Whither the Stock Market

Investors received a dose of reality this week. After weeks of waiting for the results of the bank stress tests and of watching the stock market rise or fall with the fortunes of bank stocks, traders this week had to confront what was happening in the real world: the state of the global economy.

The markets took a roller coaster ride this week, with the down days, unfortunately for the bulls, outweighing the up days.

We will look at current economic conditions and try to determine whether the recent rally in stocks was in fact the leading indicator for an economic recovery or if it was just another bear market rally (of which, we’ve already had three or four during this recession).



Background

Stocks had fallen about fifty percent from their pre-Lehman highs (we equate the Treasury’s failure to bail out Lehman Brothers back in September with the beginning of the most recent crisis in both the market and the economy) until March 9, when they began their most recent rally. Since March 9, going into the this week, both the S&P and the Dow had recovered about one third from those lows.

Most of the rally, in our opinion, had occurred because of optimism regarding the financial system. It started following Treasury Secretary Tim Geithner’s unveiling of his latest bank bailout plan, including specifics regarding stress tests that officials would be conducting at the nation’s top nineteen banks. It continued as leaks regarding the results of those tests appeared to indicate that none of the top nineteen would be found to be insolvent or would have to be nationalized. Last week, when the results were finally announced and confirmed this optimism, the rally suddenly came to a halt (buy on the rumor, sell on the news).

In all fairness, banks’ health wasn’t the only reason for the rally. From time to time, comments from various officials, most notably Fed Chairman Ben Bernanke, regarding "green shoots" of economic recovery also encouraged investors.
None of the green shoots, however, seemed to signal an actual recovery. Rather they only showed the economy wasn’t falling as precipitously as it had been earlier in the year. House prices were still in decline, but the drops each month were smaller than the previous month. The country was still losing massive amounts of jobs, but April’s loss was "only" 539,000, compared to 663,000 the month before - a major improvement (although April’s job loss was the seventh biggest in history). Nevertheless, the unemployment rate still climbed to 8.9 percent, on its way to 10 percent?

What the green shoots were really showing was a decline in the rate of decline. As one commentator put it, people were no longer talking about a repeat of the Great Depression, only about the Great Recession.



The Recovery

About two weeks ago, writers in the Financial Times laid out four conditions that might be signs of a nascent recovery. It might be helpful to revisit those conditions today.

The first condition was an easing in financial conditions. The health of the banks is a necessary part of that condition. The stress tests "showed" that the banks were not seriously undercapitalized. But a number of economists have pointed out that perhaps the stress tests weren’t stressful enough. And, as we pointed out last week, banks have learned to "game" the system. They will do whatever is needed to ensure that they meet capital requirements. But will they do enough to ensure that the flow of credit to businesses resumes?

One indicator of easing credit conditions is the 3-month LIBOR rate, which fell below one percent for the first time this week. But another segment of the financial system that, in the past, has been responsible for lending - loan securitization - has so far failed to even approach pre-crisis levels.

A second condition for economic recovery is a bottoming out in US home sales and signs of life in the construction market. Mortgage rates are at record lows and home prices are down 30 percent from their highs, indicating that opportunities for a recovery in the sector are there. An index of pending home sales rose by 2 points in March. But, again, as we have pointed out before, one number doesn’t constitute a trend. Perhaps in coming weeks we will see confirmation of a housing recovery. But it’s not evident yet.

The third condition the FT pointed to was a recovery in consumer spending. GDP in the US fell a depressing 6.1 percent (annualized) in the first quarter. Yet, the one bright spot in the report was the fact that consumer spending actually rose 2.2 percent. If this were a harbinger of things to come, it would be good news. But this week, the commerce department reported that retail sales declined 0.4 percent in April, when economists had been predicting an increase. And retail stores are still reporting that consumers are only buying essentials, leaving discretionary items on the shelves and on the racks.

We believe consumer spending will play a vital role in the recovery. But three factors will weigh on spending: fear of job loss, confidence in a housing recovery, and further reduction of household debt.

As we pointed out above, employers are still shedding jobs, and the unemployment rate continues to climb. Yesterday, Chrysler announced it was closing almost 800 dealerships. GM is expected to close twice as many in coming weeks. That could mean the loss of another 150,00 jobs. News like this doesn’t help to build consumer confidence.

Confidence in a housing recovery won’t occur until there is hard evidence of a recovery. And we think that this recession has really frightened consumers: the household savings rate is up to 4.2 percent and could reach as high as 6 percent.

The fourth condition the FT signaled as pointing to a global economic recovery was encouraging numbers from China. China spent the equivalent of $586 billion in its own fiscal stimulus package last November and it seems to be paying off. The Chinese government reported that first quarter GDP growth was 6.1 percent (annualized), down from 6.8 percent in the previous quarter, but still healthy growth. Industrial production rose 8.3 percent in March after gaining only 2.8 percent in January-February. But exports fell 30 percent in the first quarter. Loan growth was 25 percent in the quarter, much of it resulting from government strong-arming of the banks to lend. This has resulted in a big increase in investment spending. But some analysts believe the lending/spending is creating severe production overcapacity, and could be setting China up for a setback in the future.
Another factor which could delay recovery is the lack of capital spending. The decline in capital spending accounted for 4.7 percent of the 6.1 percent decline in GDP in the first quarter. Capital spending has fallen 16.8 percent since the third quarter 2008. Until that turns around, any recovery will be difficult.

On the plus side, there are two factors, which, we believe, could be contributing to a nascent recovery. One is the recent run-up in commodity prices. Crude oil this week topped $60 a barrel for the first time in six months. Much of the increases have been attributed to China, on a global buying spree, taking advantage of low prices to stockpile critical commodities. However, it could also be an indication of a wider growing optimism among purchasing managers, in general.

A second factor that could lead to economic recovery is the draw-down in business inventories. Firms slashing production and reducing inventories have resulted in a situation where current inventories are so low that firms will soon have to begin restocking inventories, which could also help economic recovery.

In summary, we see more disappointment ahead for the economic bulls and, correspondingly, for the market bulls. We see more weakness in stocks in the coming weeks.



Outlook for India Stocks and the Rupee

Stocks in India traded in a narrow range this past week, while the Rupee fell against the Dollar. The stock market seemed to be hinging on election results, which will be announced this weekend. We feel a Congress victory will lead to a sell-off next week. The Rupee is trading in the pattern of all emerging market currencies: when traders are uncertain about economic or market conditions, they tend to run to the safe-haven currencies, the US Dollar and the Japanese Yen, and sell all other currencies including the emerging market currencies. That was the case this week. We see this situation continuing next week as well and therefore look for the Rupee to continue to trade lower vs. both the Dollar and the Yen. Gold, which approached $930 an ounce this week, should also trade higher next week.