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Why haven’t stock prices fallen more? I’ve been asking myself that question every day for weeks and I don’t have a good answer. The US economic data continues to weaken. Europe is still grappling with its debt problems and a Greek default - at a minimum - seems more likely by the day. It seems more obvious as well that China’s economy is slowing. The debate over future US fiscal policy continues without resolution and looks likely to remain an issue into the next election. Commodity prices have corrected a little but oil prices still hover around $100. The dollar has rebounded from its lows but is still weak and gold remains near an all time high. Emerging market countries not only have to worry about potential Chinese weakness but excessive inflation as well. All of these issues have potential negative consequences for US and global growth and yet US stocks have fallen just 2.8%. What is going on?
I don’t know what the future holds and neither does anyone else. Advisors who tell you with great confidence that they know what the market will do are either delusional or liars or possibly delusional liars. I try to keep my delusions contained to matters that don’t affect our investments, like my ability to hit a golf ball straight or write the great American novel both of which appear to be projects for my next life. When it comes to investing, I constantly question my views of the economy and markets. The recent action has me wondering if the things I have been so worried about the last few months are possibly less than meets the eye.
Let’s start with QE II which I have said repeatedly is a net negative for the US economy. The rise in commodity prices - oil specifically - and general inflation has put pressure on corporate margins and reduced real consumer spending. I think it has also reduced investment and hiring as commodity price volatility reduces the ability of companies to plan for the future. I have assumed to this point that most people see QE II as a positive because it has raised stock prices, but what if I’m wrong? What if others see it more like I do, as a negative? If that is true, the end of QE II will be a positive for the US economy and maybe the reason stock prices haven’t fallen much is because investors are pricing in better economic performance after its end.
What about the European debt mess? The fear has been that a default by Greece would not only negatively affect European banks but also could lead to a contagion among the other highly indebted economies. The facts are a little more murky. Greek bonds are already trading at roughly 50% of face value so the losses to European banks have already occurred even if they haven’t been recognized on their balance sheets (US banks have little direct exposure having sold most of their bonds to the ECB). What if regulators change the rules and just allow the European banks to write off the losses over the next decade? For that matter, how much of the exposure has been shifted to the ECB and other European central banks? Another fear has been that the PIIGS might just leave the Euro and that would be the death knell for the common currency. But what is the logic of that? If Greece, Portugal and Ireland leave the Euro, they could devalue, restore competitiveness and grow. And the Euro might be more attractive without them than with them and it would allow the ECB to concentrate on German inflation rather than the Greek depression. Losing the weak sisters might be the best thing that could happen to the Euro.
Slowing Chinese growth is another concern that may be overblown. The Chinese authorities have been trying to fight inflation through higher bank capital requirements and interest rates and while that hasn’t had much effect on inflation yet, it does seem to be slowing their growth rate. Could slower Chinese growth be a positive for the global economy? If China has been the source of excess demand for commodities (and many think it has) wouldn’t slower growth reduce that demand and allow commodity prices to find a lower equilibrium? While the effect on commodity producing countries might be significant, wouldn’t it be a positive for the rest of the global economy? For that matter, it might even be a positive for the commodity producers. Countries like Brazil have been trying to slow capital inflows to fight inflation; lower commodity prices might just be the thing that does the trick.
Finally, we come to the US fiscal problems. The two sides are far apart and a deal seems unlikely. President Obama has a political incentive to get a deal done so he can try to retain independent voters but the plans he has produced so far might be enough for political talking points but come up short on actually reducing the deficit. Republicans have produced somewhat better plans but they have little political incentive to cut a deal with the President. But what if getting a deal done isn’t necessary to reduce the deficit? The real issue for reducing the deficit is growth and if the problems above aren’t as big as they first seem or even turn out to be positives, US growth might surprise on the upside. If growth is better than expected, rising tax revenues would make the deficit a much easier problem to solve.
I am skeptical that all these issues will be resolved painlessly but I have to acknowledge the possibilities. The market has not fallen nearly as much as I have been expecting and sentiment has turned more negative recently. The American Association of Individual Investors poll shows just 25.6% bulls right now with bears ringing in over 40%. Those aren’t numbers I would normally associate with a top. In fact, they are numbers that in the past have been seen closer to bottoms. With the large emphasis I place on sentiment that is something I can’t ignore. I haven’t yet changed our investment stance and we still have a large allocation to cash but that may have to change as these issues are resolved.
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The economic data last week continued the recent pattern of weakness. I know that sentence is getting old but it remains true week after week. There is still nothing in the data that points to a new recession and the conditions I would expect if that were the case do not exist. The yield curve has flattened some recently but remains very steep. Credit spreads have moved out a little but not to a degree that indicates stress. US growth is weakening but there is nothing that points to recession - yet.
We got mixed news on housing last week. New home sales were up 7.3% and inventories shrunk to just 175k or 6.5 months of supply at this very depressed sales rate. As I’ve said many times over the last few years, we have to get rid of the excess inventory before we build more housing units and the fewer we build today just means more we have to build tomorrow. Unfortunately, pending home sales fell off a cliff last month, down 11.6%. I see that as a growth problem and not likely to change until people feel more comfortable about their job situation. We’ll get there with housing but we aren’t there yet.
Personal income and outlays both showed gains in April. Income rose 0.4% while spending rose the same amount. Unfortunately, inflation was also up so most of the gain in spending was due to higher prices rather than rising volume. The good news on income is being totally offset by higher prices. Hopefully that starts to change as QE II comes to an end and China slows.
Durable goods orders were down on the month and while transportation was a big part of the drop, the declines were widespread. The only significant increase was in computers and electronics. Business spending fell 2.6% but that was after a big rise last month. Durable orders are notoriously volatile and I don’t place much emphasis on it month to month. So far the trend is still higher but it is definitely slowing.
Jobless claims were up 10k on the week to 424k. The outlook for jobs has eroded over the last two months as inflation has ticked higher. Until companies get a better feel for future raw materials cost, they aren’t likely to start hiring.
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