt crisis also entered a "sweet spot" following the start of the ECB's Long Term Repurchase Operation (LTRO) and the Eurozone settlement with Greece that stopped the immediate liquidity crisis and took it out of the headlines without actually curing the insolvency issue.  The LTRO provided about 1 trillion Euros to bail out troubled European banks in return for the debtor nations' promise of austerity.   However, the continued worsening of the economic outlook in the EU's debtor economies has once again led to soaring bond interest rates, particularly in Spain.

The problem is that austerity in the weaker nations causes their economies to decline even more, leading to greater budget deficits and the need for even more bailouts.  It also tends to cause internal dissention and increase the popularity of political parties that would attempt to abandon or substantially reduce the austerity program.  That makes it highly unlikely that the stronger nations would continue their liquidity programs to the detriment of their own taxpayers.  The EU has now been "kicking this can down the road" for more than two years and appears to be running out of road.

The market has now shown significant signs that momentum is waning.  The S&P 500 fell below its 50-day moving average for the first time since December, although it slightly climbed back over it today.  After a big run to the upside, investors who missed the rally often attempt to use the first sign of weakness to get aboard, and this is what is probably happening now.  In our view, this is just a temporary bounce that will fail and make new lows.  We believe that the downside risk is substantial.