Wednesday, June 08, 2011

Stocks Suddenly Losing Favor

The following commentary was released today to subscribers of the Forbes Special Situation Survey.

Stocks have suddenly exhibited weakness with the S&P 500 down about 6% since its April 29 high. Housing, employment, and energy continue to present the greatest headwinds. The latest S&P/Case-Shiller figures indicate that existing housing prices have double-dipped, setting new lows since their 2006 highs; nonfarm payroll figures have weakened once again with the unemployment rate jumping to 9.1%; and although energy prices have backed off their recent highs, the high cost of gasoline continues to present a significant challenge to most consumers.

Furthermore, high levels of debt remain a serious concern. Some economists argue that government debt as a proportion of GDP is not out of line, at least when compared to WWII era levels. However, if we include unfunded liabilities (i.e., social security, Medicare and Medicaid), state and local government debt, corporate debt, and consumer debt, total debt as a percent of GDP is at record levels. Government’s inability to properly address the debt and deficit is becoming an increasingly worrisome issue for the economy and investors.

One concern not often discussed is the increasing amount of programmed trading taking place in the markets. Programmed trading was behind the “flash crash” of May 6, 2010 when the Dow plunged 600 points in a matter of minutes. As institutional investors increase their reliance on computerized algorithms to execute orders, fewer human beings are involved in the actual decision-making process of buying and selling stocks. This is exaggerating the movements in stock prices. Investing, as opposed to trading, becomes more challenging in this kind of market. While it is still safe to assume that relying on fundamentals makes sense over the long term, irrational behavior can dominate the markets over the short term. Just as bubbles often get larger before they burst, undervalued stocks can get cheaper before investors come to their senses. Research in Motion (RIMM), one of the stocks on our buy list, is getting hammered by this kind of activity. A combination of irrational behavior and programmed trading appears to have contributed to the stock’s decline.

Given the serious problems in the economy, there really was no justification for the market’s strong rally from last September through April. Although some stocks appear to be extremely cheap, investors should remain extremely cautious about the overall market’s prospects. I recently had the opportunity to meet with several experienced investors including Forbes columnists Gary Shilling and Ken Fisher. Shilling continues to be bearish on stocks. That’s no surprise. Fisher, who is usually bullish, says he now expects stocks to finish relatively flat for the year. Given the serious challenges that must be overcome, it’s starting to look as if even a flat year might be too optimistic of a forecast.