As we head into the final two weeks of both the year and the new century’s first decade , eyes are peeled for evidence of a Santa Claus rally. For the better part of the past century, market performance research demonstrates a year-end positive seasonal bias. Its occasional absence, followed often by a weak market, gave birth to the couplet: “If Santa Claus should fail to call, bears may come to Broad and Wall.” To determine the likelihood of seeing Santa this year, I’ll list the many pros and cons that analysts and commentators cite for a continuation of the 2009 rally or for its possible demise. There is a tremendous diversity of opinion.
The rally off the March lows has seen all major U.S. stock markets advance by more than 60%. The absence of even a single correction of 10% or more testifies to the power of the rally, although momentum has waned noticeably since October. Measures of buying power have declined significantly over that period, but selling power has declined even more, permitting the market averages to continue their upward drift. Volume has also declined markedly as the rally has lengthened, which calls recent advances into question in the minds of seasoned traders who want to see volume verify price moves.
Bulls are encouraged by the inability of prices to break down out of the trading range that has characterized the past five weeks. On the other hand, bears note that there has been no follow-through on several small breaks to new price highs. Neither side has shown enough fire power to sustain a meaningful move.
Most analysts see the 60% plus move as the first leg of a new bull market. A smaller group of mostly older analysts judge the rally to be nothing more than a partial recovery of the massive decline from October 2007. They point out that even after one of Wall Street’s greatest rapid rallies, stock prices are merely back to the levels of 1998–more than a decade ago.
Investor confidence, almost non-existent near the March market lows, has surged as prices continue to rise and fend off all attempts at meaningful corrections. That process is positive to a point, but investor sentiment has now reached levels of excessive optimism that is typical at market peaks. Risk was an abhorrent four-letter word just eight months ago; many investors are welcoming risk to their portfolios with open arms today. It is noteworthy that the best returns this year have come from the riskiest, most volatile areas. Junk bonds have done spectacularly well, and the very best returns have come from the junkiest of the junk, those companies just a heartbeat away from default.
Interest rates remain near historic lows. That is clearly good for business, and low bond yields provide little competition for stocks. Direct government purchases of fixed income securities ranging from U.S. Treasuries to toxic mortgage-backed paper obviously played a major role in pushing rates down across the board. It’s anyone’s guess as to what will happen to interest rates when government steps back and lets free market forces determine interest rates. Will massive money creation lead inexorably to inflation–even hyper-inflation–or will unprecedented levels of debt push the economy into a deflationary debt collapse? Could foreign debt holders like China defeat U.S. monetary authorities’ intended policies?
The grandest government rescue program in history is still unfolding. The most obvious immediate beneficiaries have been our largest financial institutions. To a lesser extent consumers have benefitted from various stimulus efforts designed to avoid foreclosures and to accelerate purchases for such major items as automobiles. Corporate earnings are growing, albeit largely from cost cutting rather than revenue gains. Corporate inventories–dramatically depleted when companies worried about business coming to a standstill a year ago–are being rebuilt, and industrial production is growing to meet that need to rebuild inventories. Rebuilding inventories is a one-time phenomenon, however, and corporate output growth and earnings growth will be sustained only if consumers resume spending.
Consumer sentiment is improving, but off a very low base. Sentiment numbers are still at levels typical during recessions. Retail sales are likewise growing, but also compared to the horribly depressed base of late 2008, when markets and the economy were collapsing.
Bullish economists are encouraged by the relatively steady decline of job losses and are forecasting a return to job growth in early 2010. While companies are evidently laying off fewer workers than in recent quarters, the total number of unemployed continues to grow, and most economists expect the unemployment rate to trend yet higher before peaking. With job uncertainty still prevalent and impending retirement ever closer–especially for the Boomer generation–it is unlikely that consumers will soon revert to recent past spending patterns characterized by little regard for saving or debt levels. On the contrary, households are clearly cutting back on their levels of debt and are adding to savings. While that behavior is certainly prudent at the micro level, it is dangerous at the macro level, which needs heavy doses of consumer spending.
Even with government amelioration programs, foreclosures are still numerous and are expected to continue. That inevitably has a crushing financial and psychological effect on a measurable segment of our society. Most households–even short of foreclosure–are still reeling from the huge loss of net worth over the past two years due to the collapses in both equity and real estate prices. Even the well-to-do have become more circumspect in their spending.
While federal efforts have rescued major financial institutions and, at least for the time being, stabilized the financial system, great fragility remains. Medium and small-sized banks continue to fail weekly, and the FDIC’s “insurance fund” is dangerously low. Giant banks are repaying the money loaned to them under the TARP program, but hundreds of billions of additional rescue dollars will yet be needed to keep afloat such entities as Fannie Mae, Freddie Mac, AIG and GMAC.
The financial system remains in precarious condition. Much of the toxic paper that nearly brought the world economy to a halt remains unsaleable and rests on the books of commercial banks and the Federal Reserve. Dubai, Greece, Ireland, Spain and inevitably others demonstrate that even sovereign debt may not escape this financial crisis unscathed.
Just months ago the Fed distributed massive amounts of U.S. taxpayer money to our commercial banking system, and there it remains. Strong admonitions from the President notwithstanding, banks are not lending that money. Banks have raised their lending standards, and borrowers who could qualify are reducing their debt levels. Small businesses, which would employ more people if they could grow, are finding it very difficult to borrow. Big banks are retaining money in the form of free reserves, bolstering their capital ratios and making almost risk-free returns off the very steep yield curve spread.
The greatest growth is occurring in emerging nations. Many analysts believe that such countries will be the prime engines of growth to pull the world out of this recession and into a multi-year advance. Of course those emerging governments and their central banks, as in the United States, have provided record levels of stimulus. Historically these have largely been exporting countries. It is pure speculation to suppose that they will easily convert to importers. There is also much concern that unparalleled levels of stimulus in China, for example, may result in bubbles, bank failures and runaway inflation.
Markets are always in danger of out-of-the-blue surprises. There are, however, a few areas of identifiable concern. Increased taxes and increased government regulation are almost certainly coming, with the timing a little hazy. We’ve heard at least the beginning of geopolitical saber-rattling with the looming prospect of Iranian nuclear power. Economic problems are surfacing in Europe. Commercial real estate default problems are coming; we don’t know how severe they will prove to be. Huge amounts of private equity debt are coming due over the next few years. The asset values of most companies purchased with that debt are badly depressed. Will these debts be rolled over or defaulted away? As industries in countries throughout the world are financially stressed, there is a growing tendency for protectionism. Though politically effective at home, protectionism works to contract world trade volumes.
By way of broad summary, we are experiencing significant growth in most economic measures, but off a severely depressed base. The rates of growth are impressive, but the actual levels of production and sentiment are still depressed. It remains to be seen whether the impressive growth rates prove predictive of economic progress in the quarters ahead or whether they are merely a “sugar high” born of the greatest stimulus infusion in history. A major part of the investor’s bet is whether the government will ultimately get it right. Will a collection of academics, Wall Streeters and politicians, who as a group didn’t see the problems arising–in fact, facilitated them–, find the right path on which to steer the world economy?
Ultimately the near-term determinant of the stock market’s path will be the investing public’s expectations of eventual outcomes. In the short run investor psychology is more key than fundamental conditions. That makes market direction highly unpredictable.
Overall we can see that the most negative conditions already exist. The most positive conditions are those that we anticipate and hope for based on projections of favorable trends. One overriding consideration in looking into such an uncertain future is that to buy stocks at current levels is to pay far above historically normal amounts for a dollar of sales, earnings, dividends and book value. At these levels the most favorable expectations must be realized or prices could fall significantly.
Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.