The S&P 500 has now decisively broken down below its 2002 lows, taking out the psychologically important 700 level in the process. This puts us into largely uncharted territory.
At the risk of sounding like a broken record, the main driver of this selling pressure remains continued concerns over the fate of the US economy and the prospects for a recovery. As I've pointed out in the last few issues of Pay Me Weekly, there's not even a whiff of recovery in the economic data as I see it. In fact, one could argue persuasively that we haven't even hit bottom yet; if current trends continue first quarter GDP statistics could be even worse than the fourth quarter's 6.2 percent slide.
From a shorter-term perspective, the release of President Obama's aggressive preliminary budget also clearly played a role in the selling late last week and into this week. I'll offer a more detailed rundown of the budget and its impacts on the economy and stock market later on in today's report.
But not all the news is bad. I'm encouraged to see the positive economic data coming out of China--it appears a nascent recovery is taking hold there. As my colleague Yiannis Mostrous has been pointing out in his newsletter Silk Road Investor, the Chinese stimulus package announced last year is equal to roughly 13 percent of the nation's GDP and much of that stimulus will actually impact the Chinese economy this year. It's quite possible that the economy will meet its 8 percent growth target without the need for a follow-on stimulus package.
A few data points bear watching in China, including the Purchasing Manager's Index (PMI) for manufacturing and new loan growth. Check out the chart of China's new lending activity below.
This chart shows new loans extended by Chinese banks. In many cases banks are making these loans to help fund the new infrastructure investments the government is making.
The current reading of 1.6 trillion renminbi is a record for this series and double the December total. It's a positive sign to see loan growth in China; most developed-economy banks remain reluctant to extend credit, tightening lending standards after piling up bad debts on their balance sheets.
As I noted in last week's issue, the breakdown of loan securitization and bank lending has adversely impacted the US velocity of money. The result: Fiscal and monetary policy have less of an impact on the real economy than would normally be the case.
In China, however, this isn't an issue. The impact of every dollar the government spends is multiplied several times over thanks to relatively easy access to debt capital.
This chart shows the China Purchasing Manager's Index (PMI) for Manufacturing. Readings above 50 on the PMI indicate that manufacturing in China is expanding, while readings below 50 indicate contraction.
As you can see, PMI held up relatively well up until roughly mid-summer of 2008. As the global credit crunch intensified moving into the autumn, PMI deteriorated rapidly, hitting a low under 40 in November of last year. But, the index has now seen three straight months of rapid recovery. Although still in a zone indicating contraction, the recovery trend here looks to be for real.
While a continued slide in the broader market averages might seem to indicate that the market has dismissed the positive data out of China, that's not the case. The commodity markets, not global equity markets, are the most direct beneficiaries of a recovery in the Chinese economy because China has been the key marginal driver of global demand in markets as diverse as oil, grains and copper. These markets are clearly showing encouraging signs, as both oil and copper have rallied off recent lows in the past week.
In addition, the Baltic Dry Index, a measure of rates charged to ship dry commodities such as coal and metals, has recovered somewhat from multi-year lows set late in 2008. This could be a sign that Chinese demand for commodity imports is beginning to pick up.
A couple of additional trends bear watching in the commodity markets. First, check out the chart below of the spread in price between West Texas Intermediate (WTI) and London-traded Brent crude oil.
Brent is a slightly lower grade of crude than WTI; therefore, WTI has traditionally traded at a more than $1 premium per barrel to the price of Brent.
Over the past few months, however, this relationship has broken down. At one point in January, WTI was trading around $10 a barrel under the price of Brent. Brent is considered an international crude oil benchmark, while WTI is the key American benchmark. What this unusual relationship indicated was that the crude oil market globally was a lot tighter than in the US. In particular, crude oil inventories in the US, especially at the key Cushing hub, were extraordinarily bloated at the beginning of the year.
But over the past few weeks this situation has begun to reverse. US crude oil inventory reports have begun to show a drop from record levels--there's still glut in the US, but at least the data is moving in the right direction.
This tightening may indicate that cutbacks in global oil production are beginning to gain traction in the physical oil market. Furthermore, demand statistics released weekly by the US Energy Information Administration (EIA) indicate that US demand for oil is beginning to stabilize; in the most recent release, US gasoline demand is actually higher year-over-year. Perhaps falling gasoline prices are finally impacting demand.
Oil will be a key market to watch over the next few months. Further positive news out of China coupled with continued production cutbacks would be positive catalysts. It's quite possible that commodity markets will begin to recover before the S&P 500.
Politics is sometimes a third rail in the newsletter industry. If you make political commentary, you're bound to annoy at least some part of your audience. That's exactly why I've tended to remain as apolitical as possible when writing about the market and the economy.
But given the rising role of the state and the market's unhealthy focus on the latest news out of Washington, we simply can't afford to ignore politics completely. In that vein, regardless of what you might think about Obama's policies, the stimulus package and the preliminary budget, one thing is for certain: The US stock market isn't exactly enthusiastic.
There are a few reasons for the negative reaction. First, markets abhor uncertainty, and the introduction of the preliminary budget introduced several key uncertainties. Second, the Obama budget clearly spells higher taxes and a bigger government; neither has traditionally been a positive for the stock market.
Finally, health care stocks have clearly been a leadership group for the market so far this year. But the industry got hit hard last week, underperforming the broader market by a near 2-to-1 margin. This effectively kicked the legs out from under one of the market's few remaining generals.
The following analysis is excerpted from this week's issue of my subscription-based newsletter The Energy Strategist.
Source: A New Era of Responsibility, Office of Management and Budget
This chart shows total federal government outlays (spending) as a percent of US GDP going back to 1941. As you can see, spending has been steadily on the rise since 2001-02 after falling fairly steadily after 1982. Obama's budget calls for outlays equal to nearly 28 percent of GDP for this fiscal year. That's the largest spending since World War II, during which outlays equal to more than 40 percent of GDP were the norm.
These numbers are based on the administration's estimates. They seem totally unrealistic to me. Specifically, the preliminary budget projects that US nominal GDP will grow at around 4.42 percent annualized between 2008 and 2019. That's only slightly below the roughly 4.7 percent annualized growth in nominal GDP the US experienced in the 1990s.
The '90s were among the best decades in US in history in terms of economic performance. To expect a repeat of that performance is naïve at best. More likely these are simply the sort of performance numbers that were needed to meet stated deficit targets; to be fair, this is a ploy that's been used by presidents from both parties. Here's a chart showing a more realistic projection of the US fiscal situation.
Source: A New Era of Responsibility, Office of Management and Budget
To create this chart, I took the outlay figures from Obama's budget proposal but tweaked the GDP numbers. I assumed the US economy shrinks 1 percent in 2009--a rather conservative estimate in my view and much more realistic than the small gain the budget projects. Then I simply compounded US GDP at a 2.5 percent annualized pace out through 2019.
As you can see, the picture here is even more alarming. The size of federal outlays expands to nearly 30 percent of GDP by the end of the period, the highest since 1945. And even under the Obama budget's relatively rosy projections for federal tax receipts and growth, net debt held by the public would expand from about 41 percent of US GDP at the end of 2008 to more than 67 percent in 2019.
As far as the stock market is concerned, all this spending spells higher income taxes. Using Obama's projections, total federal receipts rise from 17.7 percent of GDP in 2008 to a new high of 19.5 percent in 2019. Under my conservative/realistic assumptions for GDP growth, US government receipts would have to rise to 25 percent of GDP by 2019 to meet the preliminary budget's deficit targets.
Source: A New Era of Responsibility, Office of Management and Budget; Bloomberg
As you can see, under my conservative assumptions tax revenues would have to hit record levels to fund all the planned spending under the preliminary budget and reduce the deficit as planned.
Rising public debt, income taxes and rising spending are hardly factors that tend to give cheer to the broader market averages. Whatever you might think about the merits of Obama's plan, remember that the markets abhor uncertainty. Historic spending and the possibility of major tax increases to fund it all introduce a new level of political uncertainty.
As for healthcare stocks, the S&P 500 Health Care Index had outperformed the S&P 500 in 2009 until it dropped 11.4 percent last week while the broader market slipped 4.5 percent. Much of that weakness was focused on the Health Maintenance Organizations (HMO) such as Humana (NYSE: HUM); the S&P AmBest HMO index plummeted 22.6 percent last week.
The main concern stemming from the president's budget with respect to health care was the establishment of a USD634 billion fund for reform of the industry. Roughly half of this fund would be financed by tax increases, the other half by cutbacks in Medicare and Medicaid spending. Of the roughly USD316 slated to come from Medicare cutbacks, more than half (USD177 billion over 10 years) is supposed to come from a reform to the Medicare Advantage (MA) system.
Without getting into too much detail, under MA, Americans covered under Medicare can elect to be covered by private health insurers. In exchange the government pays the private insurers a fee for each Medicare recipient they cover. The Obama plan would essentially have the effect of lowering the amount these private insurers get, cutting into their profit margins. Many private insurers may decide the MA business is no longer lucrative enough to be viable; in one stroke of a pen, this eliminates what was one of the biggest profit centers for a company like Humana.
The other part of the Budget that raised some eyebrows was a provision that would increase the rebate that drugmakers must give Medicare when selling their branded drugs. Eli Lilly (NYSE: LLY) has already stated the change would cost the company hundreds of millions in lost revenues if enacted.
To be fair, Obama has spoken extensively about MA before, and this move wasn't totally unexpected. However, many market participants were scared off by the speed at which the new Administration is proposing reforms and the ambitious extent of those moves. Senate Majority Leader Harry Reid has stated that he would like to pass new health care legislation by August; this looks highly unlikely, and even several Democrats have said the debate is likely to extend into 2010.
Obama's ambition sucked the wind out of the sails of one of the market's few remaining leadership groups. The S&P 500 Health Care and Information Technology sectors are the most heavily weighted groups in the S&P 500; it's undeniable that their recent wavering has contributed to the index's overall weakness.
In Personal Finance, health care has been and remains among my favored sectors. The Obama budget is most negative for the HMOs, a group I have not recommended in the newsletter. While pharmaceutical, biotechnology and medical device firms all sold off in sympathy with the HMOs, the actual effects on these industries should be relatively mild. This week, many of the health care stocks I follow have actually rebounded even as the HMOs have continued to tumble. The market has already become selective in sorting out the impacts of the budget.
In addition to health care, the budget also included sections that will impact the energy and utility industries. I will leave a discussion of those effects to a future issue.
In closing, I'd like to invite Pay Me Weekly readers to visit our free weblog (blog), At These Levels. The blog allows me and my fellow editors to offer ongoing up-to-the-minute commentary concerning the fast-moving markets, political developments and economic data; readers can also post comments and ask questions. Earlier this week, for example, I explained one of my favorite strategies for making money and generating income in volatile markets, writing covered calls.
I'm also now on Twitter, a free service that's experienced a rapid growth in popularity over the past year. Twitter allows users to post short, quick commentaries on the fly. To hear my latest thoughts, go to http://www.twitter.com/, sign up for a free account and follow me--my Twitter username is Elliott_KCI.
I'd also like to extend a special invitation to all Pay Me Weekly subscribers to attend the Atlanta Wealth Conference, hosted in a beautiful mountain setting in northern Georgia. This conference has always been a personal favorite of mine, as it's smaller than most with only 175 attendees.
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