Hello Old Friend, It's Been A While

I'm still here! Between getting this house finished, trying to find employment, and writing a business plan (more on that at some point down the line), I've obviously been a touch delinquent in posting my most recent thoughts. At the same time though, I've pounded everyone as to why this economy might take its sweet time in healing fully enough that I thought that rather than hammering home the same points, I'd let the situation begin to play out, which it now seems to be doing.

Investors seem to be finally coming around to the fact that many of the ubiquitous "green shoots" aren't going to bloom anytime soon. While trying to will the market to new heights, many folks were turning a blind eye to the weeds infesting the garden. The fact of the matter is, while it looks like we're past the worst, the market seems poised to price in a scenario that's more rosy than real (can you tell I've been working outside?). This is not to say that we're in nosebleed territory yet per se, its just that a whole lot of things have to go right to keep us in the mid 900's on the S&P, in my opinion.

So the market has pulled off of its highs as a couple of bad economic reports started to join the "less bad" and investors have been forced to realize that the economic growth that may be forthcoming (which in and of itself is an improvement from what we've been experiencing) is indeed going to be a slow grind vs. a typical post-recession bounce. In my view, this is the first step in the process of getting us to what I believe will be a higher low before moving higher later. Unfortunately however, it might ultimately be a little lower than we are here.

Let's take a look at a couple of issues on the economic front. First off, we got a dose of reality with the most recent employment report, which showed a much worse than expected decline of 467K and a jump in the unemployment rate to 9.6%. To be fair, this is still very much better than the peak job loss numbers in the high 600K's, and anyone who wasn't expecting the unemployment rate to keep heading north must be living under a rock, but nonetheless it did break a trend of improving data on this front. This plus a worse than expected consumer confidence report did its part in smacking the market to its senses.

We need to look at the employment situation in concert with the overall spending/saving environment to get a handle on the economic drag the consumer is likely to have. The savings rate has now jumped to 7% (as I had expected) as consumers, both employed and unemployed, have squirreled away their money post the market and housing armageddon. This is significant. It is most certainly a positive for the long term, as consumer balance sheets must be repaired for spending to increase in earnest again in the future. However, on a near term basis, it is likely to act as a major drag on economic growth.

The consumer accounted for 70% of economic growth at the peak. The savings rate has moved from 0% to 7%. This, all else being equal, produces -4% hit to GDP. Of course, all else is not equal, with the Government trying to fill the hole with massive spending programs. However, when one drills down into said programs, you're left not wanting to hold your breath that they're going to all that sustainable. Sooooo, the main driver of the economy is likely to be held back substantially for a while and while the Government has come along to plug the hole on a near term basis, we're probably in store for below trend economic growth (and therefore, earnings growth) as the buying power runs out.

Another piece of the puzzle that argues against the economy shooting higher anytime soon is the transportation sector. As I've written in the past, what we really need to see is any rumblings of improvement coming from the producers of things to be confirmed by news out of the movers of things (and their respective market averages). This is simply not happening. The latest numbers out of the ports are showing container shipments down 22% y/y. The rail traffic data is getting worse, not better, with June's result down 22% vs. down 16% in the 1Q. The averages are showing similar results, with the Dow Transports not confirming the Dow Industrials move to new highs. This is NOT what new bull markets are made of. Until we see a change in the news out of the transportation sector, its going to be hard to argue for a robust move up forthcoming in the economy.

Turning to the market itself, the internals are so/so. I've already mentioned the issue with the non-confirmation of the transports, but there are a couple of other issues of which to take note. First off, the Lowry data (which I've mentioned before - measures the amount of supply and demand for stocks) has taken a big turn for the worse. While selling pressure has stayed somewhat consistent, buying power has recently dropped like a stone - back to the lows seen in March. Additionally, the Yen/Euro currency cross, which traders look at as a sign of investors' willingness to take risk, looks like it's worth monitoring, although it's still positive. Finally, the S&P breaking 900 violates a level of technical support. So one can't write off the possibility of more upside to come, one must be vigilant.

I'm rooting for the market here. Believe me, I'd much rather be extolling the virtues of an imminent rally that will take the country out of the dumps. That would be better for all of us poor souls who are wandering in the wilderness at the moment. This said, I will point out a couple of things that are on the more positive end of the spectrum.

As I wrote earlier, the realization that the market has gotten ahead of reality is the first step in the process of making that all important higher low. The realization will lead to acceptance and the lowering of expectations. Now, while this is occurring, you can expect volitile markets with bouts of downside, both in terms of stock prices and expectations themselves. This is where I'll get more interested.

The market is driven by expectations. It moves when they are bested or missed. Expectations need to be brought down from levels where the surprise is more than likely going to be on the downside to levels where the surprise is more than likely to be on the upside, and there are indeed indications that the there can be upside surprises in the future.

The data in the housing market continues to improve slowly. The improvement is not in a straight line, nor should we expect it to be, but there are pieces moving in the right direction. Home re-sales were up for the 2nd straight month in June for the first time since '05. Pending home sales were up for the 4th consecutive month for the first time since the peak. California home prices rose for the 3rd month in a row, and the percentage of foreclosure sales has moved down to 30% from 50% of the total. California was ground zero for the housing implosion, so this shouldn't be taken for granted.

Even on the job front, which is obviously difficult, there are hints that we're closing in on the worst. Planned layoffs in the ADP survey were down for the 5th straight month, and are at the lowest levels seen since March of last year. Weekly claims have been headed lower and are poised to break into the 500Ks for the first time in a while. Should this occur, it could represent the definitive move lower in claims that one looks for to signal the recession's end. Stay tuned.

The point here is this: we're in an adjustment period which may not be pleasant but is necessary. Before too long, it'll be time to dust off the screens, shake out the cobwebs, and take a look at individual stocks on the long side once again. The time to act might not be now, but the time to prepare is here. Fair value on the S&P looks to be around 960, so in the end, it depends on how cute you want to play it. For me, I've got my long positions, but I'm going to stay hedged for now.

'Till next time!

TRB