Where the Stock Market Goes From Here

recessionIn a secular bear market, which is where I firmly believe we are today, there are three phases:

A phase I bear market—often referred to as the first down-leg—brings stock prices crashing down. From its high of 14,164 in October 2007, the Dow Jones Industrial Average crashed to 6,440 by March 2009—a 55% drop. This first phase of the secular bear market is behind us.

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 96% 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, that stocks are a safe bet again. This phase of the secular bear market is still upon us. But, as I have been writing, the bear market rally that started in March of 2009 is getting tired and near its top.

From a technical perspective, the right shoulder of a classic head-and-shoulder’s pattern has been completed. I have been ready to throw in the towel on this bear market rally, but given that the government and the Federal Reserve have fought the natural forces of the 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 II 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’m sure many of my readers are reading this and saying, “Michael, this can’t happen. Our economy would crash again.” I also 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 and how it has played out many times before.

The government can take on as much debt as it likes (which is actually a terrible thing for the economy in the long term) and our central bank can increase the money supply as much it wants (another terrible exercise, as inflation and higher interest rates are always the end result of too much money printing).

Right now, market watchers are obsessed with waiting for the Fed to announce another round of “quantitative easing” (a fancy name for printing more money). Yes, QE3 will come. Yes, the stock market will move up because of it; but once investors realize QE3 will not save us, we will move to the painful Phase II of this bear market. (Also see: “Stock Market’s Current P/E Valuation a Fallacy.”)

Michael’s Personal Notes

The big banks continue to benefit at the cost of the small banks.

When the financial crisis hit, big banks received government bailouts, while the smaller banks that did not take part in the mortgage-backed securities scandal received nothing (no “bailout money”) for doing the right thing.

Four years later, big banks continue to reap the benefits of government bailouts. In the meantime, small banks are paying the price for being responsible.

In 1980, there were over 13,000 banks U.S.; but, today, there are roughly 6,600 banks (source: Wall Street Journal, June 19, 2012). Thus far, 2012 is shaping up to be the year of the most bank mergers. In 2002, there were over 4,000 banks with assets of at least $100 million. Today, there are only 2,416 banks with over $100 million in assets.

The reason small banks are selling out to bigger banks or merging is that once the financial crisis hit, even though these small banks held no toxic mortgage-backed securities like the big banks, some of the loans they did have were defaulted upon. This was bound to happen, as the ensuing recession caused businesses and consumers to feel economic distress, which meant they had to default on loans they could no longer pay back.

Because the economic recovery has not taken hold here in the U.S., businesses and consumers are not spending, which means they are not taking on new loans. Since the main business of smaller banks is loans, they have been hurting. In the meantime, big banks are speculating on the markets and have received government bailouts in the form of loans.

The low-interest-rate policy currently in place also works against smaller banks and the big banks alike, as banks cannot earn the money they used to when short-term rates and long-term rates were at more normal levels.

As if this state of affairs weren’t unfair enough, the small banks have been told that even though they have done nothing wrong, they must comply with the capital requirements demanded by global regulatory standard Basel III, just like the big banks.

The Basel Committee was created in response to the financial crisis and the suspicious lending practices of the big banks. The committee was established to prevent future crises and hopefully further government bailouts. The Committee attempts to ensure the big banks have enough “good” capital on their books to offset any potential losses.

Basel III is forcing big banks and now small banks alike to raise their core tier-one capital ratios. This means all banks must have a larger amount of specific capital in place. Many small banks are spending time trying to figure out how to comply with regulations, as opposed to expanding their businesses.

The stock market valuations of the big banks remain low, possibly an indicator that there still may be toxic assets on their balance sheets we do not know about. The upcoming U.S. recession will also be difficult for banks, large and small (see: “The Inevitable U.S. Recession; Part II Starts”). Smaller banks that are run more responsibly are being punished as well, which means that, unless an investor knows which banks will be bought out, it could be a dangerous sector of the market to be in.

What He Said:

“When I look around today, I see falling stock prices…I see falling house prices…and prices falling for retail goods stores. The media has it all wrong blaming (worrying about) inflation. In my opinion, the single biggest threat to the U.S. economy and to the Fed in 2008 is deflation. You can bet the Fed will expand the money supply and drop interest rates aggressively as deflation starts to rear its ugly head.” Michael Lombardi in Profit Confidential, December 17, 2007. Michael was one of the first to warn of deflation. By late 2008, world economies were embedded in their worst state of deflation since the Great Depression.