At current levels the market remains at risk for a significant decline while the potential upside rewards are limited. Stocks are discounting everything that can possibly go right and are virtually ignoring the numerous factors that can go wrong. Investors are vigorously asserting that most of the risks are transient while the favourable factors will be long-lasting. In reality the reverse is more likely the case. The risks will be around for some time and have the potential to cause great damage, while it is the favourable factors that seem transitory.
1) The economy is a virtual ward of the government. It has taken massive unprecedented stimulus in the form of near-zero interest rates, QE1, QE2 and a $1.5 trillion fiscal deficit to come up with the weakest economic recovery since the great depression of the 1930s. However, this stimulus will begin winding down within a short time. Congress and the White house are under severe political pressure to come up with some meaningful cuts in the deficit, meaning that fiscal policy will become more restrictive. This is true of monetary policy as well. QE2, which is scheduled to end on June 30th, has gobbled up about 70% of all the Treasury bond issuance since its inception in November. Some one will take up the slack, but most likely only after being enticed by higher interest rates.
2) Without the stimulus it is doubtful that economic growth can be self-sustaining. When QE1 ended the economic growth numbers sagged and the market dropped about 15%. Housing is still weakening, consumer spending is not supported by wages and core new orders for durable goods have weakened over the last two months.
3) Another risk is the political battles that could ensue during both the budget reduction proceedings and the debt limit issue. Both sides have taken positions that make it difficult to compromise. Not only can this lead to some scary headlines, but the eventual outcome is itself not assured.
4) Although QE2 has boosted the market and helped some segments of the economy it has had negative implications as well. Interest rates have gone up rather than down and commodity prices have soared. In addition developing nations as well as the EU have been facing higher inflation causing them to raise interest rates and risk slowing down global economic growth.
5) Geopolitical risks are rising along with the price of oil. Although oil prices dropped a bit today as a result of a dubious mediation offer by Venezuelan President Chavez, any quick settlement of the Mid-East turmoil is a delusion. We’ve seen a lot of bulls minimize the situation as transient. No doubt these are the same people who thought that the dot-com boom would last forever and that subprime debt wasn’t important enough to matter. While Egypt and now Libya have been the focus of attention, the Gulf States are far more important. Bahrain and Yemen are already in turmoil and the anxiety is now spreading to Oman. The Saudi stock market has plunged 11% in two days and the Monarchy has already taken preventive measures in an attempt to halt the spread. About 40% of the world’s energy comes from the Gulf States that are also host to a number of key U.S. military bases. And any weakening of the nations on the Arabian Peninsula also strengthens the hand of Iran.
6) The soaring prices of commodities, including food, cotton and energy is resulting in serious cost increases for a wide array of corporations. Those with proprietary products or services and those who sell to other businesses can pass these costs on in the form of price increases. However, corporations that sell to consumers will find themselves in a cost/price squeeze as households just cannot afford the price increases with wages rising so modestly and consumer credit still fairly tight. This means that current earnings forecasts for 2011 are far too high and will have to be revised down.
7) Stock market sentiment is unusually bullish. The Ned Davis Research crowd sentiment poll has averaged 68% at market peaks since 1995, and is now at 73%. When almost everyone is on one side of the trade it is time to take the other.
8) At current levels the S&P 500 is selling at about 19.6 times cyclically-smoothed trailing reported earnings. That is about 30% above fair value based on the historical average of 15.
In sum, fiscal and monetary policy are undergoing a change from ease to restraint at a time when the economy is still fragile, earnings estimates are too high, geopolitical risks are on the rise, market sentiment is overly bullish and valuations are high. This is not a recipe for continued market strength.