The Silver Lining in This Market

If you are a longtime reader of this column, you know my opinion on the stock market:

A 25-year bull market in stocks ended in October of 2007. The bull market was the result of a great period of leveraging by consumers and businesses, as interest rates fell for 25 years.

In October of 2007, a great bear market was born, as a period of de-leveraging started. Phase I of the bear market brought stocks to a 12-year low by March 2009. From there, we entered Phase II of the bear market; that’s when the bear market sucks investors back into stocks under the false pretense that the economy is improving.

When this current phase of the bear market ends—the phase often referred to as the “suckers’ rally”—Phase III of the bear market will come into play, ultimately bringing stocks below the original bear market low point. Remember that number…6,440 on the Dow Jones Industrial Average. (I know…I know. People think I’m crazy predicting that the Dow Jones Industrial Average will fall that low again. But I’ve made crazier predictions that have come true!)

Without getting too much into it, analysts like me look at two groups of indicators to determine where the stock market is headed: technical and fundamental. The technical indicators can be quite complicated. We look at the support and resistance levels of stock indices to try to determine stock price direction. The fundamentals are quite easy. We look at the economy, corporate earnings, monetary policy, and investor sentiment to determine stock market direction.

Investor sentiment is important, as this has proven to be correct so many times. The theory goes like this…

If investors and stock advisors, in the majority, feel that stocks are going up, they usually go down. Similarly, if investors and stock advisors, again in the majority, feel that stocks will fall in price, they usually rise.

And this brings me to today’s point…

In 2011,U.S. stock mutual funds had their second-worst year for redemptions on record. Last year, investors pulled about $130 billion out of U.S.equity mutual funds (Source: Investment Company Institute). The year 2011 was the fifth consecutive year that investors pulled money out of U.S. mutual funds that invest in U.S. stocks.

A general negative investor attitude for stocks, as evidenced by so many investors pulling money out of U.S. equity funds, is good for stocks…helps them ride that “wall of worry” higher. That’s the silver lining in this market.

Mark my words: by the time this current phase of the bear market—the bear market rally—is done, investors will be won over to stocks. That’s when the bear market will pull the rug out from under the feet of investors again.

Michael’s Personal Notes:

This is a problem…

Factory orders in Germany dropped the most in three years in November (Source:Economy Ministry,Berlin).

Economic growth forecasting companies and institutes are quickly lowering their GDP forecasts for Germany this year. The weak November factory orders for Germany and new forecasts that GDP growth will fall sharply in 2012 give credence to my belief that the eurozone is already in recession (See: Eurozone in Recession, According to Popular Financial e-Letter).

In 2011, I started writing more on the eurozone as my concerns for the region heightened. I traveled to Europe twice last year to see firsthand how the poor economic conditions are hampering Europeans. I didn’t like what I saw. The debt crisis in the eurozone is hitting European citizens very hard. Economically, 2012 will be a challenge for the eurozone and it will spill into the U.S.

Very large American businesses derive substantial sales from the eurozone. Just skimming annual reports, we find that McDonald’s Corporation (NYSE/MCD) gets more than a third of its total sales from Europe; Kraft Foods Inc. (NYSE/KFT) is about the same. About one-quarter of the sales of Apple Inc. (NASDAQ/AAPL) come from Europe. According to the International Business Times, a full 14% of all sales generated by the 500 companies making up the S&P 500 come from Europe!

Finally,U.S. banks have huge exposure to the debt crisis in the eurozone. Several research reports have been circulated about U.S. bank exposure to the eurozone debt market. With combined direct lending and credit default swaps, the estimate of U.S. banks’ exposure to the eurozone are in the $500-billion to $1.0-trillion range.

Germany’s economy slowing could be the final nail in the coffin for the eurozone this year. Is it any wonder that the stock prices of so many American banks are so depressed?

The problems in the eurozone could have a big impact on American companies (especially the banks) and the stock market in 2012. This is one area I will be watching very closely for my readers throughout the year.

There are only three choices in dealing with the eurozone debt crisis: China bails them out (not likely, as China’s economy is slowing now, too); the euro is dissolved (would wreak havoc on the smaller eurozone countries); or Germany finally gives in and lets the European Central Bank start printing money at an accelerated rate (here comes inflation). The alternatives don’t look good. (See also: Break-up of Eurozone a Foregone Conclusion?)

Where the Market Stands; Where it’s Headed:

With one week behind us, the Dow Jones Industrial Average is up 1.2% for 2012. All eyes are on Alcoa, Inc. (NYSE/AA), the first company in the Dow Jones Industrial Average to report fourth-quarter 2011 earnings. Alcoa will do so after the close of the bell today. Traditionally, Alcoa’s earnings set the early tone for each quarter’s earnings and how the markets react to them.

We are getting close to the third anniversary of the bear market rally that started in March of 2009. The government and the Fed have fought the bear tooth and nail, hence why this rally has lasted so long. But signs that the bear market rally is getting old and tired are obvious: 2011 was the worst year for stocks in three years,U.S. corporate earnings growth in the fourth quarter of 2011 was the slowest quarterly earnings growth in two years.

What He Said:

“I personally expect the next couple of years to be terrible for U.S. housing sales, foreclosures, and the construction market. These events will dampen the U.S economic picture significantly in the months ahead, leading to the recession I am predicting for the U.S. economy later this year.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2007. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.