All About the Bear in Sheep’s Clothing

Man with bear headThe third quarter has ended and the stock market rally continues, with earnings season right around the corner. Key stock indices have shown some solid gains. The S&P 500 rose 5.8% in the third quarter and the Dow Jones Industrial Average rose 4.3%.

The risks to be in the stock markets are increasing as the fundamentals of the economy, except for an expanding money supply, are getting worse. The global economy is a facing severe economic slowdown and the U.S. economy is not immune to it.

Yesterday, the media was all over the “rebound” in U.S. manufacturing after a report showed that manufacturing in the U.S. expanded in September. The Institute for Supply Management’s Purchasing Managers Index (PMI) rose to 51.5 in September compared to 49.6 in August. The focus was off of the fact that, in the same period, new export orders continued their decline for the fourth straight month. (Source: Institute for Supply Management, October 1, 2012.)

Meanwhile, elsewhere in the global economy, manufacturing is suffering severely and the economic slowdown has become widespread. China’s manufacturing has been contracting for 11 months straight because of an economic slowdown within its key trading partners in the global economy. (Source: HSBC Holding Plc, September 29, 2012.)

Consistent PMI readings above 50 would suggest healthy manufacturing. But that’s simply not the case for U.S. manufacturing; PMI was below 50 for last three months and just edged higher this month. I don’t see what the big deal is about September’s 51.5 PMI reading; one good number does not suggest gloomy economic growth or reasons for key stock indices to rally.

Dear reader; the higher a stock market rises with no real reason, as we are experiencing now, the more analysts and the media grasp at straws to explain why it is rising.

The economic problems at hand are still unresolved. The debt crisis in the eurozone is bringing down the global economy. The U.S. economy will be highly affected by the slowdown in the global economy, as U.S. exports to the developing countries and emerging markets accounted for almost half of its economic growth witnessed after the financial crisis. (Source: Wall Street Journal, October 1, 2012.)

The World Trade Organization (WTO) predicts that the trade in the global economy will only expand by 2.5% in 2012, compared to 5.0% in 2011. We are going the wrong way—trade in the global economy grew at a hefty 13.8% in 2010. (Source: World Trade Organization, September 21, 2012.)

This time around, the U.S. economy is in dire straits and the demand from other developing countries and emerging markets is also decreasing. The only question left is simply: when does the bear come out of its sheep’s clothing and surprise the naïve investors?

Companies like FedEx Corporation (NYSE/FDX) and Caterpillar Inc. (NYSE/CAT) have already provided warnings about their earning growth due to the slowdown in global economy—don’t be surprised to see a lot more companies follow.

The fundamentals are yelling that the stock market shouldn’t be rising, because the global economy is facing hurdles. More countries are facing economic slowdown and global demand is decreasing—the Federal Reserve acknowledges this by the fact it has left the money tap open (i.e. no expiry date for QE3).

Dear reader; the markets can stay irrational for extended periods of time. But when reality sets in, the markets come crashing down harder than they first climbed.

Michael’s Personal Notes:

After rigorous attempts by the Federal Reserve to boost the U.S. economy, the only after-effect of quantitative easing I’ve seen has been a ballooning of the stock market—another bubble created. Wherever I look, I can’t help but be skeptical about the current state of the economy.

Back when the financial crisis began, the Federal Reserve’s main goal should have been to bring consumer confidence into the economy and promote lending. Why? So consumer spending could increase and from there businesses could start growing again. After all, consumer spending accounts for 70% of the U.S. gross domestic product (GDP).

Sounds like a perfect plan, but unfortunately it has turned into a perfect storm. If the Federal Reserve’s plan of flooding the system with money to get the U.S. economy going were working, we would be seeing consumer spending and lending pick up—not in just one sector or city, but across the board.

The after-shocks of the financial crisis have left consumer spending and lending depressed and there are no signs of them improving.

Real disposable income in the U.S., income after inflation, decreased 0.3% in August. (Source: Bureau of Economic Analysis, September 28, 2012.) “Economics 101” suggests that, when there is more disposable income, spending increases. Similarly, less disposable income means lower consumer spending, which is the current case in the U.S. economy.

In 2011, U.S. consumer lending was down 40% compared to the lending in 2006. (Source: Wall Street Journal, September 26, 2012.) Lending has picked up in some smaller cities, but remains under pressure in bigger cities.

As I have been writing in these pages, consumer spending has to increase for the U.S. economy to see any economic growth. And the only way consumer spending can increase is if people have increasing income—something eluding Americans in 2012.

The U.S. economy is still in the mess that was created by the financial crisis. Sure, the worst is over when compared to some scary days that the stock market and world economy experienced back in 2008.

But today we have other serious problems: unsustainable U.S. government debt; an unprecedented increase in the money supply, which could lead to rapid inflation; many municipalities under pressure to declare bankruptcy; decreasing personal disposable income; a slowing world economy; and U.S. consumer spending growth that’s almost non-existent.

To date, I can’t see how the Federal Reserve’s attempts to boost the U.S. economy with QE1, QE2, and QE3 have been helpful to the average Joe American. The most basic ingredients for economic growth—consumer spending and lending—are just not there.

Where the Market Stands; Where It’s Headed:

Some insightful comments on the stock market from my esteemed colleague Anthony Jasansky, P. Eng., I want to share with my readers:

“After weeks of comments about unsatisfactory growth in the economy and employment, on September 13, 2012, the Fed finally announced the much-anticipated QE3. Quoting its ‘mandate of fostering maximum employment and price stability,’ the Fed will purchase additional agency mortgage-backed securities at a pace of $40.0 billion/month. No time limit has been set for the program. QE3 essentially mutated into ‘QE Unlimited.’

“Following the typical pattern of buying on rumors and selling on news, the advance in stocks, bonds and commodities from their June 2012 lows came to an end the next day, September 14. The question now is: how large will the post September 13 correction be?

“Significantly, many other central banks, including the ECB and the China Bank, are also hell-bent on flooding their struggling economies with more money. The experience of the last three years shows that, while the massive money printing by the Fed has done wonders for financial and commodity markets it has been far less effective in stimulating sustainable economic growth and employment. Perhaps the third time around the Fed will be more successful living up to its true mandate. After all, the mandate does not mention gunning up the market.

“Having received what the market had eagerly anticipated, I assume the focus will shift back to the long-running euro drama. Spain and Italy are now upstaging Greece, and will likely be the news-makers providing the media with brilliant explanations for every swing and gyration the financial markets experience. These market swings may be of little use to investors with time frames measured in months or years, but present a bonanza for flash traders exploiting minute fluctuations and relative mispricing of various classes of securities.

“I expect further market weakness in the coming weeks.”

What He Said:

“The conversation at parties is no longer about the stock market, it’s about real estate. ‘Our home has gone up this much,’ or ‘Our country home has doubled in price.’ Looking around today, it would be very difficult to find people who believe that one day it could be out of vogue to own real estate, because properties would be such a bad investment. Those investors who believe a dark day will never come for the property market are just fooling themselves.” Michael Lombardi in Profit Confidential, June 6, 2005. Michael started warning about the crisis coming in the U.S. real estate market right at the peak of the boom, now widely believed to be 2005.