11/07/07
S&P 500: 1520
Nasdaq: 2825
10 year Treasury bond: 4.36%
David R. Snyder, CFA
Since this bull market began back in October 2002 or March 2003, there have been seven corrections of between five and ten percent. During each correction, I was absolutely convinced that the decline would be limited to between five and ten percent and that the bull market would then resume its upward momentum. However, when my indicators issued a sell signal on 10/11/07 with the S&P 500 at its high of 1572, it was the first time I began to question my longer term bull market thesis. Then on 10/30/07, I made the call at our company’s meeting that a bear market started for the broader market last June or July, and that a bear market for the major stock market averages either began on 10/11/07 or will begin early next year with the S&P 500 peaking no higher than the October high. I expect the stock market to make a near term low sometime in the next couple of weeks and then rally into the end of the year before finally rolling over.
There are several major differences between this correction and the prior seven corrections. First, the S&P 500 made new highs before the correction began without the advance/decline line hitting new highs. Second, the divergences within the market are extreme. The financials are hitting new lows while technology, commodities, and industrials are making new highs. Third, this is the first correction where earnings estimates are being lowered. Fourth, the Fed has been cutting interest rates and the financials and retailers are not responding. Fifth, volatility around earnings reports has increased sharply this reporting season. Sixth, there is complete insanity in the financial markets with simultaneous bubbles and spikes in many different speculative assets.
The most important factor is the divergence of the financials. My research reveals that the longer the time period the financials are not following the major stock market averages to new highs, the higher the chances for a bear market. By my calculations, the money center banks, which are a good proxy for the financials, made their highs in February. The S&P 500 made new highs eight months later while the money center banks were well off their highs. The only times in the last 20 years that the stock market continued to make new highs for a sustained period without the participation of the financials were 1986-87, 1989-90 and 1999-2000. In each of these time periods, severe bear markets began between 8 and 11 months after the financials made their last new highs. If history is any guide, a bear market should thus begin between October and January. In the past the divergence between the financials and the rest of the market was always resolved with the financials pulling the rest of the stock market down.
The financials are a leading indicator of the economy and the stock market. It is very worrisome that the credit crisis is this severe with the unemployment rate near cycle lows. The housing market has never been this overvalued in the history of our country. Prices will have to decline substantially before the housing market bottoms and will probably take years to play out. Housing is the most important financial asset for most Americans and thus the housing collapse will have dramatic ripple effects on the economy. The housing problems have been confined to the subprime and home equity mortgages, but will escalate sharply into mainstream mortgages when we enter a
recession. The commercial real estate market is as overvalued as the residential market, yet it has not rolled over yet. Financial institutions are holding more commercial mortgages then residential, so when the commercial real estate market collapses, these additional defaults will devastate the banking system. Then add the multitude of derivatives and leverage associated with these real estate assets and we have the recipe for disaster.
Many are comparing the current credit crisis with the 1998 credit crisis. However, there are major differences. The 1998 credit crisis was based on problems in emerging markets that investors feared would spread to our economy. The current credit crisis is based on real problems in our housing market, not just perceived problems. Credit spreads in emerging markets began to tighten only after these countries had reached full fledged recessions. We have not reached the recession stage yet, although I expect one to occur by the second half of next year. Also, we did have a bear market (more than 20% decline in S&P 500) in 1998, although it was short lived.
One of the most disturbing events is the muted stock market response to Fed rate cuts unlike 1998. Normally the financials and retailers are the biggest beneficiaries of the Fed rate cuts, but these groups are actually trading lower today after three Fed rate cuts in the last couple of months. The stock market is telling us that the Fed rate cuts are not enough and many more are needed to stabilize the housing market. But the Fed is constrained by all of the other asset bubbles.
This coming bear market reminds me most of the 1990 bear market. The Fed had stopped raising rates in the Spring of 1989 and the stock market and the financials then rose sharply for about six months. The Fed then began to lower rates in the second half of 1989 and while the major averages continued higher through July of 1990, the financials peaked in September of 1989, giving plenty of warning of the bear market that began in July 1990. The Fed was behind the curve and did not lower rates fast enough. In 1990 the Fed was constrained by higher oil prices. Similar to 1989, the Fed stopped lowering interest rates in July of 2006 and the stock market and the financials surged for six months. Then the stock market and the financials began to diverge even as the Fed began to lower interest rates last summer. Overvalued real estate was the main problem in 1990 just as it is today.
Real estate recessions occur every other economic cycle. Real estate collapsed in the 1975 recession but held up during the 1981-82 recession. Then real estate plunged during the 1990 recession but survived the 2001 recession. These are very long cycles and we are due for a down cycle.
I have written in the past how the first tightening cycle of each decade usually doesn’t cause a recession. This decade will likely be different because the tightening cycle lasted so long. It took two and a half years (2004-2006) to complete the tightening cycle whereas the last two decades the first tightening cycle lasted only one year. Also, there are many more excesses in the financial markets and the economy this decade. I have never seen so many bubbles in the financial markets and the economy. There are
simultaneous bubbles in housing, commercial real estate, energy, gold, commodities, art, foreign currencies, emerging markets, US current account deficit, high yield debt, hedge funds, private equity/leveraged buyouts and derivatives.
Many investors argue that the downside in the stock market is limited because the price/earnings (P/E) ratio is only 15 or 16 for the S&P 500 versus 25 or 26 in 2000. However the P/E on normalized earnings is in the low 20’s. In 2000 technology was over 30% of the S&P 500 but less than 10% of the earnings, so when their inflated earnings collapsed, it didn’t bring overall earnings down that much. In contrast, all of the inflated earnings this cycle are in low P/E sectors such as oil, commodities, financials and industrials. Earnings from these sectors make up more than 50% of the earnings of the S&P 500 and could easily drop 50% in the next recession. Pre-tax margins are at all time highs and are not sustainable.
A secular bear market began in 2000. I argued at the bottom of the bear market in 2002 that we would have one of the strongest recoveries in the world economy and stock markets that would last in to 2008 or 2009. We have had a five year bull market where the S&P 500 has gained well over 100%, the mid and small capitalization stocks have increased between 150 and 200% and foreign and emerging markets have increased between 200 and 400%. Nobody envisioned this type of a recovery in the context of a secular bear market. This is why I told everyone in 2002 to ignore the fact that we were in a secular bear market. Now we must pay heed to the secular bear market. One of the reasons that the P/E of the stock market didn’t expand much this cycle despite a doubling of earnings is because in secular bear markets the P/E’s contract each succeeding cycle.
The world economy has grown above trend for four years now. In the past the world economy has never grown above trend for more than four years in a row. Investors expecting the world economy especially in China and India to decouple from the US will be dead wrong. The US consumer has driven world economic growth. China’s economic growth has come primarily from growth in exports to the US and fixed asset growth to build the infrastructure for the exports. Their undervalued currency has added dramatically to their export growth. They now plan to let the yuan increase 10% per year which will constrain their export growth. China’s middle class is only 100 million and are big savers. US imports will decline sharply as the US consumer retrenches.
It is absurd to believe that Europe is going to avoid the housing problems of the US. Their commercial and residential real estate markets are more overvalued than in the US. The US is still growing faster than Europe despite our subprime problems. Europe is one year behind the US in the tightening cycle and usually lags the US by a year. Thus expect housing problems to hit Europe next year. And their overvalued currency will hurt their economic growth.
Technically the stock market is forming a rounding top. The S&P 500 highs in June and July were only marginally exceeded in October. Oftentimes the stock market takes six months to form a long term top. In 2000 the S&P 500 hit a high in March and then revisited that high in September. After this current downturn, it is possible that the S&P
500 has a year end rally to the highs seen in the summer and early Fall, setting up a six month rounding top. It is possible that the 1550’s level will be the top of each cyclical bull market during this secular bear market which I don’t expect to end until 2017 to 2020.
The stock market has never lasted more than five years without a bear market since the 1800’s, except for the 1991- 98 period. We have now gone over five years without a bear market so we are overdue. Emerging stock markets have had positive returns for five straight years, which has never happened before. It can’t last. At the end of bull markets there are always spikes in the sectors that have performed the best during the bull market. Thus the recent spikes in oil, gold and other commodities along with the spike in the Euro and the doubling of the Chinese stock market in 60 days are all signs of a top. Also, investors are piling into a narrowing set of overvalued stocks. The coming bear market will be severe and won’t bottom until October of 2010. The worst performing sectors will be where all the current excesses lie. Commodities, especially oil, alternative energy, financials, housing, commercial real estate, and industrials will be absolutely devastated. The Fed will have to lower interest rates all the way to 0% and we will face similar problems as Japan faced in the 1990’s. Foreign and emerging stock markets will perform worse than the US especially as the dollar strengthens. We will be faced with worldwide deflation for the first time since the 1930’s. Long term Treasury bonds will be the best investment during this extended bear market. The secular bull market in long term Treasury bonds will not end until next decade with 10 year Treasury bonds reaching 2% before they bottom.
Full Disclosure: This is not an analyst report and merely represents the opinion of the author and not that of any investment firm. The contents of this report are based on sources believed to be reliable. It is not intended for circulation. This is not a solicitation or recommendation to buy or sell any securities. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock’s expected performance and risk.