Critical Economic and Market Commentary | 1.7.10

Posted At : January 7, 2010 2:11 PM

Market Update – Year starts with a bang

So far the first few days this year have been pretty good. There are several so called indicators based on January performance, some focusing on the first 3 days, 5 days and some on the whole month. However, I have found the first day to be the best indicator, and this year’s triple digit gain is a positive sign. Triple digit gains and losses by the DJI on the first trading day of the year have not been unusual over the past decade. I did a little research and found that in the last ten years (2000-2009), the Dow has a triple digit gain four times (’03, ’04, ’06 & ’09) and a triple digit loss three times (’00, ’01 and ’08).  Although a quick start doesn’t guarantee anything, the big gains in the DJI on the first trading day has often translated into solid gains for the year.  For those years when the DJI started out with triple digit gains, the S&P 500 rose as follows:  ’03 up 26%, ’04 up 9%, ’06 up 13.6% and ’09 up 23%.  On the flip side, triple digit DJI losses translated into lousy years, with the S&P 500 dropping 10.1% in ’00, 13% in ’01 and 38.5% in ’08.

For the intermediate term, there are no overt signs, as yet, of a top, although most technical indicators are at clearly overbought levels and a correction should be expected. My biggest concern is with the investor sentiment readings.  The most recent American Assoc. of Individual Investors (AAII) poll shows that 49% are bullish, a big jump from the previous week of 37% and just 23% are bearish, the lowest reading since Feb. ’07, just prior to a 10-day, 6% drop in the S&P 500. Also, this week’s Barron’s mutual fund cash flow data showed the largest flows into equity funds since late May ’09, just prior to the June-July correction.  These sentiment readings along with the overbought readings on short to intermediate term indicators, suggest the risks of a correction rising. Regardless of this however, the major trend still appears strong on a very selective basis. The risk of another catastrophe a few months down the road remains strong and every investor should have an exit strategy.

Economic Update – Viagra market remains firm

As I enter my 4th decade in this business, the market is as divided as I’ve ever seen it. Investors on both sides are so emotionally committed to their positions that it reminds me of the 2004 presidential election. Certainly the negatives cannot be ignored.  The increased massive federal debt putting us in the banana republic category, rising unemployment, worsening demographics and the fear of higher interest rates are very scary prophecies. However, these are not today’s problems.

For the immediate term, we have a Goldilocks scenario. Low interest rates, massive liquidity (the fact that it’s from the government makes no difference) and stock market momentum. This is the great Viagra market, with government stimulus the little blue pill, and as long as we’re in the 4 hour period before we should call a doctor, we can keep hope up.

For the longer term, the outlook is still very dangerous. Bear market cycles last 17-25 years, and we are only about half way through this. This recession is unlike any other we have experienced since the Great Depression. Typical recessions are inventory-adjustment recessions, caused by businesses getting too optimistic about sales and then having to adjust. You get temporarily higher levels of unemployment as inventories drop, and then you get the rebound.

This recession was caused not by too much inventory but by too much credit and leverage in the system. And now we are in the process of deleveraging, with the process nowhere near complete. While the crisis stage is over (at least for now), there is still a lot of debt to be retired on the consumer side of the equation, and a lot of debt to be written off on the financial-system side. Total consumer debt is shrinking for the first time on 60 years, and the decline shows no sign of abating. Credit card companies have reduced available credit by $1.6 trillion dollars, and for good reason and bank charge-offs for credit cards are going to rise as the unemployment numbers get worse.

The world economy is resetting to a new a new world economic order. One with lower and lower demand due to the natural demographic shift of our aging population saving more and spending less. This is being exacerbated by the destruction of liquidity by the deleveraging process. In the end, no amount of government stimulus can change that.

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