Since mid-March, the financial markets have experienced significant rallies. Does this represent the end of the recession and start of a sustained bull market, or are these advances due for a correction? Thomas Dillman, Executive Vice President of Mutual of America Capital Management Corporation, examines the evidence being touted by both sides and the impact that either viewpoint could have on the U.S. and global economies in the coming months and into 2010.
The Global Stock Market Rally
Over the past six months, world global stock and bond markets staged a powerful rally since the lows registered in early March. On a year-to-date basis, developing and emerging stock markets showed the most dramatic advances, averaging increases of 40% to 50%. The developed nations are also all in positive territory year-to-date, but have not advanced as much as the developing and emerging markets, averaging increases of 10% to 30%.
At the same time, all markets remain below their 2007-08 peaks in a range that generally varies between 20% and 40%. The key issue facing investors is: Are these advances justified by fundamentals, whether current or prospective?
The Evidence
There are two sides to this debate. The Bull Market Case argues that this rally represents the beginning of a new bull market that will be sustained by a global economic recovery. The Bear Market Case takes the opposite view, arguing that the type of recovery being discounted by the global stock and bond market rallies is unsustainable in the face of fundamental, long-term impediments. Let's examine each perspective in turn.
The Bull Market Case
The Bulls' case is premised on the notion that the unprecedented global monetary and fiscal response implemented over the last year has not only avoided a deflationary implosion on the order of the Great Depression of the 1930s, but has provided the liquidity necessary to save the global financial system and to restart the global economic engine. These efforts have included the establishment and maintenance of very low interest rates; the implementation of highly innovative liquidity programs; government bailouts of key corporations, especially financial services companies; and large fiscal stimulus programs with selective incentive programs to stimulate key economic sectors (e.g., the "cash-for-clunkers" plan to support the auto industry).
The Bulls argue that the result of these stimulus programs was to prompt a substantial improvement in most economic statistics. The first observation, coinciding with the beginning of the stock and bond market rallies in early March, evidenced a deceleration in the rate of decline of economic data. After the dramatic declines witnessed in most spending, employment, and production measures in almost every national economy over the prior two quarters, things were likely to get "less bad." However, whereas the Bears remained traumatized by the financial crisis and the economic implosion, the Bulls interpreted these first signs of a slowdown in deterioration as the hallmark of an incipient bottoming and eventual upturn, and were willing to take the risk of investing on that prospect.
By the end of the second quarter, the data started to turn positive as a number of nations, including China, India, France, Germany, and Japan, reported positive Gross Domestic Product ("GDP") numbers for that period. In the United States, housing sales and prices began to stabilize, production indices began to move higher, the rate of layoffs declined (although it remained at high levels), and even consumer spending began to tick up into positive territory. As a consequence, the economic consensus began to move toward a declaration of the end of recession and a prediction of positive 3rd quarter GDP on the order of 2% to 3%.
Another key argument for the Bulls was the unexpected improvement in corporate profitability in the United States, also reflected in economies abroad. S&P 500® profits in the 2nd quarter of 2009 were down substantially less on a year-over-year basis than during the previous quarter, although such a deceleration was likely given the 32% drop during 1st quarter. However, more impressively, the magnitude of positive variance between the actual profits reported for the 2nd quarter and what had been expected was unprecedented—specifically, profits came in 17% ahead of expectations.
Further support for the notion of corporate profit improvement was the fact that the profits in the GDP accounts, which represent all U.S. businesses, increased between the 1st and 2nd quarters. In the wake of these results, corporate earnings estimates for 2009 and 2010 by analysts have begun to rise, and positive earnings estimate revisions have recently begun to exceed negative earnings estimate revisions. Part of what has driven these positive revisions is the increasing number of corporate managements expressing cautious optimism and raising guidance for future sales and earnings prospects.
Finally, the stock and bond market rallies themselves are strong support for stabilization and recovery. Markets are discounting mechanisms, meaning that securities prices move well before the fundamentals actually improve. The discussion above, which describes the economic improvement slowly unfolding in the midst of one of the most powerful stock and bond market advances on record, captures this dynamic. Perhaps the most compelling piece of evidence supporting the Bulls is the dramatic improvement in credit markets. The contraction in corporate investment grade and junk bond spreads is also strong support for the Bulls. And, of course, the appreciation in stocks and bonds has reversed a significant portion of the losses to net worth suffered by consumers last year.
The Bear Market Case
The central theme of the Bears' case is that sustainable global economic recovery will require strong U.S. participation, but the U.S. economy faces formidable long-term structural headwinds that make it all but impossible for recovery to be as imminent or as strong as the current market rally seems to be anticipating.
First, and foremost, the Bears argue that an overleveraged consumer, representing 70% of the economy, is burdened with reduced net worth (e.g., housing recession, stock market decline), as well as either unemployment, or the fear of it. The savings rate has risen to levels not seen in decades, while spending remains muted, and would probably be worse if not for tax relief from the stimulus bill and special incentives such as "cash for clunkers." The uptick in housing sales has been dominated by transactions involving foreclosed properties trading at extremely depressed prices and has been supported by government intervention in the form of very low mortgage rates, a variety of funding programs, and a generous $8,000 credit for first-time home buyers. Furthermore, consumer credit markets (e.g., bank loans, credit cards) have contracted significantly as consumers have retrenched; in August, consumer credit contracted by the largest amount on record. In short, the U.S. economy, as well as the export-oriented economies of the world previously dependent on the U.S. consumer, will likely remain weak for an extended period of time.
Second, unprecedented and rising government deficits to fund economic stimulus, the new Administration's aggressive domestic initiatives in healthcare, as well as energy independence and environmental protection, will without doubt require higher corporate and individual taxes, always a constraint on growth because they siphon off funds for potential spending and investment.
Third, the real estate sector, on the residential side, still faces rising delinquencies and foreclosures, and therefore will most likely continue to put downward pressure on prices. Meanwhile, the commercial side is just now entering a recession foreshadowing significant defaults that threaten to further weaken an already fragile banking sector.
Fourth, the global financial system is far from being able to function without the help of government. Toxic assets remain on many bank balance sheets. Government programs to remove these assets from banks' balance sheets have proceeded slowly and remain modest versus original expectations. In addition, banks continue to refuse to lend except to the most credit-worthy corporate borrowers and have raised rates and fees on consumer credit cards. While credit spreads have contracted significantly from the panic highs witnessed in the 4th quarter of 2008 and 1st quarter of 2009, and new issuances are surprisingly strong, the reason for these incipient signs of a return to credit market health remains the commitment of central banks around the world to continue to provide a safety net and "do whatever it takes."
Additionally, the Bears argue that the positive corporate earnings surprises generated during the last two quarters heralded by the Bulls are generally due to aggressive cost cutting. Revenues are down at unprecedented double-digit rates, and only through extreme cuts to employment, capital expenditures, and advertising, coupled with ruthless working capital management, have managements been able to generate the better-than-expected earnings and cash flow results. The key to future profit growth is revenue growth, which depends on increases in demand. However, prospects for a demand pick-up of any magnitude face the economic headwinds noted above, including high levels of unemployment unlikely to be reversed anytime soon, a reluctant consumer, and a credit starved corporate sector, except for the largest and most cash-rich companies.
Finally, a recently emerging concern is the potential economic and market impact of the unwinding of the monetary stimulus programs put in place to stop the crisis. A number of programs have expired, although some have been extended. At some point, the government will have to attempt to transition the economy and financial markets back to self-sufficiency. That transition has a good chance of roiling markets for a period of time pending the outcome.
The Current Consensus
Given the magnitude of the stock market rally, coupled with the lack of visibility regarding the prospects for economic growth and for corporate revenue and profit generation, most commentators have been calling for a correction.
In late August and early September of 2009, the Chinese (Shanghai) market declined approximately 25% in response to fears about the effect of reduced stimulus on GDP and profit growth in that country. (It is worth noting that the Chinese stock market was one of the first to advance after the financial crisis of last fall.) During the same period, the U. S. market, along with most other markets, showed some difficulty continuing their advances of the previous month.
Finally, the Bears would argue that the market is overvalued because consensus expectations for profits over the remainder of this year and for 2010 are unlikely to be met, and we are facing a period in the near future where earnings estimates will begin to be revised downward again.
A Contrarian View
It is easy to be negative on the outlook given the magnitude of the crisis we apparently avoided, and the fact that so many problems remain to be solved (e.g., unemployment), while at the same time new problems were created by the response to the crisis (e.g., deficits, potential inflation). However, the following observations offer a more optimistic outlook for markets.
First, bull markets always "climb a wall of worry." When everyone seems to agree, that's when markets tend to surprise. And bull markets generally always begin with low quality rallies such as the one we've been experiencing. The rally since March of 2009 reflects this characterization. Of course, that still begs the question whether the rally can continue.
Nonetheless, the Bulls argue that central banks around the world provided unprecedented liquidity and generally have signaled that they will remain accommodative. As the old saying goes, "Don't fight the Fed," especially when our Federal Reserve has been joined by all the central banks around the world. Furthermore, liquidity that does not flow into economic activity tends to find its way into markets. Constrained bank lending, sluggish monetary growth around the world, and very low monetary "velocity" affirm liquidity is not being used for economic purposes, at least so far.
In terms of U.S. fiscal policy, the bulk of the U.S. fiscal stimulus program is yet to come. Of the nearly $500 billion earmarked for spending (as opposed to the $300 billion specified for tax credits), only about $300 billion has been authorized, while only about $150-to-$200 billion has actually been released for spending, and some of that has not yet been spent. Thus, the bulk of the direct stimulus to the economy will occur over the next several quarters.
On the global economic front, U.S. and European growth may prove very sluggish for some time, but a number of new "engines" of global growth have been emerging, including China, India, and Brazil. Asia, in general, is in the process of developing a consumer middle class that will over time shift those economies away from export dependence and provide markets for more and more American and European goods. While that may not help U.S. and European GDP, it will support U.S. and European corporate profit growth.
Finally, with regard to corporate profits, which is the key driver of stock and corporate bond market performance, earnings estimates are rising, as already noted, and once such a trend begins, it tends to continue for a sustained period of time. Skeptics question how the economic fundamentals could support such increases. However, assuming that improvements in economic data, management guidance, and earnings estimates continue, consensus estimates for this year and 2010 would continue to rise. The potential upside on the S&P 500® is 1200, about a 12% increase from the closing price at the end of the third quarter. Moreover, if growth continues, the market will look out beyond 2010 and discount even higher earnings. In short, the stock market could continue its advance for longer than skeptics think.
Conclusion
That said, there always remain risks on the downside. Perhaps the most compelling downside risk factor is that the market has already advanced more than any prior "bear market rally" following a market crash. A correction of 10% to 15% would not be unusual, even if the economic recovery does continue to unfold. And if the concerns highlighted by the Bears begin to dominate the news, or the economic data begin to roll over, the market could potentially decline by an even greater amount.
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