The outlook for the economy does not support the excessive valuation of the market indexes while the technical picture reflects a market subject to a significant decline. The domestic economic problems include the unsustainability of consumer spending, high unemployment, the continuing weak housing sector, the commodity price squeeze, excessive household debt, a low savings rate and the fiscal squeeze at state and local governments. Major global problems include the still-festering European sovereign debt problems and monetary tightening by China and a slew of other nations in efforts to combat rising inflation.
In the U.S., fiscal policy, which helped boost the economy in 2010, will be close to neutral this year. The tax compromise between the Administration and Congress basically maintained the status quo while the 2% reduction in Social Security tax withholding will be largely offset by state and local tax increases and spending cuts. In addition the states and local governments will be laying off employees, reducing spending and increasing taxes, all impediments to economic growth. This will happen even in the absence of more dire forecasts such as bankruptcies.
Neither can QE2 be counted on to solve our economic problems. It’s notable that the entire 2010 rise in the stock market occurred immediately following Chairman Bernanke’s speech announcing the imminent implementation of QE2, and his hope that it would push stock prices higher and goose the economy. History indicates, however, that a rising stock market has only minimal effects on boosting spending. Although QE2 has been in force for only a short time it has already resulted in unintended consequences such as driving long rates (including mortgages) up rather than down, and in causing a major jump in commodity prices that is driving up the price of energy and food that will hinder economic growth.
It is notable that most of the last half increase in GDP came from a reduced household savings rate and increased inventory investment. The lower savings rate helped fuel consumer spending during a time of minimal wage increases, high unemployment and weak housing prices. However, in current circumstances, savings rates are more likely to rise than fall, and with income stagnant and household debt still extremely high, the rate of consumer spending growth is likely to diminish in the period ahead. Furthermore without inventory growth, real final sales growth has been minimal since the start of the recovery. With inventories now replenished from their recession levels the GDP contribution from this sector to will probably slow down in 2011.
Another headwind to the economy is the continuing weak housing market that has been buffeted by declining prices, underwater mortgages, a huge foreclosure backlog, excess inventories and more recently rising mortgage rates. For the vast majority of American households, homes are a far more important component of net wealth than stocks.
Adding to the problem, it is unlikely that the U.S. will get much help from the global economy. The European Union has been unable to solve its sovereign debt problems, and the crisis will continue to re-emerge throughout the year. China is attempting to slow down its internal inflation through tighter monetary policy, hoping, as usual for a soft landing. We know, however, that the pundits always predict a soft landing, and most often end up with a full-blown recession. Furthermore, from Brazil to Poland and numerous other nations we are witnessing a series of rate increases to slow down their economies.
The stock market has come a long way since March 2009 and is now showing signs of technical deterioration with bullish sentiment at historical highs and momentum slowing down in terms of a reduced number of new highs and lower upside volume. In the last few days the speculative juices appear to be diminishing as well. As a potential “canary in the coal mine”, F 5 Networks, a stock associated with cloud computing, dropped 21% today despite reporting revenue and earnings increases of 41% and 69% respectively. All this was a result of merely missing their revenue estimate by 0.7% and slightly reducing their current quarter sales guidance even though earnings exceeded expectations. If that doesn’t show how high expectations have become, we don’t know what does. When expectations have become so high that stocks decline sharply on a minor shortfall, a significant correction or worse is highly likely.
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