Sunday, March 18, 2012

Global Market Forecast: The United States Economy & Stock Market

Global Market Forecast: Introduction
Global Market Forecast: Sovereign Debt Review
Global Market Forecast: United States Economy & Stock Market
Global Market Forecast: Conclusion

Right now, do stocks represent a good entry point for new capital looking for a home?

We are going to look at that question from multiple angles. Markets move throughout secular bull and bear markets. Since 2000, we've been in a secular bear market in stocks.

Secular markets, which usually last between 15 - 20 years, have smaller periods of expansion and contraction within the larger trend.  This can be seen by reviewing charts of the two most recent bear markets for stocks.

The first was during the great depression: 1928-1949.  As you can see in the chart below, during the depression the market experienced two significant market crashes.  However, it also experienced periods of expansion, noted with the green arrows.


The next secular bear market for stocks occurred between 1965-1982.  This was seen as a "sideways" market that saw a recurring boom bust cycle ending with the market right back where it started almost twenty years after the bear market began.  Investors in the stock market were crushed after inflation was factored into their returns.


The final chart shows the boom bust cycle for our current secular bear market.  We have seen two significant downturns in stocks and two significant up trends.  The market has now rallied over 100% off the bottom of 2009.


After reviewing history, the important question is, "What comes next?"  Many market participants believe we are following a cycle seen during the Great Depression, only in reverse, meaning we experienced the 50% correction first (2008 - 2009), and we will finish with a larger crash, similar to what was seen in 1929.

Others believe we are in a sideways market more along the lines of the 1970's.  We may experience corrections, but overall the market will trend sideways until it finds the footing to begin the next secular bull market.

Since the crash of 2008, retail investors (regular Americans making investment decisions through 401k's and IRA's) have moved their money out of stock funds and put them into bond funds.  This can be tracked through TIC data that is released every month.  

This can be viewed as a positive, as it means there is "money on the sidelines" available to come back into the market.  Or, it can viewed negatively since the most recent market rally has been driven exclusively from hedge funds and commercial banks that have invested a portion of the liquidity the Fed injected into the financial system through QE programs.

In a normal cycle, after the market has risen for an extended period, the retail investors once again feel confident to enter back into the market.  The institutional investors can then hand the baton to them to push the market higher.  This was seen during the bull market of 1982-2000, when investors (who wanted nothing to do with stocks in the early 80's) began to slowly build confidence in the market as they watched prices move higher and higher.

But what if the retail investors do not return and pick up the baton from here?  After experiencing a market crash in 2000, another crash in 2008, and a flash crash in 2010, the baby boomer generation is now terrified of watching their retirement capital evaporate in another leg down in the market.

The retail investor not returning to the market and/or beginning to sell their stocks to live on during retirement, creates the possibility of another Great Depression like crash.  With stocks now in the hands of banks, hedge funds, and high frequency trading machines, we know and have seen how quickly the market can free fall when the bids are removed.

Even if that type of scenario does not occur, you can see in the charts above that we are currently resting on the upper end of a major market rally during a secular bear market.  Based on historical trends this has been the most dangerous time to enter the market.  The following graph shows the psychological cycle investors experience during these sideways bear markets:


In order to invest money today, you must believe that stocks, currently sitting at high extremely high valuations and extremely high sentiment levels, will see these valuations balanced out through extensive economic growth.  Or, you must believe that overpriced stocks will become more overpriced.  Both scenarios are possible.

During the late 1800's through the 1950's, America built an economy around manufacturing and savings.  We produced goods and exported them to the world.  We were one of the world's largest oil exporters.  The 1950's was the peak of America's true economic dominance.  The UK followed a similar path to become the world's most dominant economy during the 1800's before America took over the throne.

During this process of growth, America found itself with the privilege of becoming home to the world's reserve currency.  This means that most transactions around the world are conducted through American dollars creating an increased demand for our currency. You can see the most recent holders of this title in the graph below.


Having the world's reserve currency gave America the ability to run large trade and government deficits. From its peak in the 1950's & 1960's, America began to slowly transform from a manufacturing economy to one based on services and consumption.

We had a chance to correct this imbalance in the early 1980's when interest rates were raised close to 20% to slow down inflation.  A deep recession at that time could have cleansed the built up mal-investments and turned us back toward the path that made America an economic power.  Our leaders decided instead to boost the economy through deficit spending.  By choosing this path, they found the secret political stimulus/drug that has been the backbone of our economy ever since.

After that period, any downturn in the economy was met with an increase in government spending and a lowering of interest rates.  Lower interest rates allowed consumers to borrow more when shopping for cars and visiting the mall and new government loan programs were created for housing and student loans.


America became a nation of borrowing and spending, and they paid off this interest with more and more income derived from service jobs.  The manufacturing base continued to deteriorate and savings declined.  The following graphic visually demonstrates the major shift in the United States economy after 1980:

Now America, similar to many of the countries described in Global Market Forecast: Sovereign Debt Review, is faced with a bloated balance sheet for the private sector (corporate and consumers) and the public sector (government debt) Our government debt to GDP is now over 100%.  Our private debt to GDP, shown in the graph below, touched 300% before beginning to contract in 2008.  



The total debt to GDP (including the government) is close to 360%; worse than Greece.

Remember that payments on government debt have to come from the businesses and consumers that make up that nation.  If the private sector is already burdened with their own mountain of debt payments, it makes the repayment of government debt as well almost impossible.

This does not even factor in the state and local government debts, which are a nightmare.  We are beginning to see large cities and counties begin the process of bankruptcy.  This problem will continue to grow as taxes received from real estate continue to fall along with falling property prices.  A reduction in spending at the state and local level reduces the size of their local economy as government workers face pay cuts or lay offs.


This is also seen in many areas of the bubble economy heavily dependent on debt growth, such as real estate and finance.  Real estate created jobs in the form of construction, sales, and mortgage financing.  The decline in the economy has been felt in the financial sector as many of the largest banks and insurance companies continue to lay off workers, reduce pay, or cut back on bonuses.

The unemployment rate, tracking down with real estate, continues to hover above 8%.  Some market observers, like this website, believe that the unemployment situation is far worse than the official numbers reported by the government when you factor in those that have taken part time jobs and those that have given up looking for work.


In order to deal with the most recent downturn, the United States is following the same blueprint that was created back in 1980: deficit spending and lowering interest rates.  Only this time the magnitude of these programs are enormous. The Obama administration has run trillion plus deficits for four years running, and not only has the Federal Reserve lowered and kept interest rates at 0%, but they have begun printing money to purchase government bonds and mortgage securities.

The goal is to get both consumers and businesses once again borrowing and spending.  America is desperate not to get caught up in the death spiral that countries in the European Union face where reduced spending reduces GDP, which makes the debt already incurred more difficult to manage.

The Fed is trying to artificially keep rates lower than the rate of inflation, a process known as financial repression which I discussed in great detail in What Is Financial Repression?.  This has been successful in driving money out further into risk/higher yielding assets.


The Fed knows that they must increase credit in order to grow the economy.  If people are borrowing and spending, it keeps the machine functioning.  The only problem is that Americans, just discussed in terms of their 260% debt to GDP, are now tapped out.  The income they are taking in, which has either been reduced or cut completely during the most recent depression, is not enough to cover the debt already incurred, never mind new private debt & government debt (which must be paid through taxation or inflation).

Gas prices are 7% away from their all time record high back in July 2008.  The cost of food, insurance, medical payments, gasoline, and rent is rising.  While the Fed had the green light for QE2 when oil prices were at $75, they are going to think much longer about embarking on QE3 with oil prices approaching $110.

Where will the growth come from that will balance the current overvaluation in stocks?  Can the government and the Fed get everyone to buy back into one more credit bubble?  Maybe.

Betting on this outcome was far safer when the stock market was 40% to 50% lower and the sentiment toward the market was at multi-decade lows.  At these levels, based on the coming slowdown in the global economy due to the massive debt overhang, and the continued stagnant (or reduced) growth in the United States, the risk/reward level of entering the market appears extremely high.

Let's review that risk/reward ratio now.

Up Next: Global Market Forecast: Conclusion

h/t Jim Puplava, John Williams, Zero Hedge



1 comment:

  1. In WWII there were posters encouraging people to save gasoline: "Is your trip REALLY necessary? "

    I'd like to see a similar poster now " Is your college degree REALLY necessary?"

    ReplyDelete