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.
