Markets Losing Steam

Stock prices fell yesterday. We would not be surprised to see them fall some more – not simply because the stock market has just achieved its biggest two-month advance since the 1930s, but also because the economy remains just as ill as it was on March 9th, when the stock market rally first started.

The only thing about the economy that has changed during the last two months is the way folks TALK about it. Back in early March, when the Dow was making 12-year lows, the news media carried continuous stories of doom and gloom. A second Great Depression was all but certain.

But now that the Blue Chip index has jumped a whopping 2,000 points, most members of the financial press have recanted their faith in doom and gloom. “The economy is recovering,” they say. “The macro- economic data are showing signs of ‘improvement’ and ‘stabilization.’” Judgment Day has come and gone, they believe. Only the land of milk and honey and TARP fund re-payments awaits.

“While the [economic] numbers are still bad, they’re less bad,” beamed one typical professional investor last Friday.

And so what?

Falling more slowly is still falling…and it will never be rising.

So let’s take a dispassionate look at some of the recent economic reports…and then decide whether these data show signs of “improvement” and “stabilization.”

Last Friday, the Labor Department announced that 539,000 workers lost their jobs during the month of April. Jubilant investors cheered the job losses as “less than expected.” But the Labor Department simultaneously revised the job losses for February and March to totals that were 66,000 more than originally reported.

In other words, if you add the revised losses from February and March to the April total, you get 605,000 jobs lost in April, not 539,000. But even if we take the Labor Department’s numbers at face value, we wind up with 1,238,000 lost jobs since the stock market rally began in early March. What other signs of “stabilization” have surfaced since the rally began? Here’s a short list:

• Industrial production fell for the sixth straight month – hitting the lowest level since 1998.

• The ISM Index of business activity dropped for the seventh straight month.

• Factory utilization fell to it lowest level since recording- keeping for this data series began in 1967.

• The S&P/Case-Shiller Index of home prices fell for the 25th straight month.

• An additional 600,000 families lost their homes to foreclosure.

• The number of homeowners who fell 60 days behind on their mortgage payments grew to more than 5 million.

• The number of homeowners who owe more on their mortgages than their houses are worth grew to more than 8 million.

Obviously, investors do not collude with one another to ignore ominous economic data. It just happens. Happy delusions are infectious. We humans sometimes see what we want to see…and fail to see what we don’t want to see.

We’d rather imagine the green shoots of recovery than confront the rot of economic decay. And we’d MUCH rather see soaring share prices than plummeting ones. So what’s the harm in a little delusional optimism?

Well…there’s no harm whatsoever in a little delusional optimism, as long as the delusion persists. But if upcoming economic reports do not continue to inspire rainbows, unicorns, warm fuzzies, group hugs and other feel-good vibes, share prices might retreat for a while. And that would be a bummer

Markets make opinions, as we never tire of reminding the Rude readership. So it’s no surprise that a great big 2,000-point Dow rally has made the very solid opinion that the economy is recovering.

But your editors are not buying it. The market has not made OUR opinion. To the contrary, we think the market has lost its mind. The only reason we haven’t lost ours is because we understand that markets do not reflect underlying economic realities each and every second. Sometimes stock prices overshoot to the downside, sometimes they overshoot to the upside and sometimes they go so far off the reservation that you wonder if they’ll every return.

We think the market has overshot to the upside. It might overshoot some more. But the recession is not over, and 2,000 Dow points won’t make it be over. The credit crisis is not over either. And a bogus “stress test” charade won’t make it be over.

The recently concluded stress test of America’s largest financial institutions is a good idea, conceptually. The FDIC and/or the Fed should have conducted these tests years ago. But the tests contain at least three fatal flaws:

1) Re-building bank common equity up to 4% is woefully inadequate. At 4%, banks would be operating with 25-to-1 leverage – a balance sheet structure that any prudent investor would consider reckless and/or “insane.”

2) The assets on most bank balance sheets remain susceptible to severe impairment. In other words, these assets could still suffer extreme mark-downs. If, in aggregate, these assets were to lose 4% of their value, the nation’s banks would possess tangible common equity of approximately zero.

3) The “stress” to which the bank examiners subjected the balance sheets under their review was not very stressful. Examiners used an “adverse scenario” that featured a 3.3% drop in GDP this year and an 8.9% unemployment rate. Well, guess what, the unemployment rate is already 8.9% and GDP during the first quarter collapsed at an annualized rate of minus 6.3%, compared to the fourth quarter of 2008. So maybe the “adverse scenario” is not nearly adverse enough.

Three “stress test” facts worth considering.

The Daily Reckoning