The global economic backdrop continues to provide many reasons to sell stocks, but very few reasons to buy them — gold stocks being one of the few exceptions.
The weight of US economic data points to a recessionary environment over the next few quarters. Analysts have not cut their 2011 and 2012 earnings estimates far enough to reflect the recent dramatic deterioration in economic conditions.
The stock market may seem somewhat cheap, based upon overall valuation numbers. But that’s not necessarily encouraging. The stock market typically looks cheap on a trailing earnings basis ahead of a recession. So I would expect the stock market to remain week for several months, but probably not collapse. That’s because the very low yields available on bonds are unlikely to attract capital away from the stock market. On the other hand, low rates can’t really send stocks surging, either. In the coming months, I expect most stocks to slowly grind lower, interrupted by bursts of central bank-fueled rallies.
The euro crisis may come to a head in the next few weeks. Germany may need to suffer a 2008-style market sell-off before the public is scared enough to support the “Eurobond” concept. This fear catalyst alone could pull down the rest of the global stock market, given the size of the problem — at least until we see a fiscal transfer union and/or a much more aggressive European Central Bank.
And the Federal Reserve looks like it’s laying the groundwork for QE3. We have seen trial balloons floated in the press — most recently by Chicago Fed president Charles Evans. In an interview with The Wall Street Journal, Evans said, “We need to do much more to increase the level of [monetary] accommodation.” In a CNBC interview, Mr. Evans expressed his opinion that demand from emerging markets — not QE2 — drove the 2010-11 rally in commodities. Therefore, using Evans’ logic, another round of QE “accommodation” would not lead to another surge in commodities.
Apparently, the academic ivory tower blinds one from the obvious: QE2 exported US dollar inflation to China and other export-oriented economies. They have been returning the favor in the form of higher prices for products exported to the US. QE3 would accelerate this trend, possibly even sparking a panic out of US paper. This is a longer-run prospect if the Fed doesn’t start acknowledging the connection between the size of its balance sheet and commodity prices.
In the shorter run — as in the next several weeks — the stock market would likely have to sell off sharply from here before support for more QE reaches a critical mass. Then, once QE3 is implemented, after a short “sugar high,” the stock market would look ahead and start discounting the impact of higher raw materials prices on future cash flows. Companies without pricing power are at risk of a margin squeeze. In particular, several of the companies that I have recommended selling short in my investment service, Strategic Short Report, are facing this exact risk.
It’s obvious that the appetite for more “fiscal stimulus” is not great. Tonight, we’ll hear President Obama’s latest job creation proposal. There will be the typical Keynesian “get cash into consumers’ hands” proposals — stimulus that won’t work…again.
But there’s a chance the Obama administration might try to implement a backdoor, off-balance sheet, stimulus plan. Several newspaper articles have hinted that we could see a proposal to streamline mortgage refinancing through Fannie Mae and Freddie Mac. This could happen regardless of Republican opposition.
These two housing-bubble-inflating institutions have been out of focus since entering conservatorship three years ago. They guarantee hundreds of billions worth of mortgage-backed securities that pay yields in the range of 5-7%. The homeowners paying these rates haven’t been able to refinance, mostly due to a lack of home equity. Loosening the loan-to-value requirements could result in a surge in refinancing at rates closer to 4% for 30-year mortgages, which would result in a wealth transfer from creditors to borrowers. While putting extra monthly cash into many household budgets, this policy would be the latest in a long line of policies we’ve seen over the past three years to transfer wealth from savers to borrowers.
This idea looks like it has Ben Bernanke’s fingerprints all over it, because he seems frustrated that his rate cuts haven’t translated into cheaper borrowing costs for many households. Also, if many GSE-guaranteed mortgages currently yielding 5-7% were to prepay after refinancing, Bernanke could reinvest the proceeds of the Fed’s mortgage-backed security holdings into more Treasury purchases…a “mini QE” operation. Such a plan, if it unfolded, would add to the inflation problem in the US.
As long as the Fed and other central banks maintain super-easy policies, we will see a steady erosion of corporate profit margins. Directly: The cost structure of operating business will make “higher highs,” in technical parlance. Indirectly: Corporate pricing power will remain weak as commodity inflation is working its way through the pipeline, squeezing household budgets. But none of this is obvious to Fed economists, because their Keynesian models don’t say that the world works this way.
In the wake of last week’s depressing payroll report, it looks like we’re back into another leg of the “risk off” trade. Plus, the European banking system remains stressed.
Hold your short positions!