Banks Are Not the Only Problem

The market advanced about 70% from the March lows without a drop of as much as 10%, and has done so on declining volume.  Each rally top has occurred on lower upside volume than the rally preceding it, while downside volume has recently been rising.  The VIX has dropped from slightly over 50 earlier in the year to 17.5 a few days ago indicating an increasing willingness to take risk.  This willingness is reflected in the major decline in junk bond yields to a level not far above the yield levels reached at the height of risk-taking in 2007.  The percentage of bearish advisory services has dropped to its lowest level in 22 years.  Since the fourth quarter earnings report season started favorable reports have only resulted in the stocks of reporting companies selling off on the news, an indication that optimistic earnings have already been built into market forecasts.  Notably, the sell-off also happened after an election result in Massachusetts that was highly favored by the market.  This pattern fits neatly with the indications of increased risk-taking and excessive optimism.  Green shoots are no longer enough to move the market.

At the same time there are some early indications that the effects of government stimulus to the economy may be starting to wear off.  Non-farm payroll employment fell by 85,000 in December while manufacturing production declined 0.1%.  Retail sales were off by 0.3% and housing starts 4%.  The NAHB index for January has drifted off to 15, down from 19 in September.  Mortgage applications are scraping along the bottom and are down substantially from a few months earlier.  The January Philadelphia Fed Index dropped to 15.2 from 22.5 in December.  The ABC News/Washington Post Consumer Comfort Index has dipped from minus 41 to minus 49 in the last two weeks.  After rising for a while the number of new job openings has declined in the last two months to a level barely above the July lows.

Although the renewed decline in various economic indicators is recent and subject to reversal, there is good reason to believe that the fall-off will continue as the previous green shoots were largely a function of government stimulus that has already been ended or will be ended soon.  No further income tax refunds are in sight and the cash for clunkers program is finished.  The Fed has purchased a trillion dollars worth of mortgages, a program that is being wound down.  Its purchase of long-term Treasuries ended in October.  The extended home buyers tax credit ends on April 30th.  Home prices are still about 10-to-15% overvalued based on wages and rents.  Homes for sale and temporarily being held back from sale are at record levels and RealtyTrac is estimating a record 3 million more defaults this year.

While all of the above is happening, let's not forget the extreme importance of China beginning to tighten monetary policy, and Greek fiscal problems coming to the fore.  China's fourth quarter GDP increased 10.8% if their numbers can be believed.  They also announced recently that their imports were up 53%.  Now we don't pretend to be experts on the Chinese economy, but with 70% of the world's economy (the U.S., the EU and Japan) growing weakly or not at all, how does an export-oriented economy grow at 10.8%?  And where are all those imports (mostly commodities) going?  If China cuts back on commodity imports, which seems highly likely, commodities will take a hit, and this may already have started.

The Greek problem may end up having even more market impact than any of the above.  The Greek government's fiscal deficit has reached 12.7% of GDP and Greek bonds have recently tumbled.  Since Greece is an EU member it cannot use an easy monetary policy to offset any dire economic consequences of cutting back its deficit, and any move by the EU to tighten its own monetary policy would drag Greece down with it.  Furthermore if Greece were to leave the EU in order to conduct its own policy, the EU and the Euro currency would be destroyed.  All in all there doesn't appear to be any good options. The Greek problem has led to a flight to safety toward the dollar and away from the Euro and concurrently out of commodities.  In addition to Greece other EU members have serious fiscal problems as well.  The fiscal deficit-to-GDP ratio is 12.2% in Ireland, 9.6% in Spain, 6.7% in Portugal and 5.5% in Italy.  EU rules call for a maximum deficit of 3%, and it is difficult to see how this goal can be met without economic havoc that would spread globally.

In sum we think the stock market has a lot of serious problems far greater than the President's banking proposal and that those who brush off the relatively small recent decline as a tempest in a teapot are making the same mistake they made at the peak of the dot.com bubble in 2000 and the top of the housing-related boom in 2007.