In summary, the current excitement about
the market reminds us of the
extreme bullishness exhibited near the
tops in early 2000 and late 2007.
The outcome is likely to be the same.
February 3, 2011
The stock market is at a highly vulnerable point, both fundamentally and technically. Fundamentally, the current rate of economic growth is unsustainable and the valuation of the S and P 500 is significantly above its long-term average. Technically, the market is overbought and is losing momentum. We cite the following points.
- Consumer spending has been outpacing the ability to spend. Spending has exceeded income in five of the last six months. During this time nominal spending has increased 2.8%, compared to only 1.9% in personal income. In order to accomplish this, households took their savings rate down to 5.3% of income from 6.3% six months earlier. As we have pointed out numerous times, household debt is still near record levels and consumers still have a long way to go in deleveraging their balance sheets.
- Housing remains a major weak spot with a rising pipeline of coming foreclosures, excess inventories and falling prices. In addition rising bond rates are causing mortgage rates to climb. (UPDATE: 30 year mortgage rate jumped to 5.05% this past week from 4.81% prior week)
- States and local governments are slashing budgets through a combination of raising taxes and cutting spending. This, obviously, is a major drag on the overall economy.
- Private jobs have increased at an average of 112,000 a month over the past year, but about half of that has been in low-paying health care, social services and temporary employment. (UPDATE: on 2/4/11, BLS reported a net +36,000 jobs in January)
- QE2 is scheduled to end in five months. Just as the anticipation of QE2 in August led to a substantial rise in the market, the anticipation of its ending may well have the opposite effect, combined with the other factors we mention.
- With commodity prices soaring and consumers unable or unwilling to accept price increases, a large number of corporations will undergo major cost increases that will squeeze profit margins, a factor not calculated into current earnings forecasts. (UPDATE: Kraft Foods states revenue growth will be from higher prices versus higher volume)
- Europe's sovereign debt problems have not been solved and the crisis will continue to fester. Any real solution will not be friendly to economic growth.
- The crisis in Tunisia and Egypt are not random exogenous events. Soaring food prices, high unemployment and wealth disparities are as much a factor as repressive governments. People tend to tolerate dictatorships more when they aren't hungry.
- China is a bubble waiting to burst. Think back to the late 80's when everyone was as optimistic about Japan as they are about China today.
- At today's closing price the S and P 500 is selling at 19.2 times cyclically smoothed reported earnings, compared to a historical average of about 15. (UPDATE: the S and P 500 is up another 34 points/2.7% as of the close on 2/11/11)
- In addition to the above fundamentals the market is technically vulnerable. It has climbed about 95% over the last 23 months and 30% since the July low. Sentiment has become heavily bullish while the market is losing momentum as fewer stocks are moving higher on each successive top. Volume for advancing stocks is dropping while volume for declining stocks is rising. The number of new daily highs is also dropping as is the percentage of stocks making new 50-day highs.