Treading Water and Seeking Muddle-Through Outcomes
By Frank Barbera CMT. January 13, 2009
This week's article is entitled ‘Treading Water’ as it describes the overall environment markets and economies now reside in coming into the New Year in 2009. Looking back at prior years, 2006, 2007, 2008, it was obvious to everyone except a nobel-laureate economist that things were not right in the financial markets and that huge imbalances existed in the global economy. It always amazes us how the ‘ivory tower’ types fail to recognize the 5 tonne elephant in the room, things like the Housing Bubble, the Credit Bubble and the kind of excessive systemic leverage which had taken control of the global financial system in recent years.
As far back as April 2007, we wrote about the possibility of a strong ‘depression’ type economic contraction unfolding in 2008 along with identifying the bear market from the outset with the S&P near 1500. Along the way, we highlighted many of the big stories of the last two years including General Motors, Lehman, AIG, Fannie Mae/Freddie Mac along with the start of the sub-prime crisis in our columns on Financial Sense going back to early 2007 before sub-prime hit the headlines. Yet with the crowd now mumbling ‘deflation’ at every turn, and the recession obvious to one and all, it is analytically a time to reign in the forecasting and perhaps begin focusing on more muddle-through outcomes.
There are many elements of the current picture that seem like high probability outcomes. To be sure, the recession will likely continue dominating the headlines for at least the next four to six months. In the equity markets, the bear market is not over and the first half of 2009 will likely see stock prices once again retesting the November 2008 lows in the low 700 area. On the corporate front, lay offs will continue to rise and earnings will remain under pressure throughout 2009. At present, the current consensus from stock analysts suggests the S&P will earn $42.26 in 2009 down 12.04% from $48.05 in 2008. From peak earnings in the prior cycle near $92 on the S&P, a decline of an additional 12% in 2009 would mean that earnings have declined by 54% from peak values. With the S&P at 870, the Trailing P/E for 2009 would still be 20.71X which is still a sky high multiple. Thus, while stocks may appear less expensive in many instances, it is far from a slam-dunk that the market as a whole has come down enough to qualify as being cheap. In our view, the weakness seen over the last few days already suggests bear market deterioration setting in. Still, this does not mean that the S&P can’t experience yet another trading rally, particularly with the presidential inauguration only one week away. Nevertheless, the medium term uptrend has been losing internal strength and in bear market climates, that is always something to be aware of as overstaying one’s welcome in a bear market rally phase is always an unpleasant experience. Adding a note of caution into this mix are a number of technical indicators which have recently moved to medium term overbought values. Among these, the ARMS Index has recently dipped down to below .80 arguing at the very least that the January highs could have been the bear market rally breadth peak. Again, in bear markets, these kinds of readings can be a strong caution signal but don’t always line up directly with a final high.
Above: S&P 500 with ARMS Index
So what to make of it all? As we see it, the first few months of the 2009 will likely best be spent trying to be somewhat agnostic on the subject of “Deflation versus Inflation.” On the deflation side, the ledger right now is admittedly very powerful and in some way still quite compelling, especially if you look only at the outer manifestations of recession and call that ‘deflation.’ Yet in truth, as Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon,” and to that end, money supply aggregates are still growing throughout the world, and within a few months a lot of the bailout money and stimulus program dollars will be working their way into the global economy. So far, ‘Velocity,’ which is a key ingredient to reversing the deflationary tide, has not given any evidence of arresting its decline and remains in a solid downtrend. This hints that it may be a number of months before any recovery could begin to take shape. Yet, on the future recovery, or ‘reflation’ side, it is hard to believe that all of this massive money creation will go for naught in terms of not doing any good, or having zero impact on arresting the downside contraction. I mean these numbers are staggering! Here in the US, the total of stimulus and bail out monies is already north of 7 trillion dollars in total commitments, with total spending already well beyond 3.50 trillion dollars. A while back, James Bianco of Bianco Research tried to put these figures in perspective by comparing the bail out costs in 2008/2009 to some of the bigger government expenditures of the last 200 years.
- Marshall Plan: Cost: $12.7 billion, Inflation Adjusted Cost: $115.3 billion
- Louisiana Purchase: Cost: $15 million, Inflation Adjusted Cost: $217 billion
- Race to the Moon: Cost: $36.4 billion, Inflation Adjusted Cost: $237 billion
- S&L Crisis: Cost: $153 billion, Inflation Adjusted Cost: $256 billion
- Korean War: Cost: $54 billion, Inflation Adjusted Cost: $454 billion
- The New Deal: Cost: $32 billion (Est), Inflation Adjusted Cost: $500 billion (Est)
- Invasion of Iraq: Cost: $551b, Inflation Adjusted Cost: $597 billion
- Vietnam War: Cost: $111 billion, Inflation Adjusted Cost: $698 billion
- NASA: Cost: $416.7 billion, Inflation Adjusted Cost: $851.2 billion
Totaling all of these past expenditures – combined and adjusting the values to today’s dollars yields a total of around $3.92 Trillion dollars. The point here is that (and recalling that Obama will soon be proposing a spending package of at least another $700 billion) by the time this is over, the US will easily have spent a sum in excess of $4 Trillion dollars in bail out/stimulus monies – a total that will likely exceed the combined prior total of past major expenditures. That is a mind-blowing outcome, and it speaks to how serious the events of the last 12 months are in context with past history.
Elsewhere around the world and particularly in China, the massive stimulus program looks robust, suggesting that Asia could spearhead the next growth recovery cycle. The point at this time is that all of this counter-veiling effort is likely to have some affect, and could at least blunt some of the escalating deflationary/recessionary forces. Mind you, here in the US, we still expect a very long “U” shaped recession/recovery, which will mainly be an ongoing recession that ‘ebbs and flows” over the next few years. The hangover is likely to last for some time. Yet, during the second half of this year and in early 2010, there is a reasonable chance that the economic data will begin to lift, and that the recession mindset will gradually begin to improve. Call it a marginal recovery phase. Under most circumstances we do not expect to see any sort of broad based recovery. Yet, a plateau, even an “uninspired, gradually upward sloping plateau” is a better outcome than a continued death plunge into the deflationary abyss.
Speaking of the ‘deflationary abyss,’ while there is much in the way of legitimate concern, as we have already noted, there is nevertheless at this time a great deal of widespread focus. Consulting any variety of magazines, websites, and newspapers, ‘deflation/depression’ is the idea of the day. Just yesterday in his parting press conference, George Bush noted that in recent months he was told by his leading economic advisors that “if something is not done now, then a depression greater then the Great Depression could take place.” While this is not news to most of us who read financial sense, it was a pretty striking and candid admission. What we observe is that the ‘depression’ camp right now is getting pretty crowded, with even the President using the “D-word.” Earlier today, I ran a Google Trends search for words/phrases such as “Recession,” “Inflation,” “Great Depression,” “Deflation” and from this constructed a simple algorithm summing up all the uses of “Great Depression + Recession + Deflation” and subtracting out the references to “Inflation.” The graph is shown below:
Above: Google Trends (summation of the searches for “Deflation”, “Recession”, “Great Depression” less “Inflation”)
While the chart has dipped just like the VIX Index has over the last few weeks, it has still been quite the bull market in “gloom and doom” over the last few months and that should at least give us some measure of pause about getting too excessively bearish on 2009. In my view, it is not impossible that the stock market could under go some additional bear market declines during the first half of the year and then turn up in the second half of the year foreshadowing an improvement in the economy in 2010. On this subject, if Obama is successful and gets a large stimulus package passed early on in his administration, the full impact of that legislation will hit the economy in early 2010. On that basis, and assuming the stock market is a good future discounting mechanism, it would not be shocking to see the market make an important low six months ahead of time in the summer of 2009. For now, it seems as though 2009 has too many wild cards to make a high confidence assessment with only the data in hand. As a result, the bets approach in this climate is for long term investors to stand aside as this market is best suited to those with a short term trading mentality. In my view, when things begin to clarify themselves there will be many larger themes that could emerge. For now however, a trading mindset along the lines of “Make the money, Take the Money” is probably the best approach. To that end, stocks do seem once again oversold on a very short term basis and could be setting up for yet another small bear market rally sequence.
In the chart above, we show the S&P 500 with the 9 day RSI. Through today, the RSI is down to the vicinity of its 30 day lower band. On the lower clip, we show the RSI as a function of the trading bands, where it is plain to see that the indicator has traveled from overbought at the very beginning of the year to relatively oversold right now. This market will require ‘hit and run’ tactics and the focus for now should be on most short term swings. If there is another rally, we will be watching the behavior of retailing issues with the idea of potentially setting up some “Long/Short” strategies in the days ahead. In recessions, shorting ‘high beta’ or ‘consumer discretionary’ against long positions in consumer staples can be a good recipe for trading success.
If and when the bear market does re-assert itself, something I expect in the weeks ahead, Consumer Discretionary will likely fall versus Consumer Staples with the R/S Ratio turning down. Again, as a trade, this concept is probably still ‘too early’ right now, but could be worth a second look if the S&P does surge into the Obama inauguration. With major medium term resistance forming for the S&P in the 960-970 zone, at those levels, I believe this idea could be worth a close look. At times like this, where the forecasting of major outcomes is harder to perceive, perhaps Long-Short is one way of treading water and making money while watching to see which way the larger outcome will ultimately resolve.
Above: ETF comparison – Consumer Discretionary has been recovering over the last few weeks versus Consumer Staples.
That’s all for now,
© 2009 Frank Barbera