This blog post originally appeared on RealMoney Silver on Nov. 11 at 7:44 a.m. EST.Investors face unconventional headwinds today, both short and intermediate term. As always, a sense of time frame is of paramount importance in matters of investing and trading. This might be more so today than in prior cycles as broad and systemic controversies have, by definition, uncertain outcomes and help to explain the almost unimaginable market volatility and the fatigue we all face when confronting routine intraday swings of 3% to 5%. We have to be honest with ourselves and respect that the complexity of today's economic challenges renders the investment mosaic unusually ambiguous. It is hard to be convicted in any time frame. I have emphasized that there are three important questions that we must ask ourselves in order to frame our stock market expectations. I'll present them again below but this time with my answers in italics:
- 1. How deep and long-lasting will the recession be? While the largest year-over-year decline in GDP will probably be in the current quarter, it is unlikely that the economy will recover until late next year. 2. Who will be the marginal buyer to sustain the current rally? With mutual fund and hedge fund investors withdrawing capital at a record rate and corporations likely to husband their resources (at the expense of accelerating their corporate stock buybacks), it is difficult to see a materially improving demand/supply equation for equities over the next six months that would serve to sustain a market advance. 3. To what degree have current market prices discounted a weakening earnings and economic picture? Arguably, stock prices have, to some degree, discounted the weaker economic and profit backdrop.
The Short TermThere are a number of short-term influences:
- Obviously, we have the selling associated with hedge fund redemptions.
- Also, we must consider the degree to which fiscal and monetary policy will affect the slope of the economy.
- Whither the emerging markets?
- How broad will the Treasury's umbilical chord of capital need to be in order to stabilize the credit markets?
- How long is the toxic reach of the arms of American International Group (AIG) and Lehman Brothers?
- Will there be a bailout of the automobile manufacturers?
- What will be the effect of the change in our government's leadership?
- Finally, remember that we have entered a period of seasonal year-end market strength.
The Intermediate TermThe intermediate term is the tricky issue for me. Typically, economic and financial problems do work out, and markets tend to recover from shocks. From my perch, however, the intermediate term is still murky, clouded by the uncertainty of the magnitude of the financial, stock market and economic shocks over the past 12 months. The threats, ramifications and challenges of the long tail of the credit mess, the dysfunctional financial intermediaries that finance economic growth, the broadening weakness in the consumer and the impact of the breakdown in stock and home prices (on the consumer, our universities, municipalities and other institutions) remain in doubt. As I wrote in " Welcome to Dystopia" last week, the outlook for the next three to five years has been jarred. Our social, economic and political future has materially changed, owing to the deep and muddy financial ditch in which we are now squarely stuck. Moreover, the scope and duration of the financial meltdown has placed our economy well past the tipping point, and it will have an enduring and negative intermediate-term effect. Consider that U.S. home prices have dropped by over $5 trillion in the last one and a half years and that, during the month of October alone, nearly $10 trillion has been lost in the global equity markets. Quite frankly, that ditch is so deep right now that we are in big trouble if our policymakers get it wrong over the next 12 months. My concern is that we might even be in trouble for a long period of time if they get it right.
- An economic recovery is not nearly as visible as the optimists would like you to believe. There remains a long tail to today's problems.
- Credit will remain dear, despite evidence of a statistical thaw in credit -- the three-month LIBOR stands at 2.18% (down from a peak of 4.75%), the TED spread is at 1.7% (down from a recent peak of 4.60%), two-year bank swap spreads are at 105 basis points (down from 160 basis points), the LIBOR/Overnight Spread is at 1.6% (down from a recent peak of 3.60%); all these measures are now below pre-Lehman bankruptcy readings -- as pendulums nearly always move to the opposite extreme.
- Finally, the uncertainty regarding corporate profits (i.e., the lifeblood of a bull market) remains the single most important reason why, over the foreseeable future, a sustained rally in equities seems unlikely.