Proof Stock Market Rally’s Just
an Old-fashioned Bear Trap

corporate profitsJust a few months ago, some economists were saying that the U.S. would escape the recession in Europe and the slowdown in China, to which I argued, “NOT A CHANCE.”

About 40% of all profits earned by the S&P 500 companies come from overseas (source: Bloomberg; April 9, 2012). When you look at that percentage, we quickly see it is impossible for American companies to withstand the recession in Europe and the slowdown in China.

Even the very big companies are complaining about problems overseas:

General Electric Company (NYSE/GE), the world’s largest maker of medical imaging equipment and an S&P 500 company, is warning that healthcare sales in Europe are going to be hurt by the recession they are experiencing in that part of the world, affecting GE’s earnings reports.

3M Company (NYSE/MMM)—another company within the S&P 500—is stating that the slowdown in China is going to hurt sales at its consumer products business there, thus affecting its earnings reports for 2012.

Due to the recession in Europe, The Dow Chemical Company (NYSE/DOW), a component of the S&P 500, shut down five factories and cut 900 jobs. This will lower the company’s profit growth when it releases its earnings reports throughout the year.

McDonald’s Corporation (NYSE/MCD) has yet to release any earnings reports in 2012, but this S&P 500 company says that same-store sales for February were lower due to Europe, as consumers there cut spending because of the recession.

Parker Hannifin Corporation (NYSE/PH), a manufacturer of fluid power systems and an S&P 500 company, cut its full-year profit estimates, well ahead of its earnings reports for 2012. The company cited slowing international demand for its products—Europe and Asia.

Staples, Inc. (NASDAQ/SPLS), also an S&P 500 company, reduced its profit forecast for 2012 due to the recession in Europe. On the U.S. economy, the company remains cautiously optimistic.

From the above, it is obvious that the slowdown in China and the recession in Europe have had significant impact on these S&P 500 companies. I have a strong feeling there are going to be many more earnings disappointments from large multinational American companies on the heels of higher commodity prices and slower international growth.

At the end of the day, the stock trades at a multiple of future earnings of the companies that trade in it. Weaker earnings growth by the S&P 500 companies with exposure to Europe and China coupled with record high corporate insider trading bodes well for my theory that we are simply in a bear market rally.

There is no substance to either the stock market rally or economic growth (domestic of international)—as the general public will soon so abruptly find out. (Also see: The Makings of a Classic Bear Market Trap.)

Michael’s Personal Notes:

I have been writing in these pages about the terrible plight of municipalities attempting to fix their massive budget deficits (see A Crisis Gone Worse: Many Municipalities Consider Bankruptcy).

The central problem with these budget deficits is pensions. Governments throughout the U.S. are desperately trying to find answers to the question of how to pay their obligations to retirees despite the fact that their pension plans are massively underfunded.

To avoid getting into such trouble, most corporations have almost completely eliminated defined retirement benefit plans. In 1983, 62% of all retirement plans offered were defined benefit retirement plans, but that dropped to just 17% in 2007 and probably fell a little more in the last few years (source: Boston College Center for Retirement Research).

Of course, there are still some unions left in this country, which will ensure the survival of defined retirement benefit plans. It is bad enough that the governments are unable to meet their massive budget deficits, but now corporations are in the same boat.

Since the financial crisis of 2007, new regulations were created, which forced companies to report their corporate profits differently. These measures were enacted in 2011 and, after one full year of reporting under the new standards, budget deficits for corporations were revealed when it comes to pensions.

Credit Suisse has analyzed the situation and believes pensions plans are only 52% funded. This means that, for every dollar of pensions owed, corporations in the U.S. have $0.52 in cash to meet these obligations through their corporate profits.

Credit Suisse estimates that the shortfall in pensions by corporations—budget deficits—comes to a staggering $369 billion.

Corporations can’t raise taxes like municipalities to meet budget deficits, but companies can either raise employee contributions to the pension plans to make up the budget deficits or cut the payouts of the pension plans. How well will that go over with unions?

You know the answer to that: Strikes and general animosity between the company and their employees, which will not be good for employee morale and in turn will reduce productivity, thus reducing corporate profits.

Seven large corporations within the S&P 500, including Safeway Inc. (NYSE/SWY) and United Parcel Service, Inc. (NYSE/UPS), have budget deficits when it comes to pensions that represent a significant portion of what they are worth today.

If these companies are forced to use a large part of their corporate profits to fill this budget deficit gap, their stock prices will suffer greatly.

Watch out for that stock market rally, dear reader.

Where the Market Stands; Where it’s Headed:

Dear reader, I want to be perfectly clear as to where I believe the stock market stands and where I believe it is headed:

After a 25-year bull market in stocks, which was fueled by a 25-year decline in interest rates and a period of great financial leveraging, a Phase I bear market (often referred to as the first down-leg) brought stock prices down sharply.

From its high of 14,164 in October 2007, the Dow Jones Industrial Average crashed to 6,440 by March 2009—a 55% drop.

A Phase II bear market (often referred to as the “rebound,” “bounce” or “sucker’s rally”) started in March of 2009. The Dow Jones Industrial Average has risen about 100% since March 9, 2009.

The bear market has been doing an excellent job during this current phase of luring investors back into the stock market. Phase II bear markets give investors the false impression that the economy has turned the corner and that stocks are a safe bet again—exactly where we are today. This phase of the secular bear market is still upon us.

Given that 2012 is a Presidential election year in the U.S., given that the government and the Fed have fought the natural forces of this bear market tooth and nail, the bear market rally, the “bounce” in this secular bear market, has been long.

Phase III of the secular bear market is when stock prices come crashing down again, bringing stock prices down to the point at which the Phase I bear market started or lower—in this case, 6,440 on the Dow Jones Industrial Average, about 50% below where the stock market sits today.

Yes, I understand that I’m one of the few stock market analysts out there with this opinion. But history is history. What I have explained above, the stark reality of where we are with the stock market, is how a secular bear market works.

The government can take on as much debt as it likes ($5.0 trillion and counting since President Obama took office) and our central bank can increase the money supply as much it wants (an increase of about $2.0 trillion since the credit crisis began). And you can bet your last dollar that there will be Q3 and that Phase III of the bear market will set in. But too much debt and too much money printing always lead to rapid inflation and higher interest rates. Hundreds of years of economic history have proven this.

What He Said:

“Consumer confidence does not change overnight. In the U.S., 70% of GDP is based on consumer spending. And in my life, all the recessions I have seen or studied have only come to an end when consumers started spending. With consumer sentiment getting worse, and with the U.S. personal savings rate near record lows, it may take two or three years for consumers to start spending again.” Michael Lombardi in PROFIT CONFIDENTIAL, February 25, 2008. By the end of 2008, the rest of the world was realizing the recession would be much longer and deeper than most had realized.