Jim Kopas

This past week I have been busy finishing up the quarterly newsletter for Pring Turner Capital Group and will have it posted early next week.  Therefore, for the investment article of the week, I have posted an article written by J.D. Steinhilber that does a great job of explaining the current market condition and what investors should expect in the months ahead.  Enjoy!

Market Review: Recent Pullbacks Should Be Viewed in Context

By J.D. Steinhilber

Equity markets just enjoyed their best quarter since 1998, but in the past two weeks have come under a degree of selling pressure not seen since the early June/late July correction. Pullbacks have been relatively minor thus far – clipping only 5% off the S&P 500 – but the odds seem to favor a deeper correction. By any measure, the stock market had gotten extended following seven consecutive months of gains. At its recent peak on September 23, the S&P 500 was 62% higher than its early March low and 20% above its 200-day moving price average. Not since 1983 has the index traded this far above its 200-day moving average. The stock market has entered a riskier phase as a result of this intermediate-term overbought condition and the large gains that have already occurred.

Investors contemplating new commitments to stocks need to be prepared that a correction of 10%+ could occur at any time. Using the S&P 500, the first line of major support comes in at 975-1000, and that may well contain any further weakness that could develop. If those levels give way, the S&P 500 would be vulnerable to a deeper correction to the 925 area, which we suspect would represent the worst case scenario between now and the end of the year. The weight of the evidence suggests that such a correction would be in the context of an ongoing bull market that will extend well into 2010 (at a minimum). Moreover, the upside potential from further advances is significant enough to argue against taking anything other than modest defensive measures at this stage. The trend in stock prices is decisively up; the internal technical health of the market is strong in terms of widespread participation (breadth) and the absence of negative divergences.

Investor sentiment is no longer the strong positive it was just a couple of months ago, when many investors still questioned whether a new bull market was indeed underway. Market optimism has been gradually rebuilt after the devastation of the past bear market, but bullishness can hardly be considered extreme enough to impede further gains.

Valuations are not intrinsically cheap, as they were in the early phase of the rally, but they are reasonably priced, especially in light of the alternatives available to investors. Stocks have discounted a fairly robust recovery in the economy and corporate earnings, and our sense is that expectations have gotten a bit ahead of themselves. When you come through a 25 year secular credit expansion, it will be a multi-year transition process to bring the private sector’s debt levels into alignment with its debt servicing capacity. As a consequence, the recovery will likely be long and drawn out, despite massive ongoing government intervention to stabilize the economy. Disappointing news on the economy seems to be the most likely catalyst for potential downside volatility in the months ahead.

But balancing out this risk for markets is the extraordinarily potent stimulus provided by the Federal Reserve’s ultra-easy monetary policy. Whether through its 0% interest rate policy, which is driving money out of safe deposits and into risk assets, or its continuing direct intervention in credit markets through quantitative easing operations, the Fed has literally flooded financial markets with liquidity and created a powerful impetus towards higher prices for financial assets. The Fed opened the monetary floodgates last fall, producing a surge in money supply growth, which peaked at a 20% annual rate in early 2009.

The financial markets have been the primary beneficiary of the rapid money supply growth in the past year. The prices of goods and services likely will not begin to adjust upward until well into next year, due to the enormous slack in the economy, giving the Fed a green light to keep its foot on the monetary pedal. We are sympathetic to the argument that this is a not a “rational” bull market because the underlying debt problem has not been solved. It is certainly true that the abuse of leverage and the mismatch between aggregate debt levels and underlying debt servicing capacity, which was at the heart of the financial crisis, have not been rectified. Rather, debt has largely been shifted from the private sector to the public sector. But this longer-term reality does not imply that in the short run the wall of money that has been thrown at the system will not be successful in stabilizing the economy and inflating financial markets. Nor does the “liquidity-driven” bull market now at work in financial assets seem likely to go away anytime in the foreseeable future. In the absence of a crisis of confi-dence in the U.S. dollar or in the demand for and pricing of Treasury debt, monetary policy at the Federal Reserve will be dictated first and foremost by employment conditions and the housing market.

Last week’s employment report for September confirmed that the labor market continues to be very weak. The unemployment rate climbed to 9.8%, its highest level in 26 years. The alternate U-6 unemployment rate, which factors in marginally employed (i.e., involuntarily part-time) workers, rose to 17%, its highest level in the history of that data series. Similarly, the housing market remains vulnerable, due to persistent excess supply and the fact that mortgage delinquency rates continue to rise, as a result of unemployment, negative home equity, and forced deleveraging of real estate speculators.

Apart from these factors, the Fed will be under political pressure to resist raising rates in order to prevent the Treasury’s borrowing costs from rising at a time when the government is running multitrillion deficits to shore up the economy. The Federal Reserve will likely keep short-term rates at or near zero for an extended period (i.e. well into 2010). As a result, money will continue to flow out of safe deposits earning a negative real yield, and leveraged “carry trade” investors (i.e. hedge funds) will continue to borrow in U.S. dollars to fund the purchase of higher returning risk assets.

In short, markets should remain well-lubricated with liquidity to prevent a serious breakdown in prices and perhaps support significantly higher prices. So investors must deal with the tension between the knowledge that the debt problem in the economy has largely been “papered over” and the appearance that government sponsored reflation is working (again!), without triggering the repercussions of substantially higher government debt financing costs or a crisis in the U.S. dollar.

Jim Kopas Investments