June 14, 2012....
Bob Brinker took last Sunday off from Moneytalk, so David Korn took the opportunity to review Brinker's Five Root Causes of a Bear Market. David also added his own analysis and conclusions about the likelihood of recession or bear market.
David Korn writes a weekly newsletter that includes a summary of Bob Brinker's Moneytalk. These excerpts are posted with permission, David Korn wrote:
BEAR MARKET ANALYSIS
Back in the days when the secular bull market was coming to an end, Bob was
asked what factors he would look at to forecast whether a bear market was
coming. At that time, Bob discussed the five factors or "root causes" as he
refers to them that foretell a bear market. Those five root causes include
the following: (1) tightening monetary policy by the Federal Reserve; (2)
rising interest rates (especially short-term rates); (3) rising inflation;
(4) rapid economic growth; and, (5) over valuation in the market. Bob has
said that these factors "have the potential to influence the future course"
of his stock market timing model.
1. Tight Money.
The phrase "tight money" is a loose reference to when economic conditions
are such that obtaining credit is difficult and interest rates are high.
The Federal Reserve monitors the growth of the money supply because of the
effects that money supply growth is believed to have on real economic
activity. Over time, the Fed has tried to achieve its macroeconomic goals
of price stability, sustainable economic growth, and high employment in part
by influencing the size of the money supply. The Fed publishes weekly and
monthly data on two money supply measures, M1 and M2. The narrowest
measure, M1, is restricted to the most liquid forms of money; it consists of
currency in the hands of the public; travelers checks; demand deposits, and
other deposits against which checks can be written.
M2 includes M1, plus savings accounts, time deposits of under $100,000, and
balances in retail money market mutual funds. Incidentally, last month the
Federal Reserve changed the web site and format under which it is reporting
M2. If you are interested in tracking this stuff, here is the new URL:
Federal Reserve.gov
Two weeks ago, the New York Federal Reserve Bank published a research paper
that studied how the Fed's large scale asset purchases together with its
basically zero interest rate policy have impacted the monetary aggregates.
Their conclusion? Both M1 and M2 have grown quickly recently ‹ especially,
M1. They attribute most of the recent high money growth rate of M1 to the
low current interest rates as well as the growth in bank reserves that has
resulted from the Fed's asset purchase programs. M1 has been growing at an
annual rate of 20% which is very high by recent historical standards. M2
has also increased significantly in the last year. From May 9, 2011 to May
7, 2012, M2 grew by 9.6%.
If we look at just this year, the growth rate is slower, but still at a
pretty good clip. From the beginning of the year through May 7, 2012, M1
and M2 have growth rates of 6.3% and 6.5% respectively. But that growth is
relative to the fourth quarter of 2011 and does not reflect the full extent
of money supply expansion over the last few years.
Looking at loans in general, bank lending had declined in 2009 and 2010, but
commercial and industrial loans have picked up this year, growing at an
annual rate of 15.8% in April. Total loans and leases grew at 4.1% due to
weakness on consumer and real estate lending.
Still, the main determinant of faster money supply growth is reserve growth.
According to the New York Fed, "Recent growth in M1 and M2, particularly the
former, is explained primarily by the Fed's expansion of reserve balances" and that "reserve growth consistently increases money growth." Read the
paper, "What's Driving Up Money Growth" at the following url:
What's Driving Money Growth
All in all, I don't think we need to be worried at all about tight money at
this juncture as a contributing factor to a bear market. The authors of the
foregoing paper point out that "it's unlikely that the current high growth
rate will continue in the long term....as both low interest rates and the
Fed's expansion of bank reserves will likely be reversed as economic growth
accelerates." That brings about another worry, and a frequent starter of
bear markets. Our next indicator...
2. Rising Rates.
Most advisors, from the most famous bond investor, Bill Gross, to yours
truly, has at some point in recent years been spooked by the threat of
rising rates. So far, that simply has not panned out. Short-term rates
remain at record lows. Treasury yields are at record lows. Rising rates
have not been a problem. Here is a web site that provides a great snapshot
of rates, including a daily updated chart of the yield curve:
Interest Rates Today
Federal Reserve Chairman Ben Bernanke testified before the Congress this
past Thursday. Investors were looking to see if he would give clues that
the latest jobs report among other financial data, would signal any change
in policy and/or rates. While Bernanke acknowledged that the risks to the
U.S. Economy have increased and the Fed is prepared to take action if things
deteriorate further, he gave no sign that the Fed was going to change course
at its next monetary policy meeting that is scheduled for June 19-20th
saying it was "too soon" to speculate on any Fed action at that meeting for
now. Here is the link to the speech Ben Bernanke gave on the Fed's Economic
Outlook and Policy before the Joint Economic Committee, U.S. Congress:
Fed's Economic Outlook and Policy
If you look at the Fed-funds futures traders, the view among traders is that
the fed funds rate will remain near zero for another two years. This is
consistent with the FOMC's statement that it anticipates that economic
conditions are likely to warrant exceptionally low levels of the federal
funds rate at least through late 2014 ‹ a comment that Ben Bernanke
reiterated during Thursday's Congressional testimony. The FOMC has held the
funds rate inside a record low range of 0% to 0.25% since December 2008.
Bottom line? No sign for now that rising rates are foretelling a bear
market.
3. High Inflation.
We always have to worry about inflation. It¹s the hidden tax, the killer of
bear markets and can create huge problems for the economy. Too much
inflation is always bad. But deflation can be equally bad and don't get me
started about stagflation.
Going back to Ben Bernanke's speech Thursday with regard to inflation he
said the following:
"...large increased in energy prices earlier this year caused the price
index for personal consumption expenditures to rise at an annual rate of
about 3 percent over the first three months of this year. However, oil
prices and retail gasoline prices have since retraced those earlier
increases. In any case, increases in the prices of oil or other commodities
are unlikely to result in persistent increases in overall inflation so long
as household and business expectations of future price changes remain
stable. Longer-term inflation expectations have, indeed been quite well
anchored....For example, the five-year forward measure of inflation
compensation derived from yields on nominal and inflation-protected Treasury
securities suggests that inflation expectations among investors have changed
little, on net, since last fall and are lower than a year ago. Meanwhile,
the substantial slack in U.S. labor and product markets should continue to
restrain inflationary pressures. Given these conditions, inflation is
expected to remain at or slightly below the 2 percent rate that the Federal
Open Market Committee judges consistent with our statutory mandate to foster
maximum employment and stable prices."
That pretty much sums it all up. I could give you a bunch of different data
points on inflation and such, but Bernanke spoke very specifically to
inflation and seems pretty satisfied that for the moment we are good on the
inflation front.
I did want to mention the Economic Cycle Research Institute's future
inflation gauge since it is designed to forecast where inflation is going
and because ECRI has been outspoken on the forecast for recession (more on
that in fifth indicator). ECRI released its May readings for the U.S.
Future inflation gauge which rose to 102.3 from an upwardly revised 101.4 in
April. Still, those numbers aren't that notable. According to ECRI's Chief
Operations Officer, Lakshman Achuthan, "Though the USFIG increased in its
latest reading, it remains below last year's cyclical high. Thus, U.S.
inflation pressures are still somewhat subdued." Quote obtained from
article at this url:
U.S. FIG Tips Up
High inflation is not on the radar right now.
4. Rapid Economic Growth (Or Recession)
The fourth "root cause" of a bear market analysis is rapid economic growth.
One of my sharp subscribers who manages money had suggested it would be
helpful to modify this to include recession the opposite of rapid economic
growth which can also cause a bear market. I concur wholeheartedly.
About a week ago, the Bureau of Economic Analysis said their second estimate
of Gross Domestic Product adjusted for inflation for the second quarter of
2012 increased at an annual rate of 1.9%. This was a downward revision of
0.3% from April's estimate of 2.2%. GDP for the fourth quarter of 2011 was
3.0%. The growth in the last quarter was supported by gains in private
domestic demand which more than offset a drag from a decline in government
spending. These numbers evidence neither rapid growth nor recession.
The jobs report last week seems to be causing the most immediate concern
relative to the overall health of our economy. But many economists
(including Bernanke), believe that the slowing in the labor market of late
might have been exaggerated by issues related to seasonal adjustments and
the unusual warm winter we just had as well as some catch-up in hiring that
employers had been doing that had pared their workforces aggressively during
and after the recession. No doubt, we need to create more new jobs, but
when you look at the overall economic picture, things seem to be on a stable
yet slow-to-moderate growth rate for now. While things in Europe have been
volatile, the demand for our nation's exports has held up well. And U.S.
based corporations have become more competitive in the international
markets, with their bottom line profits (as the next indicator addresses)
have been doing quite well.
In Bernanke's testimony this week, he concluded that "Economic growth
appears to continue at a moderate pace over coming quarters, supported in
part by accommodative monetary policy. In particular, increases in
household spending have been relatively well sustained. Income growth has
remained quite modest, but the recent declines in energy prices should
provide some offsetting lift to real purchasing power..."
All in all, I certainly don't see rapid economic growth. On the other hand,
I don't see a recession either. But there are that do ‹ most notably, the
Economic Cycle Research Institute which is in the business of forecasting
recessions. Ironically, Bob has cited them quite frequently in his own
newsletter and stock market timing work, although he has publicly distanced
himself quite clearly form their recession forecast that was made in late
September of last year when they published the article,
"U.S. EconomyTipping into Recession"
Has the ECRI backed off on its recession call since September of last year?
No. They have a video and an article posted on their web site defending their view.
They point out that for the last three months year-over-year growth in real personal
income has stayed lower than it was at the beginning of each of the last ten recessions
and they don't believe the Fed can stop a recession even if they continue to
print money or do just the right thing policy wise. Their conclusion is quite clear:
"As students of the business cycle, we admit to being hopelessly biased in
our belief that it is simply not possible to repeal recessions in market
economies. It is not whether there will be a recession, but when. And
ECRI's indicators are telling us that a recession is likely to begin by
mid-year, if not sooner, though this may not become obvious until the end of
the year."
Read the article, "
Revoking Recession: 48th Time's the Charm"
I'm not really in ECRI's camp right now. I am not saying we won't have
another recession, and it might be sooner rather than later. There is a lot
Congress needs to address such as tax policy before next year, and there are
forces outside the U.S. that can undermine our economy. And unexpected
events (e.g. 9/11) can change everything. But right now, I don't see a bear
market happening because of a recession in the near future.
I would be remiss if I didn't mention the Presidential elections. Not quite
sure which indicator to put this under, but history suggests that the stock
market isn't going to crater during a presidential election year. Don't you
think that if you were an elected official trying to keep your seat, you
would do everything in your power to stave off a recession? Not that they
can do all that much perhaps, but I would think they would try pretty hard.
Incidentally, one of my subscribers (thanks again Bill), sent me some data
showing that June, July, August are historically the strongest months over
the last 21 election years (1928-2008). So far, June has started off with a
bang.
Bottom line on this indicator: I don't see rapid growth (which typically
leads to inflation and other ills) or a recession which leads to worse set
of problems. This indicator doesn't suggest a bear market on the immediate
horizon.
5. Over-Valuation
The market's valuation is determined by examining the price of stocks and
their earnings. With 99% of the companies in the S&P 500 having reported
first quarter results, operating earnings for the first quarter came in at
$24.31. Of the 498 companies that have reported, 321 beat estimates, 117
missed and 50 met their estimates. The first quarter's earnings look to be
the third best in history. Profit margins remain high at 9.06% versus an
average of 7.19%.
Earnings over the last year, including the first quarter, came in at $98.11.
If we use Friday's closing price of the S&P 500 at 1,325.66, that gives us a
trailing price-to-earnings (p/e) multiple of 13.51. Very reasonable in my
opinion. But alas, the stock market looks forward, not backward.
If we use Standard & Poor's estimates for the next three quarters through
the end of this year, the estimated earnings for 2012 would be $104.54.
Based on the market's close this week, that would give us a forward P/E
ratio of 12.68. That is a number we can live with. The only problem is that
those estimates can change quickly. The further out you go, the wider the
variance. It appears revenue is not going to be as high as it was in
previous quarters. Second-quarter revenue growth for S&P 500 companies is
expected to be just 2.25% compared with an average 7.3% quarterly increase
since 1998 according to Thomson Reuters. But for now at least, I think the
earnings estimates justify the market's valuation.
All in all though, I don't see any kind of significant over-valuation in the
market.
Conclusion
Analyzing the "root causes" suggests they don't foretell a bear market. I
should be a good financial newsletter writer and put a big caveat in there
by saying nothing is for certain. And perhaps you read along and came to a
different conclusion. The point of the exercise is to do the analysis so
that you can understand my position and hopefully gained some of your own
insights along the way.
David Korn's Stock Market Commentary, Interpretation of Moneytalk (Bob Brinker Host), Financial Education, Helpful Links, Guest Editorials, and Special Alert E-Mail Service. Copyright David Korn, L.L.C. 2012
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