The sharp rally off the October 4th intraday low of the S&P 500 is a result of the assumed prospect of a real plan to save the Euro and slightly improved U.S. economic numbers indicating that we may not be in a recession right now. In addition the market was probably oversold after its rapid plunge below the 1260-1370 trading zone. We think the market will soon be disappointed on both counts.Our initial reading of the reports coming out of Europe does not exactly inspire a great deal of confidence. On the surface it seems to be just another statement of intentions with all of the details to be worked out later—and, of course as the saying goes, “the devil is in the details”.
The EU itself in its release calls the plan a “broad agreement” to increase bank reserves. We would emphasise the word “broad.” Banks would be recapitalized subject to the approval of a number of policies still to be determined. It intends to broaden the rescue fund to a trillion Euros, ask Greek bondholders to take a haircut of at least 50% and force the banks to recapitalize by June 30th. How all of this is going to happen remains unclear. And the haircuts apply only to Greek debt. The hope is that the markets would gain enough confidence to ring-fence Spain and Italy from following in Greece’s footsteps. The markets have bought the story so far, but how long that feeling lasts is highly uncertain, particularly in view of the violent nature of recent trading.
As for the U.S. economy, although we’ve seen a small recent bump following the summer debt-ceiling circus, the economy remains in the doldrums. Consumer confidence remains near all-time lows as a result of the weak labour market. Consumer spending has improved somewhat lately, but only because households lowered their savings rates. Personal income is still scraping along the bottom. Core capital goods expenditures were up, but surveys indicate the business investment may slow in coming months. Confidence in the small business sector is still at historical lows. Recent unwanted inventory accumulation may also point to a coming slowdown in production. Housing is scraping along the bottom and may drop even more as the foreclosure backlog comes on to the market.
The economic sectors that have shown some recent improvement are generally coincident or lagging indicators while leading indicators appear to be showing some weakness. The ECRI Weekly Leading Indicator is at levels indicating a recession ahead. This indicator has a good record of predicting past recessions and has never forecast one that didn’t occur. If this prediction is accurate, we will be going into a recession in such a fragile economic environment that we would expect any recession to be severe. Some of the statistics are; 9.1% unemployment, 22% of homeowners underwater, about 5 million homes in inventory or shadow inventory, home prices continuing to decline, and debt (all sectors) at historically high levels.
As we have often pointed out numerous times in previous comments and special reports, the economy has a good reason to be weak. Household debt relative to GDP has exploded over the last couple of decades and consumers are now in the lengthy process of paying it down. That’s why consumers are not spending and that’s why businesses are not hiring. The demand for goods and services is just not there.
In sum, we believe that the current rally will not last much longer and that the lows of 2009 will eventually be retested. We did not expect the S&P 500 to rise above the significant resistance of 1250, but it did rise above it this week. We shouldn’t be surprised to see another “bear market trap” after the housing and stock market bubble (and the 100% move up from the oversold condition in March of 2009), all within the secular bear market that started in early 2000. It seems that investors in U.S. equities will never learn from past experience, but we would now really be surprised if the market exceeded the early May peak of 1370 on the S&P 500.