1/30/2013 6:15 PM ET|
Bull market or prelude to a bust?
The markets are nearing levels not seen since 2007 -- but let's not forget the crash that followed those highs. Conditions now look eerily similar.
There's a new exuberance sweeping the market. Major U.S. stock indexes are approaching new highs for the first time since 2007. The Dow Jones Industrial Average ($INDU) is flirting with 14,000 again.
The surge started after Washington compromised on the fiscal cliff, releasing a pent-up surge of buying demand as investors enjoyed a reprieve from budget worries, the eurozone crisis and other concerns. Also contributing: Japan's aggressive efforts to weaken the yen, which have added another central bank to the list of those abusing their currencies to pump cash into the system. Even retail investors are stepping back into stocks.
So why do I remain skeptical? Why not just throw in, set worries aside and enjoy the ride?
Because to me, this looks like 2007 all over again, with a burst of exuberance just before it all comes crashing down. Here's why I'm a doubter, and how to play it if you share those doubts. And if you don't? I'll suggest some areas worth considering if you're feeling cautiously bullish.
Party before the storm
Even as stocks crawl to new highs, there is growing evidence that this bull market -- now in its fifth calendar year -- has entered its terminal phase.
Late-stage bull markets are typified by explosions of sentiment, like the current rally. They're also marked by an erosion of economic fundamentals and a general postponement of disbelief, like we're seeing now.
In fact, the similarities between the current run and the 2007 bull market top are striking.
The gains in the major averages haven't been confirmed by rising trading volume, broad participation across the stock universe or gains in ancillary markets like commodities or emerging markets.
In fact, we're seeing investors moving out of economically sensitive sectors like basic materials and steel-makers and into less-sensitive defensive stocks like Procter & Gamble (PG) and health care issues. The move comes against a steady rollout of declining economic data, including terrible consumer confidence readings. We're also seeing ongoing confirmation that the fourth-quarter earnings season is likely to be a disappointment, tracking below expectations so far.
Yet all the negative catalysts are being ignored by the bulls, which is what we saw in 2007 and is typical of last-gasp rallies. There are also constant reminders that bullish exuberance is reaching historic levels.
People are ignoring the very real fiscal policy risks the U.S. faces over the next few weeks; yes, the debt-ceiling debate was postponed until May, but the "sequester" budget cuts and the need for a new federal spending plan hit much sooner.
We're also seeing rising resistance of inflation hawks at the Federal Reserve, the European Central Bank and elsewhere to the rich world's experiment with extreme monetary policy easing (which is growing increasingly ineffectual).
People believe Europe has been fixed. (It hasn't, and Germany is falling into recession.)
People believe 2% inflation will end Japan's multidecade malaise. (It won't.)
People believe tapped-out U.S. consumers and the nervous corporate sector will spend and invest despite the uncertainty, stagnant wages and new taxes. (They won't.)
People believe both earnings growth and growth of the gross domestic product will reaccelerate later this year, yet I see clear signs of lost momentum in both earning power and economic vigor.
Shades of 2007
Just look at the chart below of the 2007 market high.
Stocks peaked on Oct. 9 that year, at a time when conditions looked remarkably similar to how they look today. Stocks had suffered a double-dip in the previous year and had pushed over old highs set a few months prior. All was right with the world, and the market was going vertical. Bullish sentiment surged, and skeptics were dismissed.
Then, like now, hopes were high that an unquantifiable risk (the subprime problem) would be contained and papered over by the Federal Reserve. Then, like now, corporate earnings were under pressure from weak revenue growth and rising costs, but there was hope Chinese demand would compensate.
Then, like now, the market had separated massively from the economic fundamentals -- as shown in the chart below of the Citigroup U.S. Economic Surprise Index (which measures where the real data is coming in, compared with Wall Street expectations) versus the Standard & Poor's 500 Index ($INX).
People were lulled into a false sense of security by ridiculous, outlier data points that were later downwardly revised. Then, it was GDP growth estimates. In 2007, the bull market top was fueled by second- and third-quarter GDP growth estimates of 3.8% and 3.9%. This reversed a two-year deceleration in growth and confounded the pessimists.
Now, it's a drop in the unemployment rate driven not by job growth but by people leaving the workforce in disgust -- which is why the employment-to-population rate has fallen to early-1980s levels.
Within a year of 2007’s rosy predictions,the economy was miredin recession. The chart below shows what happened to stocks.
After the dust settled, the government revised those 2007 growth estimates down to 2.5% and 2.2%. But of course, it didn't refund the losses suffered by investors who, in October 2007, wanted to believe Uncle Sam.
What makes me think something similar could happen now?
Most important, the stock market has disconnected from economic realities on the ground again, as shown below.
I'll add two more things:
- The CBOE Market Volatility Index ($VIX), a commonly used gauge of market unease, is finally showing signs of caution. A more obscure gauge of this in the options market, the Credit Suisse Fear Barometer, has been showing the same for weeks. Maybe the fog of irrationality and lingering good vibes from the fiscal cliff deal are ending. Whatever the cause, options traders are starting to worry about downside risk again -- and are paying up for protection from downside losses.
- Despite impressions to the contrary, fourth-quarter earnings season is turning into a dud. As of Jan. 25, with 47% of the S&P 500 reporting, earnings are tracking 6% below the $25.51 consensus estimate on Jan. 4. Of those companies that have reported, they've collectively missed the consensus estimate for their share of total S&P 500 earnings by 13%. Because of this, the 53% of companies left to report had better be bringing good numbers, or we could be looking at an outright drop in earnings per share versus last year.
So while we face the prospect of negative EPS growth this quarter, bottom-up Wall Street analysts (a traditionally bullish bunch) are looking for earnings growth to reaccelerate to a mind-numbing 23% rate by the fourth quarter of 2013.
That just won't happen. Nor is GDP growth going to reaccelerate to more than 3% later this year, as many economists believe.
Weak earnings. Weak economy. Fiscal austerity and political uncertainty. Higher taxes. Narrowing market participation. Weakness in industrial metals.
And yet, extreme bullish sentiment and one of the least volatile rallies in the past 40 years.
By all indications, the current surge is a blow-off top, just like the one we had in 2007.
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I agree. Wall Street is disconnected from the prevailing economic conditions in this country. Easy money through fed/treasury policy has only stalled the inevitable, with interest, Todays unexpected GDP data is , yes, the fault of Bush, Tsunami, Europe, Sandy, etc.. This gig will be up soon enough. The market is trader and computer driven. Not investor fueled. The volatility has a lot more to do with Wall Street houses and hedge funds short term trading than investors. Outside large investment entities, most retail investors are out and into gold or cash.
I am no economist but in 2003, I kept telling a friend in the mortgage brokerage business that the free for all in that industry was headed for collapse. It took longer than I thought but didnt yet understand how it was being forestalled by political and cozy financial arrangements, and collusion between Wall Street and Washington. Remember Fannie and Freddie? they are still here and engaging in the same practices that contributed to the meltdown-as is Wall Street.
While the fed is still in denial, or deception mode, Joe Blow is curtailing spending, ACE manufacturing is moving to China and successful companies are hoarding cash.
Globally, there is still more than $175 trillion in derivatives that have to unwind.
Hang on to your wallets, politicians are after YOUR money.
Like Fat Cat, i started my trimming Monday and more today. Am considering something i never thought i would in over 20 years.... all cash and Gold. Any idea what happens when Obama/Bernanke end their printing orgy? They are printing at the rate of 1 Trillion per year in the bond market. That is staggering. The other end of that is our massive deficit spending and one will effect the other.
At some point, as mortgageAndDebtFree says, rates will go up and the bond markets will correct this for us. The bond market is MUCH bigger than the stock market and will take a dump. What we pay for debt will easily go from under 2% to 5%+ MINIMUM and the interest on our massive debt will top a Trillion per year. I fear this to be worse than the first, as the dollar will also crap out.
Inflation, Inflation and more Inflation will bring us down. With less money from the private sector flowing into the economy, which we all know this is what keeps it stable! there will be a big crash. The government has been building up a false wall economy that cannot support itself (no strong foundation). Look for higher taxes to come as this is their last resort to put a finger in a leaking dike. THEY ARE OUT OF FINGERS!!!
Everything is overbought; too much, to quick; 10% retraction coming up!! Then see if the government orchestrates a soft landing to stabilize the markets; if they do and it succeeds, this so-called free market system is a sham, and it would be best to put your money somewhere else
@ vb_iron chef
The FED "IS" the current bond market.
The 'bond vigilantes', of whom we used to expect to get it right, and force a correction, are not in this market.
Low yield and little to no upside pricing; folks, get out of US Treasuries if you haven't already!
Anyone still believe Obama didn't raise taxes on the middle class?
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