Rather than being dazzled by the mostly prevailing opinion on bubble TV that the market is in the process of making a bottom, let's look at the three main factors to watch--the credit situation, the economy and valuation. On each of these the outlook is decidedly negative for the market.
CREDIT-the saving of Bear Stearns was basically like an emergency tourniquet applied to a person in danger of bleeding to death. It worked in the short-term and the patient lived, but severe problems remain. The usually conservative IMF recently estimated eventual credit losses of $945 billion for banks, hedge funds, pension funds, insurance companies and sovereign wealth funds, consisting of $545 billion in residential mortgages, $240 billion in commercial real estate, $120 billion in corporate debt and $20 billion in consumer debt. This is based, of course on what is now known, and since there is still a lot that is not known, this estimate can go considerably higher. According to the BIS, credit default swaps rose 49% to a notional $43 trillion in the first half of 2007. The market for derivatives grew at the fastest pace in nine years to $516 trillion in the same period. The majority of this debt has still not been unwound and continues to remain a major threat to the credit markets. To say that all of this mess has already been discounted in the market is a really huge assumption without much basis in fact--and to brush this off as mere fear-mongering as some have done is even more astounding.
THE ECONOMY-there seems little doubt at this point that the economy has slipped into recession as consumer spending, employment and production all appear to have peaked or slowed to a crawl. Real consumer spending was unchanged in February and has barely budged since November while March chain store sales were weak. Spending should remain under pressure as a result of declining employment, lower net worth, onerous debt, lack of savings and more restrictive credit standards. Pending home sales were down 1.9% in February and down 21.4% from a year earlier, indicating further weakness ahead in housing. Eight million home owners are under water on their mortgages, and this sure to get worse in coming months. The S&P Case/Shiller 10-city housing price survey was down 11% over the past year, and monthly readings have been accelerating to the downside.
Payroll employment has been down for three straight months, something that never happens except in recessions. The 4-week moving average of new unemployment claims is the highest since October 2003, and continuing claims have been rising sharply. New orders for core capital goods have been lower in four of the past five months, an ominous harbinger for coming capital spending. Industrial production has declined 0.4% over the last five months. The Conference Board Leading Indicators have dropped for five consecutive months and 10 of the last 12. The index peaked back in January 2006. Industrial production has dropped 0.4% since September. With manufacturing inventories up for six straight months despite softening shipments, production may have to be cut back further.
The economic weakness was duly noted in the recently released Fed minutes of the last FOMC meeting. Participants were worried about a negative feedback loop that could make the economy even worse and delay recovery. They were also concerned that further cuts in interest rates might not be effective in boosting the economy. All in all we think it highly unlikely that the economy recovers in the second half as the majority believes.
VALUATION-the bulls not only think that the credit crisis is over and that the recession will be mild, but also continually insist that the market is cheap. This is not the case. As of today's close the S&P 500 was selling at 20.5 times trailing reported earnings. Despite what you hear, the historical average P/E of between 15 and 16 is based on trailing reported earnings, not on forward operating earnings. The P/E of 20.5 is at the top of the range that existed for 70 years or more prior to 1997. This also debunks the idea that there is an excessive amount of fear in this market. If there was really a lot of fear in the current market it would be selling at somewhere between 8 and 12 times and nobody would want to own it. That is certainly not the case at this time.
