Different mainstream media are reporting sentiment and technical features consistent with a major stock market top. As Japan can attest, bear markets and recessions can occur without central bank tightening. We may be in a period, as was threatened in last summer’s meltdown, in which the mere lack of an active major Fed program to support deficit spending could be enough to allow the pace of economic activity to decline. Bear markets can occur in the absence of a recession, as in 1977-8 and again in the two month-long bear market of 1987, most of which took place in one day and the great majority of which occurred on a Friday and then Black Monday. The Russell 2000 index suffered a bear market in 2011, dropping about 25% from its peak, in the absence of a declared recession.
Too many people on Wall Street and on Main Street alike believe the hype about the Fed and its magic wand. Reported facts, though, show that larger and larger global economies are having greater economic problems compared to a year ago, to which the U.S. cannot be unaffected. It’s not just Ireland, Greece and Portugal- the foci of attention in the Western world last year. Now, Spain is in recession, Portugal and Greece are in depressions, Italy is in recession, the latest U.K. data suggest it has just had a technical recession, Germany’s industrial production is flat at best, China is on the horns of high price inflation but decelerating economic growth, Brazil is struggling economically, etc. The prices of sensitive industrial materials such as copper and the non-gold precious metals are in varying stages of absolute price declines.
Last week Bloomberg.com took a break from exalting Ben Bernanke and ran Optimism Signals Stock Decline May Continue: Technical Analysis. his article describes a sentiment indicator that suggests a dangerous level of optimism amongst the pros- the same level that was seen during the topping processes in 2007, 2010 and 2011.
Investors Intelligence (II) spoke through King World News in a blog post titled in part: This Is Dangerous. The spokesman for II, John Gray, pointed to a number of sentiment and technical indicators that pointed to a top. Amongst several points raised was the high and rising number of stocks making a new high for the week and then ending lower, as a sign of distribution of stocks from stronger, better-informed hands to weaker hands. Think AAPL and GOOG as prime examples.
Also, the American Association of Individual Investors reported its weekly sentiment survey. A sudden change from persistently bullish to bearish was seen. I investigated whether this change meant the mini-correction of the past two weeks was already likely over. To my surprise, it was more the opposite. This group turned correctly bearish in the fall of 2007, never really trusted the fake-out rallies in 2008, and turned very bearish well before the Lehman collapse. Of course they stayed bearish through the bottom in 2009, which is pointed to as a contrarian indicator, but my review of this data is that these investors are quick to see trend changes. They in fact have been basically correct the past few years, at least if they invested according to their sentiment surveys. After all, it takes bulls to make a bull market and bears to make a bear market. To see this historical data, click HERE and go to the bottom of the page, then click on the right-hand tab.
Moving to more fundamental data, the academic types at ECRI persevere with their recession call, having stated on air several months ago that historically their recession calls have had an 85% accuracy rate. So what’s with Doug Kass’ 0% recession risk for 2012?
ECRI releases to the public one of several indicators they employ, the WLI. They have stated that apart from the very warm winter, seasonal adjustments were overly skewed by the Great Recession’s timing that have inadvertently made economic data in subsequent October-March periods look better than they really are, offset by making data in the other months look worse than they really are. As it happens, the WLI was updated Friday and showed its first weekly drop in quite some time. This is entirely consistent with their argument that post-Great Recession winter-time seasonal adjustments have skewed many economic measures unduly upward- to be reversed by undue down skew in upcoming months. Thus ECRI has reluctantly moved to year-on-year comparisons of the data rather than a smoothing technique of economic growth it prefers and still publicly reports. The WLI spreadsheet shows that the post-2009 peaks in the WLI in 2010, then 2011, and now (if indeed we have seen the peak) have been at successively lower levels- and the WLI is partly sensitive to prices of stocks, which have been higher year after year. Thus the rest of their indicators have been showing lower and lower levels of growth year on year. ECRI says that this data in conjunction with other non-public data is highly likely to end in a recession, though they are hopeful that it would be a mild one.
This series of successively lower peaks in the WLI parallels the successively lower peaks in interest rates the past few years. This strikes me as a form of confirmation of the ECRI hypothesis. I’m no economic forecaster, but I strongly suspect that a domestic recession, even a mild one, is not even close to being priced-in to either stocks or bonds.
Please note that nothing herein is either A) projected as anything like a certainty or B) in any way a short-term timing call. That’s why the title of this post refers to a topping process.
Even from a public purpose basis, the average stock is far higher than it needs to be to encourage competition or to make people feel good. The averages are now at a historically high valuation on most parameters, such as dividend yield and cyclically-adjusted P/E. With an aging population controlling an increasing share of investable assets, don’t think that dividend yield of the market as a whole is not going to continue to increase in importance. A great way to own the S&P 500 is via the SPY fund. This yields, per Yahoo Finance, 1.87%. The Dow Diamonds (DIA) fund yields 2.34%. Given the lack of security of principal, why shouldn’t retirees and near-retirees who feel like risking principal in the stock market not prefer a muni bond fund, which invests in investment-grade tax-free bonds? One such fund (which I own), symbol NIO, currently yields about 6%. That’s free of taxes and almost none of it is subject to the alternative minimum tax. (Note this is not a guaranteed yield, the stock price fluctuates, and the payout is likely to drop over time unless interest rates rise a good deal. Note this is also not a recommendation. This is one I own for at least the intermediate term. For now I sell some NIO or similar funds only if the stock price goes “too high” relative to net asset value.)
The problems with high stock prices as judged by many fundamental measures is compounded by what we are told by many experts is a near-record high level of profit margins. I anticipate that with governments hungry for money and labor’s share of national income at a historically low level, there is little room for expansion and lots of room for decline in after-tax corporate profit margins. Thus increasing sales, which are inevitable given deficit spending and Fed debt monetization, may not yield any, or at least a commensurate, increase in reported profits.
Also, working people may start to regain something like their after-tax historic share of the economic pie. Industry may have sliced labor to the bone coming out of the last downturn. The share of national income relative to business and labor may mean-revert.
Thus there are many short-term concerns in a backdrop of demographic, valuation, and subjective preferences to be cautious about the stock market averages for the year ahead. (For the week or two ahead, I have no idea and little interest in guessing.)
In summary, this is not a sky-is-falling jeremiad. Over long periods of time, inflation and economic/population growth have tended to give a patient, high-quality holder of high-quality common stocks a decent after-tax return. I’m not predicting that this will change, given a long-term horizon. But I mean LONG term. For now, there is a great deal of speculation in common stocks, which would is almost inevitable given that the NASDAQ recently completed its longest streak ever of consecutive gains- 14 weeks in a row. More than in 1999, when the NASDAQ set a record for the 20th century for any major index in any major stock market by doubling. Beating 1999′s weekly winning streak is meaningful. Hmmm… Do two down weeks in a row offset that? (Maybe, but is my answer.)
Now, this sort of momentum occurs for a reason. In a follow-up post, I’ll explain why I think that just as in 2007 and early 2008, there is unexpected risk not in tech stocks– where risk should always be expected– but in certain “safe” stocks in which conservative investors are hiding.