In our view the strong rally off last year’s March low is a contra-cyclical move within a secular bear market that started in March 2000. We have been undergoing a major credit crisis, followed by severe decline in income, a collapse in asset prices and record debt. A number of detailed studies have shown that economic recoveries following such events are of short duration and extremely weak at best. Despite massive efforts at stimulation, we see no reason why the outcome this time will be any different, and the evidence so far supports this view. The economy is going through a process of deleveraging debt that is creating strong headwinds against a self-sustaining recovery.
The major drivers of previous economic recoveries in the post-war period have been housing and consumer spending that was spurred by easy credit conditions. Those drivers are just not working this time around. Despite the herculean efforts of the Fed and the White House, credit still remains tight. Bank loans are down 27% from a year earlier while consumer credit is down 4%, the most since World War II. Although the monetary base has soared over the last 15 months, M2 money supply is down 0.3% and MZM money supply is down 4.2% annualized over the last three months. The strong growth of GDP in the 4th quarter was mostly due to a return to more normal inventory levels while real final sales remained weak. Consumer spending has picked up a bit, but only in comparison to the extremely low level of a year earlier. In the period ahead consumers will continue to be restricted by high unemployment, tight credit conditions, sub-par wage increases, lower net worth and the need to raise savings rates and pay off debt.
A number of factors that helped growth in the past year will no longer be operative in the year ahead. The cash for clunkers program temporarily spurred auto sales, which have reverted back to sluggish sales levels. The housing credit for first-time home buyers goosed housing demand for a while, but the extension of the program does not seem to be having the same effect, and, in any event, ends on April 30th. Furthermore the Fed’s $1.25 trillion program to purchase mortgages ends on March 31st. As we pointed out in our comment two weeks ago economic momentum already seems to have peaked in the 4th quarter as a number of recent indicators have come in under expectations.
In addition we don’t think the sovereign debt problems have ended with Greece any more than we thought the subprime loan problems ended with Bear Stearns. It remains to be seen whether Greece can carry out its promises of austerity and there is no need for us to dwell on the now well-publicized budding financial crises in the rest of the EU’s Southern tier. As we previously pointed out the debt problems have not gone away, but have been in the process of being shifted from private to public entities.
Some may wonder why we continue to emphasize the global financial and economic problems and what this has to do with the stock market. In our view this has everything to do with the stock market. The entire rally has been based on the belief that we can undergo a V-shaped recovery and that modern governments just will not allow the kind of unraveling that has followed all other major credit crises. However, governments can only try to halt the malaise by increasing their own debt and running up huge budget deficits that cannot be sustained. In the U.S. we are already seeing the backlash as the public, while still demanding that the government somehow create more jobs, is also rebelling against the prospect of ever-increasing deficits.
Therefore if the market, as we believe, is discounting events that will not happen, the disappointment will be severe-and in a market increasingly dominated by trend players, the rush for the exits can be something to behold. The market peaked on January 19th at 1150 intraday on the S&P 500, declined to 1044 and now has bounced back to 1122. In our view this is all part of a topping formation that will be followed by a substantial decline in the period ahead.