Unfortunately, no one rings a bell to announce the inflection points in either the economy or the stock market. In our work, in order to get an early jump, we track a number of early-cycle, market-based indicators including various agricultural commodities, several base metals, the Australian Dollar, the Baltic Dry Freight Index, the yield on the 2-Year Treasury Note, etc., etc. Although each of these experiences significant fluctuations on both an intra-day and a weekly basis, all of them have been in unmistakable uptrends since late last Fall. In addition, Ed Hyman’s ISI firm surveys a broad mix of companies each week to see how they view their businesses. These surveys are starting to show a tiny improvement, albeit from very depressed levels. Also, the four week moving average of unemployment claims has turned lower, several Regional Federal Reserve bank business surveys have improved in January, December sales of existing homes rose 6.5% on a month-to-month basis, reflecting lower prices as well as improved availability of financing. These signals should not be ignored.
In short, after a sharp decline in Q4:08, the odds are now rising that the U.S. economy is in the process of hitting bottom. Extremely rapid money supply growth, continued quantitative easing measures by the Fed, the imminent passage of an economic stimulus bill, as well as the likelihood that the “bad assets” will, in one way or another, be removed from bank balance sheets to facilitate increased lending, all suggest that there is a good possibility that there could be a sharp, V-shaped improvement in economic activity sooner rather than later.
If the stock market accepts this notion, the likelihood of a very sharp rally in equities becomes quite high, notwithstanding the fact that corporate earnings will be depressed for a few more quarters. However, a strong word of caution is in order. First, because the market always overshoots in both directions, particularly in the short run, a sharp correction would be likely if this thesis fails to materialize. More importantly, after an initial bounce in economic activity, fueled by improved consumer credit conditions (mortgages and auto loans), the pace of recovery in the total economy is likely to slow dramatically because the broad base of American households is still greatly overleveraged and needs to rebuild its savings rate in a period of still rising unemployment and extremely modest wage growth. Hence, beyond the initial surge which we foresee, the path of the economy is likely to look like a Square Root Sign, and that realization will also cause the stock market to correct sharply at least until stock prices reflect the reality of a very slow extended recovery.
In the meantime, this rally is likely to last long enough to provide significant trading opportunities particularly among early cycle cyclicals (commodities, energy, industrials, and selected technology issues) and other beneficiaries of the Obama fiscal stimulus program. There probably will also be large percentage gains recorded by the major banks coming off their greatly depressed stock prices. In our view, however, the banks are becoming quasi-utilities on a long term basis. Their aggressive business models have been destroyed, their extremely leveraged balance sheets will not come back any time soon. Their returns on equity will be far below the experience of recent years and as a result bank shares will sell at single digit multiples for a long time to come. With the exception of various opportunities among health care equities, for obvious reasons, we don’t have much interest in consumer stocks either. We still believe that global infrastructure building and industrialization will reassert themselves as the dominant investment themes for years to come.
Stefan D. Abrams
Managing Member
Bryden-Abrams Investment Management LLC
Phone: 212-850-1127
Email: sda@millbrookgroup.net
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