Soon-to-depart Merrill Lynch chief North American economist David Rosenberg's thoughts:
Market likely to peak the end of the week
Just as the clock is winding down on my tenure at Merrill Lynch, the equity market is winding up with an impressive near-40% rally in just nine weeks. For those that were still long the equity market back at the March 9 lows, a good ‘devil’s advocate’ exercise would be to ask yourself the question whether you would have taken the opportunity, if the offer had been presented, to have sold out your position with a 40% premium at the time. What do you think you would have said back then, as fears of financial Armageddon were setting in? We haven’t conducted a poll, but we are sure at least 90% of the longs at that point would have screamed “hit the bid!”
Are we at risk of missing the turn?
Fast forward to today, and within two months optimism seems to have yet again replaced fear. Are we at risk of missing the turn? What if this is the real deal — a new bull market? This is the question that economists, strategists and market analysts must answer.
Risk is much higher now than it was 18 weeks ago
The nine-week S&P 500 surge from 666 at the March lows to 920 as of yesterday has all but retraced the prior nine-week decline from the 2009 peak of 945 on January 6 to the lows on March 9. We believe it is appropriate to put the last nine weeks in the perspective of the previous nine weeks. To the casual observer, it really looks like nothing at all has happened this year, with the market relatively unchanged. But something very big has happened because the risk in the market, in our view, is much higher than it was the last time we were close to current market prices back in early January, for the simple reason that we believe professional investors have covered their shorts, lifted their hedges and lowered their cash positions in favor of being long the market.
Employment, output, income, sales still in a downtrend
Considering what transpired from an economic standpoint, the decline in the first nine weeks of the year was rather appropriate in the midst of the worst threequarter performance the economy has turned in roughly 70 years. The rally of the past nine weeks appears to be rooted in green shoots. While it may be the case that the pace of economic decline is no longer as negative as it was at the peak of the post-Lehman credit contraction, the reality is that employment, output, organic personal income and retail sales are still in a fundamental downtrend.
Need to see an improvement in the first derivative
We have evidence that the consumer, after a first-quarter up-tick that was frontloaded into January, is relapsing in the current quarter despite the tax relief (didn’t we see this movie last year?). Not until improvement in the second derivative morphs into improvement in the first derivative with respect to the important economic data will it really be safe to declare what we are seeing as something more than a bear market rally, as impressive as it has been.
This is a bear market rally that may have run its course
The investing public is still holding tightly to their long-term resolve, but much of the buying power at the institutional level seems to have largely run its course, in our view. That leaves us with the opinion, as tenuous as it seems in the face of this market melt-up, that this is indeed a bear market rally and one that may well have run its course. We have “round-tripped” from the beginning of the year and there is real excitement in the air about how these last nine weeks represent evidence that the economy will begin expanding sometime in the second half of
the year.
Growth pickup will likely prove transitory
While it is likely that headline GDP will improve as inventory withdrawal subsides and fiscal policy stimulus kicks in, our view is that whatever growth pickup we will see will prove to be as transitory as it was in 2002, when under similar conditions the market ultimately succumbed to a very disappointing limping post-recession recovery. So yes, there may well be some improvement in the GDP data, but it is based largely on transitory factors. We strongly believe it is premature to totally rule out the end of the vicious cycle of real estate deflation – residential and now commercial – that we have been experiencing since 2007. Balance sheet compression in the household sector will continue to pressure the personal savings rate higher at the expense of discretionary consumer spending. This is a secular development, meaning that we expect it will last several more years.
Chances of a re-test of the March lows are non-trivial
To reiterate, it seems to us likely that the risk in the market is actually higher today than it was back at the same price points in early January, and we say that with all deference to the stress tests (which given the less-than-dire economic scenarios, along with the changes to mark-to-market accounting, were destined to reveal healthy results). While the consensus seems gripped with the burden of trying to decide if there is too much risk to be out of the market, we actually still believe that the chances of a re-test of the March lows are non-trivial, especially if the widely touted second-half economic rebound fails to materialize.
Market may have a fully invested condition of ‘smart money’
While many pundits point to ‘dry powder’ on the sidelines that is ready to be put to work, our sense is that we now have to consider the prospect that we actually have a fully invested condition of ‘smart money’ in the market. If there is a risk that is not being widely discussed, it is the risk that profit-taking by the big-money investors (many who share our outlook but have been quick to take advantage of this monumental bounce in equity prices), will not be met with enough demand from the fundamental bulls. And if we ever do see the capitulation from the retail investor – this has yet to occur – then this flow-of-funds scenario can certainly trigger a re-test of the lows.
We are happy to buy these sell-offs in Treasuries
When you look at Charts 1-3, you really have to wonder whether or not the markets have been too hasty in pricing out deflation risks. There has never been a time in the post-WWII era where the 12-month trends in wages, producer costs and consumer prices were all in negative territory at the same time. This is the new reality. As the markets focus on the noise from green shoots, we are focusing our attention on the fundamental trends and the end-game. We are more than happy to buy these sell-offs in Treasuries and add scarce safe income to the portfolio. Take profits in equities and scale into Treasuries This move to 3.20% on the 10-year note resembles that inexplicable move to 5.35% back in the summer of 2007, in our view. Yes, yields are much lower today, but the inflation rate is 300 basis points lower too and the unemployment rate is 400 basis points higher. If we recall back in that summer of 2007, the equity market was hitting new highs just as bond yields were. The trade then was to take profits in the former and scale into the latter. After a near-40% surge in the S&P 500 and a near-60% surge in bond yields off their recent lows, it would seem logical to us to embark on a similar shift this time around.
Bond yields do not bottom until well into the next cycle
Even if the recession is to end soon, and that is still very debatable, bond yields do not typically bottom until we are well into the next cycle, as inflation continues to decline even after the downturn ends. So just like further upside potential in equity prices seems extremely unlikely over the near and intermediate term, further downside risk Treasury note and bond prices is also less of a risk today, in our view.
We would like to see a retest of the March 9 low
To emphasize, it could well be that we saw the market lows back on March 9. But we would like to see a successful retest before making that conclusion. The inevitable test will be the thing. But do not confuse green shoots for a sustainable recovery. After a credit collapse and asset deflation of the magnitude we just witnessed, the markets, housing prices and equities can be expected to take years to fully recover.
The data flow is less relevant this cycle than in the past
This was not a manufacturing inventory cycle, which makes the data flow less relevant than in the past. Real estate values are still deflating and the unemployment rate is still climbing; these are critical variables in determining the willingness of lenders to extend credit. And as we just saw in the Fed’s Senior Loan Officer Survey, while there may be a ‘thaw’ in the financial markets, banks are still maintaining tight guidelines. In fact, the weekly Fed data are now flagging the most intense declines in bank lending to households and businesses ever recorded. The best case is that this is a bear market rally All of this has not precluded an elastic band bounce from an egregiously oversold low in the S&P 500, and perhaps we will even test the 200-day moving average of 960 (as the 10-year note yield and NASDAQ just did). But we still do not believe what we are seeing fits the hallmark of a new bull market. In our view, the best case is that this is a bear market rally, but one that clearly has more legs than its predecessors this cycle.
Providing clients with a historical perspective
At this time, we believe it is necessary to provide clients with some historical perspective from the last colossal credit collapse in the 1930s, understanding that there were similarities as well as differences. It was extremely difficult for equity investors to make money in the decade following the June 1932 bottom. After the three-month rally (+75%) off the bottom in 1932, equity markets were extremely volatile and largely sideways for the next nine years. Keep in mind that the jury is still out as to whether the March 2009 lows were in fact the bottom, as was the case in 1932.
If March 9 was the low, what does it mean for the outlook?
It doesn’t say much, actually. The same goes for corporate spreads. The S&P 500 bottomed in mid-1932 and soared nearly 75% in the next three months. Anyone who bought at that point and hung on to their position saw no capital appreciation for nine years. Baa spreads also hit their widest levels at 724 basis points in mid-1932, a year later they were down to 380 basis points. While the initial the surge in the stock market and the tightening in corporate spreads from stratospheric levels presaged the bottom in GDP in the third quarter of 1932, the reality is that the Great Depression did not end until 1941 (and the next secular bull market did not commence until 1954). The prior peak in GDP was not reattained until the end of the 1930s, fully seven years after the introduction of the New Deal stimulus. By then the unemployment rate was still at 15%, consumer prices were deflating at a 2% annual rate and government bond yields were on
their way to sub-2% levels.
Our preference is to stick with fixed-income securities
Be careful about jumping into the stock market with both feet after this monumental rally. Consider whether or not it would be more appropriate to take advantage of the run-up to reduce equity exposure. Our preference is to stick with fixed-income securities, which we believe will work much better from a total return standpoint, as they did for years after the economy hit bottom back in the early 1930s. When we are finally coming out of this epic credit collapse and asset deflation, we should expect that the trauma exerted on household balance sheets will have triggered a long wave of attitudinal shifts toward consumer discretionary spending, homeownership and credit. The markets have a long way to go in terms of discounting that prospect.
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