Thursday, October 04, 2012

Is the Rally Going Beyond the Fundamentals?

The following commentary was previously sent to subscribers of the Forbes Special Situation Survey investment newsletter. 

We are growing increasingly concerned that the fundamentals do not justify the recent rise in stock prices. The U.S. economy continues to struggle. At the end of September, the Bureau of Economic Analysis revised its estimate for second quarter GDP growth from 1.7% (on an annual basis) to just 1.3%. Because growth is so anemic, the unemployment rate remains stuck at more than 8%. The official figure for August was 8.1%. (The September estimate will be released this Friday.) While it is true that the unemployment rate is down significantly from its peak of 10.0% in October 2009, we find the dismal participation rate more alarming. This little noticed, but extremely important metric has plunged to 63.5%, its lowest level since September 1981! In part, the decline is explained by demographics. After all, baby boomers are retiring in large numbers. Unfortunately, a greater portion of the decline in the participation rate is explained by people dropping out of the workforce simply because they are too discouraged to keep looking for work.

Even the few bits of good economic news have to be taken with a grain of salt. The latest ISM Index came in at 51.5. Any reading above 50 signals expansion in the manufacturing sector. However, this metric is barely above the critical level, meaning that any expansion is weak at best. The ISM Index was signaling contraction during the prior three months and it could easily fall below 50 again. In addition, the Chicago PMI, which came out just a few days earlier, dipped below 50, hitting its lowest level in three years. The housing market is giving some investors comfort with both new and existing home sales and prices picking up; yet the numbers remain at incredibly depressed levels. 

What explains the run up in stocks? We attribute it to a number of factors. First, Federal Reserve Chairman Ben Bernanke keeps delivering more stimuli and promises to keep interest rates low indefinitely. In a few more years, we may be talking about QE 15. The rise in stock prices shows how painful it is for investors to fight the Fed. Second, as bad as things are in Europe, investors go “risk on” every time a European politician or banker indicates that the abyss may be a little further away than they initially thought. Third, investors are hoping that no matter who wins the presidential election in the United States, no politician would be stupid enough to let the country go over the fiscal cliff. Unfortunately, we don’t know many investors who have grown rich by overestimating the intelligence of politicians.

We are about to enter what is known on Wall Street as “earnings season.” While stock prices may rise or fall on any particular day for any number of reasons, over the long run, nothing matters more than sales and earnings. We are concerned with the large number of companies that are issuing warnings. Companies frequently lower expectations in order to beat the reduced estimates; but this time around there appear to be a greater number doing so than usual. Furthermore, sales growth is slowing. The markets have been unusually tranquil in recent months. We suspect things are about to get much more volatile. Cautious investors might want to reduce exposure to equities at this time.