In the wake of a 26% rally in the S&P 500, the strongest four weeks since 1933, which has taken the index up to its downward trending 100-day moving average line, the overriding question remains: Was it merely a bear market rally with all the attendant vulnerabilities to follow, or have investors witnessed the beginning of a sustainable bull market in equities? My bottom line is that the fundamentals are moving in the right direction, but they are not yet strong enough to sustain a bull market, especially in view of the severity and after effects of the worst credit crunch and global recession in modern history. However, I do believe that a durable double bottom occurred on November 21st and March 9th marking the lows for this bear market. A great many risks remain, but many "second derivative" metrics are turning less negative.
The rally, which began in early March from a deeply oversold technical condition, was triggered by release of a number of macro data points indicating that the steep rate of economic contraction was beginning to abate. These were not signs of an economic upturn, merely indications of a slower rate of decline. These "green shoots" led many to believe the recession is beginning to bottom out, and an upturn would commence in the second half of this year. That remains a valid hope but by no means a certainty. One very important driver of the rally has been broad money supply, which had expanded rapidly from late October through early January, thereby supporting the November to early January rally, only to contract sharply in January and February, during which time the S&P 500 fell another 23% to the year's low. Once again, money supply turned strongly positive for the month of March, driving the latest rally. Thus, a technically oversold position, coupled with signs that the recession might be bottoming out, and a strong surplus liquidity position clearly stampeded short sellers into covering positions, especially among deeply oversold cyclical issues, traditionally the earliest beneficiaries of an economic recovery. By the end of last week the S&P 500 had pushed through its downward sloping 100-day moving average line, leaving stocks vulnerable to profit taking. If history is any guide, more consolidation will be required for the 50, 100 and 200-day moving average lines to flatten out before a new bull market can get underway.
In assessing the sustainability of this latest upturn, it is important to note that while equity valuations relative to both bond yields and normalized earning power still remain reasonable, if not downright attractive, there is no sign yet of an inflection point in corporate profits, which would give investors the rationale to value equities on the basis of out-year earnings. In the absence of a turn in earnings, stocks are still overvalued based on 2009 estimates. Moreover, investors will now be confronted with nearly two months during which first quarter earnings will be reported. Not only will these results compare most unfavorably with year ago profits but, in addition, there is no likelihood that managements' guidance for the second quarter will be anything except extremely guarded. The likely impending bankruptcies of GM and Chrysler, no matter how carefully orchestrated, will involve considerable risk to the overall economy, and at a minimum the uncertainty will curb investors' enthusiasm. Also, as occurs every year in the wake of income tax payments, unadjusted money supply is likely to contract from mid-April to late June, thereby squeezing the financial system. Finally, the market will continue to contend with many uncertainties confronting the banking system, particularly the Treasury's stress tests, whose results will be available at the end of April, and the uncertainty over whether the public/private plan (PPIP) to purchase toxic assets will have the desired effect, particularly since mark-to-market accounting for these assets has been done away with. Moreover, the banks are still under stress from rising loan losses in other consumer loan categories and commercial real estate. The resulting credit crunch is still crimping trade finance, inventory finance and consumer spending. Credit is still the lynch pin to a broad economic recovery, and improvement here has been minimal at best.
The Administration's $787 bill stimulus package is just beginning to kick in, and, along with tax refunds, may well give a boost to second quarter consumer spending. Both new and existing home sales appear to be bottoming out along with automobile sales, but home prices will continue to decline until the very large excess inventory overhang has been worked off. The contraction in manufacturing is abating, as inventories have been slashed, and some restocking is occurring. Perhaps the most troubling issue remains the fact that corporate revenues are still falling faster than wage costs. Thus, job losses and the unemployment rate will continue to rise at a time when consumer balance sheets remain stretched, and most consumers are cutting back on spending in order to pay down their outstanding indebtedness. In other words, not only are the unemployed no longer spending, but those who still have jobs are reducing consumption in order to pay down debt, in response to fears of job loss and a sharply negative wealth effect from depressed house and stock prices. Moreover, those consumers who have lost their jobs are maxing out their credit cards, which undoubtedly will lead to greater loan losses for the banks, contributing further to their continued unwillingness to lend. Overall, the economy's deleveraging process is likely to require several more years, during which time economic growth in the U.S. will be well below its potential.
The sum of all this is that while a recovery in stock prices from the deeply oversold levels of early March was justified on the basis of "less bad" economic data and a strong surplus liquidity position, there does not yet appear to be either economic or technical support for a new sustainable bull market. The extent of the next period of market consolidation together with the macro data flow and the impact of government policy initiatives will give investors a clue to the direction of stock prices in the back half of the year. A low volume retreat, with limited new lows, stopping well short of the double bottom lows will boost investors' appetite for risk. This is our forecast. By the fourth quarter year-over-year profit comparisons should turn positive. This should enable a sustainable upturn to begin by late summer.
It will be led by a broad array of industrials, materials, energy and select technology issues, all benefitting from a gradual recovery in the U.S. and from a resumption of above average growth in many well positioned emerging economies. Many of these issues will be able to achieve expanding profit margins as pricing power returns to industries where demand picks up more rapidly than recently curtailed supply. Most consumer stocks, with the exception of some health care equities, will lag for some time because their revenue growth will be sub par, and their profit margins will remain under competitive pressure. Moreover, many of these issues are still generously valued and will feel the pressure of gradually rising interest rates. While most financial issues will enjoy a bounce as the credit crisis eases, the longer term outlook for this diverse group is not particularly promising since their formerly highly leveraged business models have been severely impaired. Finally, because organic growth will be harder to achieve in a slow growth economy, there will be a wave of consolidation across many industries. This trend is already evident and will gather momentum as financing becomes more readily available.
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