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April 06, 2004

Bull or Bear?
by Magnus Ekervik

Is the economy in for a ride or a plunge?

Since there are no guarantees in the stock market and only probabilities. Lets take a look at the present conditions, if they weigh in favor of the bull or the bear.

The bull view:

Strong advance with high momentum in all major indices since the october 2002 bottom, predicting strong earnings ahead and a recovery in the economy.

2003 earnings coming in at par or above forecast. Analysts forecast very strong Q1 earnings which will justify the high stock prices or propel them even higher.

Low CPI figures enables the FED to keep overnight interest rates at a record low of one percent. The easy access to cheap money in addition to massive tax refunds will boost consumption and enable corporations to expand business.

A weaker dollar is giving US businesses a currency advantage, boosting export sales.

Factory production looks very good and factory orders is approaching a decade high.

Job growth is finally improving. March figures show 300.000 new jobs created. The missing piece for a self sustaining recovery looks finally to be in place.

Election year will ensure that the present US administration will do whatever necessary to have a strong economy and low unemployment in the November election.

The bulls are celebrating the recovery and the bull view looks strong indeed. Are there pitfalls for the economy in the road ahead? Lets take a look at the bear view!

The bear view:

The momentum of the advance since october 2002 bottom has decreased steadily since the end of last year predicting that the bulls might be losing the grip of the market. During the last two months volume has increased during declines and decreased on rallies, usually a bad sign.

In March we had a bearish Dow Theory confirmation in the Dow Industrials and Dow Transports. The Dow Industrial and the Nasdaq also failed to confirm the S&P500 new high on March 5.

The Dow, S&P500 and Nasdaq has all broken their 50 day average to the downside, indicating at least a medium term trend change.

The artificially low interest rate set by the Federal Reserve to inflate financial assets and real estate market, in order to make the consumer feel rich, so that he can continue to spend America to prosperity, is not only absurd, but also not self sustaining. The consumer is now choking himself under the load of debt he has been compiling over the years. The debt saturation can be seen in the rapidly increasing bankruptcy rates and the larger amount of people being forced to postpone their monthly expenses.

In addition to debt saturation the salary increases for the average worker have been minimal since corporations have increased productivity instead of adding people to payrolls. Why are corporations postponing new hiring in this recovery? My best guess is that they are not so sure this recovery is self sustaining. Stock insider selling has been very high the last 9-12 months. If the recovery is so good, why are insiders selling at record pace? When Federal Reserve and government stimuli clings off, will the recovery fade and then die?

Gas prices are recording new highs almost every week, this will also strain the consumer, especially since more Americans then ever are driving gas thirsty SUV's.

A weaker US dollar and rising demand especially in Asia is driving the price of all commodities through the roof. This inflation of hard assets will take a big bite from corporate profits in the coming quarters. Since the competition from Asia is putting downward pressure on prices, the bulk of US profits will be eaten away before any price increases will be passed on to consumers.

Another sign of inflation is the accelerating price increases of gold and silver. In the past, this has been an excellent leading indicator of coming inflation. However considering that large commercial traders (which are usually right in the market) are holding record short positions of both metals this might indicate that the inflation will be short lived. Then follows deflation?

The bull market in bonds has been contradicting the advance in gold up until the March job numbers were released. Bond prices took a nosedive in fear of approaching inflation. Since there has been a huge carry trade in long maturity bonds by hedge funds and financial institutions, on the assumption that Federal Reserve will hold rates steady for a considerable period of time. The bond market reaction on the March job figures might be the trigger that unwinds the highly leveraged trade by these players. Higher interest rates will stop the economic recovery, bring down the stock market and pop the real estate bubble and most certainly lead the economy in to recession or perhaps even a depression, considering the enormous pile of debt accumulated over the decades.

Adding to the problem will be the expanding trade deficit and budget deficit. The budget deficit will be financed by selling US debt instruments to primarily Asian central banks. Up until recently their appetite for US debt has been very good. Lately the Treasure Dept. have had increasing problems to sell all the auctioned debt. Is a trend shift at hand? If bond market prices are rapidly declining, will Asian central banks be dumb enough to still keep buying? The latest Treasury Dept. figures show they are already losing their appetite for US debt.

Stock market valuations are also still in bubble territory. New bull markets are not born from these valuation levels of P/E 25-30(and bear markets don't end there), but from the ashes left after a severe and tormenting bear market leaving P/E levels in the 5-10 range.

Sentiment is also showing top bullish readings in almost all asset classes which normally is a bearish sign, signaling a major top. Bonds, stocks, gold, silver, oil, commodities all show top bullish readings. All of these assets have also been in strong bull markets the last year. I find it very strange that they all rise united. In a "normal" market some of these assets should contradict each other. I can only explain the rise in all assets with the enormous liquidity pump from the Federal Reserve, flooding the market with money that is finding its way into all asset classes. There is however one investment that has been loosing in both value and sentiment over the last 2 ½ years. US dollars! At this juncture a true contrarian investor would seriously consider selling all assets and buying US dollars (holding cash)! Since inflation looks like it is finally about to break the bond market bull. Rates will rise and put strain on the consumer, which will dampen demand and force businesses to lower prices. The transition from inflation to disinflation will eventually turn to bad deflation as demand weakens, and take down the values of all assets but one. The one asset that will rise on a relative basis when all other fall is CASH. The worlds most successful investor Warren Buffet is prepared for the worst and is currently holding 32 billion US dollars in cash.

Conclusion: In my opinion the saluted recovery looks very fragile and as the bond market breaks south and unwinds the leveraged carry trade, the stock market and the economy looks poised for a rude awakening. Rising interest rates will also deflate the real estate bubble and cut the last consumer life line. When this happens the consumer will finally stop the spending binge and demand will drop dramatically, and the US will enter a new recession that eventually will develop in to a depression...

Magnus Ekervik

Magnus Ekervik offers independent research and analysis of macroeconomics to financial corporations and financial newspapers. For more information please contact: mefinance@bostream.nu

Copyright © 2004 - 2005 Magnus Ekervik. All rights reserved.

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