Today we speculate about why the stock market is rising and whether it can continue to do so, given all the negative economic news. Along the way we will look at a very interesting study on stock values which will be different than the usual report you see. The world is coming to an end, or maybe not. Like an Impressionist painting, the picture looks different depending upon your distance from the canvas.
Up close, the economic picture is not all that pretty. "Unemployment jumped to an 8 year high of 6.0%. The economy lost 525,000 jobs over the last three months. Since World War II, there has been only one time that the economy lost jobs for three straight months without being in a recession, and that occurred during a steel industry strike in 1952." (Bloomberg via the Street.com).
Most economists think the U.S. would need to see a growth rate of 3% to 4% for a sustainable recovery and an increase in hiring. Unfortunately, the economy only grew at 1.6% last quarter, and the ISM (Institute for Supply Management) numbers fell to 45.4, its lowest reading since October 2001. Below 50 means the manufacturing sector is not growing and below 45 typically means a contraction is in the works.
Capacity utilization is an anemic 74.8%, making it difficult for companies to increase earnings by increasing prices. They are increasing earnings by cutting employees and expenses.
Analysts Are Still Bad
Gary Shilling tells us, "Note that for the first quarter, the analysts' consensus last January 1 was for an 11.7% year-over-year gain in S&P 500 operating earnings, but by the end of March, their forecast slipped to 8.3%. After excluding the energy sector, however, which got a big and unexpected boost courtesy of Iraq, Venezuela and Nigeria, their prognostications dropped from 8.4% last January 1 to a tiny 1.8%. Also, three times as many companies warned of earnings shortfalls in the first quarter than announced that profits would best expectations. In the first quarter of 2002, the ratio was 1.7 to 1. Company managements are learning that if they reduce earnings guidance enough, shareholders won't be disappointed. (www.agaryshilling.com)
But does that dismal track record deter analysts? Have they gotten more conservative? The answer is a simple no. Shilling writes, "The chastened but still optimistic Wall Street analysts are at it again as they peer into the future through their rose colored glasses. For 345 of the companies in the S&P 500 stock index, these wizards expect earnings growth of more than 10% per year for the next 3 to 5 years. And they expect 123 of them to see profits leaps of greater than 15%, despite the virtual lack of inflation to push up sales and earnings numbers. In the tech sector, they don't let the current, legendary mountains of excess capacity bother them. Analysts forecast more than 10% annual growth for 82 of the 91 tech stocks in the S&P 500, and more than 20% for 18 of them."
How likely is this? In the 1959-2002 years, Shilling tells is that GDP climbed 7.3% annually while S&P 500 reported profits rose 5.0%. Inflation accounted for around half the "growth" in the GDP. We have shown other studies which suggest that inflation accounts for a good deal of corporate profit growth, and that "real" corporate profits grow around 2-3% per year.
"The consensus from the standard economic crowd looks for about 2% inflation and 5% nominal economic gains. Either way, 10% profits growth isn't likely without some huge salutary force, like the unwinding of inflation in the 1980s and 1990s." I agree with Shilling on this point. But the market is rising and expecting earnings to grow. What gives? We will examine this below, but first let's look at a few more items.
"For over two years now, layoff announcements have been a staple of the daily business news and weekly initial unemployment claims have remained stubbornly above 400,000. Historically, economists, analysts and investors have viewed this 400,000 level as a breakeven point. Any reading above 400,000 indicated falling jobs, readings below it, indicate the net creation of jobs. Last week jobless claims were 448,000, after reaching 461,000 the week before." (Brian Wesbury of GKST)
How can 400,000 initial unemployment claims be viewed as "break-even?" Because there are always, even in the best of times, people losing jobs, being fired or quitting for a variety of reasons. There is a basic amount of "churn" in the employment market. There are always jobs being created as well as jobs being "downsized." If someone quits to move to another city (or gets fired) and files for unemployment, that is not the loss of a job. Someone else will be hired. 400,000 is the "churn" rate at which the employment picture is considered to be relatively stable.
But is being over 400,000 as bad as it seems? In 1992 there were 108 million people at work. Today there are 130 million. In 1992, the year of the "jobless recovery," initial claims averaged 408,000 and were 0.4% of total non-farm payrolls. Initial claims would have to rise above 490,000 today to indicate a job market as weak as that of 1992. Wesbury maintains we may need to adjust our rule of thumb.
He goes on to tell us, "Another sign that the job market is not as bad as some believe is that the household employment survey has consistently reflected a stronger jobs picture than the payroll survey. According to the household survey, the number of employed people increased by 1.2 million during the twelve months ending in March. During this same time period, the payroll survey shows a loss of 293,000 jobs. This helps explain why the unemployment rate has stabilized in the 5.5% to 6.0% range versus a 7.8% peak in the early 1990s." It also suggests people are creating their own jobs, which often happens off the radar screen. Whether or not incomes are up or down for that group is another matter, but the survey suggests people are finding a way to survive.
[As an aside, any time you are comparing absolute numbers from a previous period in history you have to be very careful to look at relative size as well. As an example, the current government deficit is huge in absolute terms. But as a percentage of GDP, it doesn't seem that much of a problem. Many economic statistics, like earnings, double every 12-15 years or less (depending upon inflation). It is quite easy for a number to be the " largest in history" and still be relatively low to the current size of the economy. Always look twice at any statistic. They can be very misleading when used by writers with an agenda. For that matter, even writers with good intentions (yes, even me) can over-emphasize or simply miss the importance of a statistic.]
I should note the University of Michigan's Consumer Sentiment Index rose to 86, up from 83.2 at mid-April and 77.6 for March. Normally, consumer sentiment and employment are tied at the hip. Yet, this month, they have diverged sharply. That gives some credence, then, to the thought that there more people working than the unemployment statistics suggest.
This suggests that consumer spending is not getting ready to go into the tank, despite lower auto sales. I continue to insist that the next few weeks and months are critical to our understanding of the strength, or lack thereof, in the economy.
Why is the Market Rising?
There is a futures contract on the Fed funds rate which trades at the Chicago Board of Trade. In the last two days the probability of a rate cut has gone from 20% to 30% at the May 6 meeting, which suggest there a good number of traders who think the Fed will look at the data and determine the economy is weaker and needs a boost. In the last two days the stock market has risen, which others say indicates that investors think that earnings and the economy are on the rise and stocks are better values.
First, let's look at earnings. About this time every quarter Carl Swenlin, the data maven from www.decisionpoint.com gives us his analysis of S&P earnings. Let me quote him:
"EARNINGS UPDATE: Earnings reporting for Q1 2003 is just beginning, and we can monitor the progress using the spreadsheet we download from the Standard & Poors web site. The latest is dated April 23 and about one-third of S&P 500 companies have reported Q1 results. It is interesting to watch original estimates being adjusted as actual results are reported. Most interesting is that pro forma estimates/results are moving higher (from $11.96 to $12.39), while GAAP results have moved slightly lower (from $11.43 to $11.40). This indicates that "earnings improvements" we are hearing about are being engineered in the pro forma dreamscape, not reality. Using Q1 GAAP estimates the P/E would be about 30.57, slightly improved over the 12-month period ending December 2002, but still grotesquely overvalued."
Over the last month, 68% of economic news releases have been worse than expected, and revisions of prior data have generally been down, according to Merrill Lynch. In many ways, the current environment is similar to that of May 2001, when the economy was receding.
It's the Flipping Indexes
Is the stock market responding to earnings increases. Maybe not, suggess Art Cashin (of CNBC fame). He suggests it may be program buying of index funds. First, he tells us about how the indexes are figured.
"The Dow has 30 stocks and a constant divisor (actually a multiplier since it is below "one"). Since the divisor is constant, a $1 move in Microsoft moves the Dow index exactly the same number of Dow points as a $1 move in any of the other 29 stocks.
"The S&P has 500 stocks. Each one is weighed by its capitalization (number of shares x price - roughly). So the $1 move in a high cap (Microsoft) far outweighs a $1 move in a lesser cap (Cashin Logic Inc.)
"The Nasdaq is weighted in a manner closer to the S&P than to the Dow. Yet most of the stocks are different. In fact, only two stocks to my knowledge are in both Dow and Nasdaq. Different weightings, different stocks yet the indexes repetitively (for the past few days) they have shown virtually identical performance.
"Earnings driven? Yeah, sure! I must be mistaken about the derivative index flippers."
He suggests the recent moves are because traders and momentum players, as well as many large institutions, are simply buying indexes. That moves every stock in the index up, as each stock must be bought for every index share bought.
Swenlin's data clearly suggests that the S&P 500 is very over-valued. But that is for the whole index. What about the individual components? Let's turn to Dr. Steve Sjuggerud for his thoughts:
"There are 500 companies in the S&P 500 (no wisecracks please - I know you could have assumed that). However, all 500 are not treated equally... In short, the bigger the stock, the bigger its impact on the index. The reality is the top 10 stocks make up about 25% of the index. Therefore, if those 10 stocks happen to be wildly overpriced, they'll make the other 490 smaller stocks look bad - guilt by association.
For example, Microsoft trades at a P/E of 29, a Price-to-Book Value (P/BV) of 5, and a Price-to-Sales Ratio (P/S) of an astounding 9. Compare that with historical market averages of 15, 2, and 1, respectively, and you can see how wildly overvalued Microsoft is. When you consider all 500 stocks equally (instead of weighting them by size, where Microsoft makes them all look expensive), the results are much different.
"In crunching the numbers, I found the median forward P/E ratio on the S&P 500 is only 13.7. The median Price-to-Book Value is 2.37. And the median Price-to-Sales Ratio 1.16. These numbers are all very much in line with historical averages... a good sign (or at least not as bad a sign as the numbers everybody quotes).
"While I don't trust the P/E number above, the other two numbers are probably okay... and both are only a little above historical averages. So the market could go anywhere from here... especially in the short term.
"I did this same analysis on the Dow and on the Nasdaq. Here are the results:
Dow Industrials (30 stocks) 14.8 Median forward P/E 3.23 Median P/BV 1.13 Median P/S
Nasdaq 100 24.4 Median forward P/E 3.55 Median P/BV 3.54 Median P/S
"So the Dow looks a little more expensive (but then again, Microsoft is one of its 30 stocks). And the Nasdaq 100 sill looks like a bad deal any way you size it up."
Value is Where You Find It
I think we can make conclusions from this. First, there are some stocks which are "value buys," at least on an historical basis. They are also probably not the largest cap stocks.
Secondly, I think this helps confirm Cashin's thesis: index buying is indiscriminately pushing up market values, and thus the recent rise is not a response to earnings "growth" in the last quarter. If it was a response to earnings, then the market action would be focused on companies with just good earnings announcements and which represented good value.
But if values are so bad, and the economic news is mostly bad news, then how can stocks go up?
It is because stocks are bought and sold "on the margin." Let me explain this term.
Let's assume the entire investment universe is composed of 100 investors. Ten of these investors are active traders. They are in the market every day, buying and selling. 25 of the investors are buy and hold. They only buy and never sell. 25 are negative about the market, and they own no stocks. The other 40 will buy or sell stocks depending upon their economic outlook, sentiment and need for cash.
But these 40 are not active traders. Only 5 of them may be trading on any given day. If there are 3 buyers and 2 sellers, there is "buying pressure." If 4 are buying and only 1 selling, there is even more buying pressure. The traders try and sense the direction of the "pressure," and trade stocks based upon their analysis of the 30 or so potential investors. (Yes, the buy and hold guys will add to the buying pressure as they increase their positions, but they also are forced to sell every now and then as well, so that equals out in my imaginary world.)
Thus, a relatively small number of investors can influence the direction of the market on any one given day. These are the investors who are the " margin" of difference, so to speak.
Here's my take on the recent rise in the market:
Long-time readers know that I think we are in a secular bear market, and that P/E values are going down significantly from here. That can happen in one of two ways: the market can go sideways for a decade or more, or it can drop significantly. But in every secular bear market, there can be periods of very large bull market runs. There was a 50% rise in the Japanese stock market, and many bull markets in excess of 30%, during this last decade. We have had two such 20% plus runs already since the highs in 2000.
The economic news has been bad for months. Many of those investors who want to sell have probably already done so prior to now. If you have not sold up till now, how likely is this week's bad news to push you into "sell mode"? Looking at the market ticker, the answer is "not very."
There is a statistic provided by Lowry's Reports which measures buying and selling pressure, which a lot of analysts watch. Richard Russell reports to us:
"Lowry's is on a "buy" signal. But there's an interesting situation here. Lowry's Selling Pressure Index has been declining twice as fast as Lowry's Buying Power Index has been rising. This means (and it's been the story all along) that the current market advance has been fueled more by sellers 'holding back' than by any strong buying.
"As a rule, it takes important and persistent selling to knock a market down. This has not happened. Lowry's statistics show that, so far, any market weakness is simply a result of a drop in Buying Power, rather than a more dangerous rise in Selling Pressure. If this market is really in trouble (rather than backing off from an overbought situation) then somewhere along the line Selling Pressure has to start tracing out an uptrend. So far, that has NOT happened."
The Dow closed up at 8582, significantly over 8521, which for those who follow classic Dow Theory is a positive buy signal. I talked with the best known Dow maven Richard Russell today and asked if there is any technical reason for the market to make a significant run from here, and he said, " No, anything can happen."
You need to understand the psychology operating here. Those who did not sell are now feeling vindicated. They feel good. What would cause them to sell now? Likewise, some of those who did sell are now feeling like they missed the boat. They want to get back in.
Two other factors to keep in mind: there are significant short positions in this market. If the market rises further, there will be increased pressure on them to cover their position. You could see a sustained rally just from short-covering. Further, there are lots of investors who are hoping to "get back to even" and who have promised their wives they will sell when they do. We will see.
That is why I have repeatedly said that this market can drift sideways in large patterns, with significant bull runs, until the next recession. It is going to take something significant to shake up investors and create some selling pressure. Whenever that happens, we will see another significant drop in the markets.
In 2000, I was able to accurately predict a recession beginning in mid-2001 based upon a remarkably accurate statistic provided to us by a Federal Reserve study.
There has not been a recession since WWII that was not preceded by a period where short term rates rose above long term rates for at least 90 days. Unfortunately, we will not have that reliable, all-purpose, never been wrong predictor of recessions to tell us when that will be: the inverted yield curve.
With the Fed artificially holding short term rates down, an inverted yield curve will not happen prior to the next recession. So, we are left to our own devices to peer into the future with indicators of far less faithfulness. Thus, we must monitor the data very carefully, which is what I do in this column, week after week. I still do not see a recession this year, just a continuation of the Muddle Through Economy. But things could change.
Is the Dollar Going Down for the Count?
I became bearish on the dollar (and bullish on gold) well over a year ago, which in hindsight was a pretty good time to do so. I am still bearish on the dollar. I am not bearish on the dollar because I think the rest of the world is in better economic shape than the US, or has better prospects. In fact, I think it is clear that Europe and Japan, among other developed nations, are in much worse shape than we are.
The dollar simply went too high. A good analogy would be Microsoft. This is a great company with superior products and great management. It has a wonderful future. But its stock just went too high. When I suggest the stock is too high it does not mean I do not think the company will do quite well.
For reasons we have detailed elsewhere, the dollar is simply too high, and will come down. That being said, I am puzzled by some writers who prognosticate a dollar disaster which will bring down the whole US economy.
The dollar is still "up" against the euro from its moment of creation. We sometimes forget the euro fell from $1.17 to $.82. The euro is just getting back to where the European Central Bank thought it should have been 3 years ago when they launched. After hitting record lows in the spring of 1995, the broad trade-weighted dollar surged some 47% through early 2002 before giving up about 8% of that gain over the past 14 months.
The US went through a significant drop in the value of the dollar in the 80's and early 90's. I seem to recall we survived just fine, although international travel, of which I was doing a great deal then, was quite expensive. The stock market even went up.
Last week, Der Spiegel wrote they see a conspiracy in the drop of the dollar. The Bush administration, they tell us, is trying to teach France and Germany a lesson by forcing the dollar down, thus making European products more expensive to the rest of the world.
Instead of blaming the US for their woes, Der Spiegel might look at the economic idiots running their country who raised taxes substantially in a weak economy and are trying to raise them again in a recession. (Full and fair disclosure: we have economic idiots in the US who want to do the same thing. Such failings are not limited to certain borders.)
The years go by quite fast. It is once again our anniversary, so I am finishing up early to take a few days off this weekend with my bride. I will be back to book writing bright and early next week. For those who have written and are expecting a response, I am somewhat (actually very) behind in correspondence, but I will catch up. But I do enjoy your letters, thoughts and articles.
I close with this note my wife sent me, in an effort to keep me humble.
"As a young scholar in India, I learned a valuable lesson. At that time, I came from a privileged family, spending most of my time reading. One day, while on a journey, as the boatman took me across a wide river, I described to him how I had gathered all my knowledge.
The boatman listened attentively; then, after a time, he asked me if I could swim. 'No,' I replied, 'I cannot.'
'Then I'm afraid your knowledge is wasted', said the boatman. 'This boat is sinking.'"
Your thinking its time to learn to swim analyst,