This blog post originally appeared on RealMoney Silver on June 2 at 8:11 a.m. EDT.
In my view, some portion of yesterday's late-afternoon selloff was artificial, a likely byproduct of the first-of-the-month outflows/redemptions and exacerbated by computers that were picking off bids in front of mutual fund sales executed in an environment of relatively low exchange volume.
I have to ask the question: when will our authorities (read:
) wake up to the damage inflicted to investors' confidence and to our equity markets by high-frequency trading strategies? And the sad answer: when the damage to investors' confidence and to the markets is complete!
Beyond my concerns regarding the troubling market manipulations, I continue to have a number of secular and intermediate-term fundamental concerns. There are numerous nontraditional headwinds to growth:
- rising taxes;
- fiscal imbalances in federal, state and local governments;
- the absence of drivers to replace the prior cycle's strength in residential and nonresidential construction;
- inept and partisan politics; and
- the long tail of the last credit cycle (Greece, Portugal, Spain, etc.).
These factors (among others) don't necessarily prevent a bull phase, but they will most certainly put a cap on the market's upside potential.
That said, my single greatest short-term concern is that credit is growing dearer as banks further pull in their lending horns -- in part, a result of the aftershock of the last credit crisis, which is now being felt in Europe. I recognize my observation of more limited credit availability runs somewhat counter to the
bank officers' lending survey. Perhaps, to quote
, those lending officers are lying "like ministers of finance on the eve of devaluation." (I have argued that restricted credit is growth-deflating and could jeopardize the bulls' self-sustaining economic growth thesis.)
In conversations last week with the managements of two serial acquirers (industrial/manufacturing) and with the management of a large M&A investment boutique, all are singing the same song. Deal backlogs are strong but not for the reasons one would expect (i.e., as an attempt to buoy tepid top-line growth prospects). Instead, numerous growing companies along many different industries simply can't get financing to support growth, and some are forced to consider being acquired as an alternative to slowing their own organic growth.
I believe that many of the uber-bullish strategists (who are often paraded in the business media) are too preoccupied with the prospects of large,
corporations (awash in cash and materially self-funding with record free cash flows) and are missing the picture underneath -- that of a vulnerable consumer and of a less-than-confident small business community, both of which simply don't have an easy path to credit. After all, credit is the lifeblood of our economy, and without it, confidence sinks, capital commitments are postponed, and job growth is lackluster. In the fullness of time, restricted credit will ultimately affect even those larger corporations.
We can't lose sight that in prior cycles, the consumer was on a binge, spending and adding debt. And small businesses, too, were growing and adding employees. Today, the movie is in reverse. This year's dominating movie release is entitled
, a documentary that certainly isn't a 3-D comedy reminiscent of the gay 1990s/early 2000s. (I remain hopeful that it doesn't become a tragedy!)
This morning's opening missive briefly touches on the role of one important ingredient to growth (credit) and is not intended to be a complete economic overview. Rather, it represents a narrow review of diminishing credit availability and its impact on today's complex economic mosaic. Importantly, I recognize that investors' economic growth expectations are already subdued, as the consensus expects the slope of economic growth to be subpar and shallow vs. prior cycles.
It remains to be seen whether consumers and small businesses will meet reduced expectations. Confidence (in the markets and in the economy) can be fragile, especially when market volatility is high (and unexplainable) and credit remains dear. But, as Pimco's Tony Crescenzi writes, history is on the side of the optimists:
The ISM's supplier delivery component remains in rare territory. In May, the index fell to 61.0 from 61.3 in April, but it was the fifth straight month that it was in the rare 60-plus zone. High levels of the supplier delivery component indicate that a higher proportion of survey respondents are making slower deliveries. This is important because broad slowing in delivery speeds tend to coincide with relatively strong monthly increases in nonfarm payrolls. Note that there have been four other periods since 1980 wherein the supplier delivery component moved above 60. In the first three of those periods, payroll gains averaged over 300,000 per month. The most recent period in 2004 saw payroll growth of about 175,000 per month. The reason payrolls tend to increase during such times is obvious: companies do not want to risk a loss of market share, which can occur during times when companies are making deliveries that are too slow to satisfy their customers. These data show the sort of tension that existed in the U.S. economy heading into May when concerns about sovereign credit risks erupted. It remains to be seen whether the cyclical tailwind or the secular headwind will dictate the course of economies and markets in the second half of this year. In the context of the past year's rally in risk assets, the recent decline in markets thus far looks small. The decline can of course morph and alter the behavior of consumers and businesses just as it did in 2008, but it will probably take a few months for the situation to sort out. Take note that most shocks dating back to 1987 affecting stress indicators such as Libor-OIS (or, back then, the spread between Libor and the federal funds rate) tended to jolt these indicators for about two to three months before waning. The current "shock" dates back to the first week of May. We humans have a large capacity to adapt, and this can be seen in a variety of circumstances. Shocks wear off in their affect on markets in part because of this ability to adapt. Perhaps the biggest shock from the sovereign debt dilemma is not past but ahead of us, which would make it too early to start the clock on an unwinding of the risk-off mode of the past month. Yet, in the absence of additional flaring of the sovereign debt dilemma, the momentum that existed in the U.S. and global economy prior to the recent flaring may be sufficient to push investors in the second half of 2010 back into a risk-on mind-set. The next month or so is crucial in this respect -- CEOs are believers in the recovery but are watching events carefully.-- Tony Crescenzi, Pimco
As I have pointed out over the past month, most domestic economic releases are signaling solid domestic growth: 2008-2009's massive fiscal stimulation is inflating the current corporate profit picture and is producing promising PMIs, ISMs and improving nonfarm payroll hirings. Despite that strength, as Tony relates, the next few months remain critical as to whether the U.S. economy and our markets can quickly recover from the recent shocks.
It remains my view that the economy and our markets will recover ... with reservations.
In summary, with each passing day and each passing crisis, it is ever more apparent that it is very different this time and that there remains tension between the secular headwinds and cyclical tailwinds. Stock prices (on historic measures) appear reasonable to undervalued (and have appeared to price in subpar growth). At only 12.5 times forward P/E on a reasonable/conservative 2010 S&P 500 profit forecast of $83 a share, our current condition is compelling against previous cycles -- especially within the context of low inflation, even lower interest rates (the yield on 10-year U.S. notes stands at 3.25%, and investment-grade yields are less than double that yield) and cash that has no return at all -- and a full or outsized exposure to equities still seems unjustified for now.
That is not to say that the markets can't rally from here. Indeed, I have argued that the markets are becoming more attractive in "
" and in other recent columns, as the forward momentum of the domestic economy seems relatively intact.
Short term, I am a market optimistic, but I am an optimist who takes his raincoat to work every day.
My best guess is that the S&P 500 will gravitate toward the higher end of an expected trading range between 1,050 and 1,180 later in the summer.
Nevertheless, we have to maintain a balance and curb our enthusiasm somewhat as the salad days are likely behind the U.S. stock market, given the more forceful secular headwinds that will have an increasing impact by next year.
Doug Kass writes daily for
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Doug Kass is the general partner Seabreeze Partners Long/Short LP and Seabreeze Partners Long/Short Offshore LP. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.