Two big economic reports dampened the mood on Wall Street in the past week: The Standard & Poor's/Case-Shiller Home Price Index and the Conference Board's Consumer Confidence Index.
But despite what the bears would have you believe, several strong companies have shrugged such data aside and broken through to new highs. In fact, long-term, we continue to see evidence that a robust business-led recovery is underway.
Still, threats remain, and so it makes sense in the short-term to be vigilant as the bulls and bears battle it out.
Who are the bulls and the bears?
Broadly speaking there are two major forces in the investing world:
The larger and slowest moving group consists of long-only mutual fund and traditional pension fund managers. These are bulls most of the time because their sole mandate is to buy and hold stocks and bonds. They analyze companies based on fundamentals such as growth expectations, discounted cash flow, balance sheet strength, price/book valuations, dividend reliability, and so on, and determine which deserve more or less of the funds at their disposal. The only major variability in their approach occurs when the flow of retirement-account money directed toward them rises during periods of swelling employment or falls during periods of shrinking employment.
2. The smaller but much faster moving group are institutional money management firms, typically hedge funds but also other structures like sovereign wealth funds and agile pension funds, that trade stocks, futures and debt based on price trend and relative-value analysis. They may be either trend traders or contra-trend traders, but this is the group that tends to provide most of the variability in day-to-day pricing. These are the pros that sell heavily at resistance, buy heavily at support, and generally influence and reinforce the daily or weekly trends that we see in the charts. They tend not to have long-term opinions, and will be bulls or bears depending on how they view the short- or medium-term direction of the markets they trade. I sometimes call these players "the Syndicate." I am in contact with a lot of them, and thus usually know what they're up to.
When I refer to the battle between bulls and bears, I'm generally referring to the day-to-day scuffles between these two large groups. Bulls win over the long term but bears can make a lot of trouble in the short term.
It's important to note here that bears have a really hard job because the long-term direction of the market, over three centuries, is up – way, way up. So they are guerrilla fighters who can be incredibly powerful from time to time and incredibly ineffective most of the time.
Right now the bears are seizing on some of the recent economic data to advance their cause.
First, the Case-Shiller data on home prices showed that prices fell 0.2% in December for the second consecutive month. On a year-over-year basis, prices are down 3.1%. But by factoring in seasonality, since the cold winter months are slow in the world of real estate, the data suggests housing continues to find support and rose another 0.3% in the month. Overall, the home price recovery appears to be stalling somewhat.
Second, consumer confidence for February dipped to 46 compared to the previous reading of 55.9 and the consensus estimate of 55. The expectations sub-index, the leading component of consumer confidence, fell a whopping 13 points to 63.8 as households become less optimistic about income growth, employment, and business conditions. We are well off of the 80-level that in the past has been consistent with economic growth.
The current conditions sub-index dropped into the teens – edging closer to the lows of the early 1980s. Only 6.2% of respondents described current business conditions as good. Only 3.6% described jobs as currently plentiful; while 47.7%, up 1.2% from last month, described them as hard to get. Overall, as you can see in the chart above, consumer sentiment has fallen back to levels reached early last year. This obviously isn't great news for retail spending.
So is moribund consumer spending enough to derail the recovery? Or will falling confidence torpedo a heavily damaged housing market?
Evidence suggests these fears are a bit overdone.
A Breakout for the Bulls?
People can tell surveyors whatever they want – but the real test is whether they are spending. And according to retailers like Home Depot Inc. (NYSE: HD), Lowe's Cos. Inc. (NYSE: LOW), and Macy's Inc. (NYSE: M), consumers are opening their wallets. At least, they were late last year.
Home Depot swung to a profit in the fourth quarter on renewed interest in home improvement projects. The same trend helped Lowe's post its first year-over-year quarterly earnings increase in seven quarters. One interesting factoid: Kitchen-cabinet sales increased for the first time in three years. This is as strong a sign of confidence as you're going to get; people just aren't going to splurge on new cherry wood cabinetry if they're worried about losing their home or their job.
The bounce back in consumer spending will come in fits and starts – with current quarter results dampened by the terrible winter weather in the eastern states. As a result, worries over the consumer, sovereign debt, and higher interest rates are just some of the troubles that will pull at the heartstrings of investors over the coming months. The result will be a grinding, high volatility move sideways in the stock market that we expect to last at least through the summer.
Long-term, we continue to see evidence that a robust business-led recovery is underway. Industrial production has increased at a 9.7% annual rate over the past seven months, according to the ISI Group. That's the fastest initial seven months of a recovery we've ever seen. In 1975, production expanded 7.4%. In 1983, production expanded 6.8%.
As corporate earnings increase, spending on equipment increases, employment increases, and consumer spending eventually increases.
Digging into the numbers reveals the magnitude of the economic rebound that is underway. The annualized growth rates are eye popping. Semiconductor equipment orders are up 646%. Raw steel production is up 89%. Machine tool orders are up 113%. The number of oil and gas drilling rigs in operation is up 86%. Heavy truck sales are up 75%. And railcar loadings are up 22%.
So after six to nine months of choppiness, the bull market will have a chance to get back on track and we can begin to make new progress in that long-term DJIA chart.
Who's Leading the Pack?
It's very useful to see which individual stocks and groups are leading on weeks like this, because they reveal where money is being put to work no matter the broad-market tumult.
Among the more interesting new highs recorded last Thursday wereLiberty Media Capital (Nasdaq: LCAPA), one of a group of odd but large show-biz business entities controlled by the former owner of Tele-Communications Inc. This company holds a mixed bag of assets including the Atlanta Braves, a handful of Midwest TV stations, a home video distributor, live-action TV production and online newsletters about knitting and scrap-booking. It's one of a growing list of consumer-oriented companies that are busting out to new highs and in the process shaking the conventional wisdom that consumers are broke.
Also jumping out to highs were several specialty finance companies that provide debt financing, including New Star Financial (Nasdaq: NEWS), which has popped to close to $6.50 a share from $3 in December. Along similar lines, I'm very intrigued by the potential atCIT GroupInc. (NYSE: CIT), which has just emerged from bankruptcy and also provides specialty financing. Another in this vein that you should watch is Capital Source Inc. (NYSE: CSE), which fell to $1.50 a share from $22 during the credit crunch in 2008-2009, and is now at $5.75 just barely emerging from a seven-month-long base at $5.50.
And finally, as I noted, there were a bunch of retailers continuing their hot streak, including the surprisingLimited Brands (NYSE: LTD), which is like in a world of its own this year, rising steadily to $22.56 after selling for as little as $10 last July. Ross Stores Inc. (NYSE: ROST) sped out to a new high, as did TJX Cos. (N YSE: TJX), another discount retailer.
The bottom line: Discount retail is red-hot, and still dirt-cheap.
Can the Bulls Overcome a Resurgent Washington?
Indeed, if there is an obstacle for the bulls to overcome right now, it's the government – not the consumer.
On the political front, U.S. President Barack Obama continues to pursue a tougher, more pro-active approach to health care reform legislation. Last week, he unveiled his own health reform legislation in response to the lack of progress in the Congress. He then proposed giving the federal government power to limit increases in health insurance premiums.
Should these efforts resurrect Obama's legislative agenda, it will blunt stocks' advance. They may not stop stocks; but they will slow progress. Wall Street prefers government gridlock, not sweeping changes to major portions of the economy. A victory for healthcare reform would increase the chances of climate change legislation being enacted this year as well. As a result, bears will have a field day as stocks in the energy and utility industries will likely come under increased scrutiny and selling pressure.
Overall, the narrative here is a government transitioning from an extremely supportive role for business (stimulus, tax cuts, low interest rates) to one that is more restrictive on activity (increased regulation, higher taxes, higher interest rates).
Remember that two weeks ago the U.S. Federal Reserve for the first time since 2007 raised one of the many interest rates it controls, and is on track to stop its direct purchases of mortgages within the next few weeks. All of these could combine with new trouble for bondholders in Europe and increased money tightening in China to be the catalyst that keeps a lid on bulls' agenda over the next nine months.
But if the correction did end in February, as the bulls believe, I really hope it does not take policymakers' eye off the ball in terms of creating lasting financial reform to ensure that the underlying cause of the 2008 financial crisis is blunted.
At the moment, I'm afraid, financial leverage is creeping into the system far more ominously than I would have expected – and if it's not curbed by law, it will make the next bear market much worse than the last one.
Credit analyst Brian Reynolds on Thursday put this issue best in recording his distaste for the fact that health-care reform, as glacial as it has been, is progressing at warp speed compared to financial industry reform. He points out that the financial crisis was generated by a simple cause: Too much leverage among bank and individuals that was exacerbated by the misuse of credit derivatives.
You would think that at least as much attention would be put to limiting and controlling leverage as the White House wants to restrain health insurers. But Reynolds points out that the truth is not a single proposal put forth so far is likely to limit the growth of leverage. In fact, every measure relating to credit is nothing more than pablum so far.
Indeed, the strongest change so far is the steering of some credit derivatives toward clearinghouses rather than the over-the-counter market. Reynolds observes that this would not only not limit leverage, but perversely it will likely mean that leverage will hit new heights.
Why? Because "the appearance of safety that the clearinghouses provide make people more willing to add leverage, and to create new unregulated forms of leverage, such as loan derivatives," he says. Reynolds sees the next round of investment bank rocket scientists using corporate loans as the foundation for new collateralized debt obligations.
Moreover, with its new rules that curb a form of short-selling, regulators at the Securities and Exchange Commission (SEC) have actually made it more likely that bearish investors will use still-unregulated credit derivatives markets to put pressure on companies, which will lead to more "out of the blue" corrections that stun equity investors with their ferocity. Beware.
[Editor's Note: As this bear-market analysis demonstrates, Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.
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News and Related Story Links:
- Money Morning:
Home Depot and Lowe's Laying the Foundation for Recovery with Little Help From the Housing Market
- Money Morning:
Obama's Targets Insurers with $950 Billion Health Care Reform Plan
- Money Morning:
Fed's Discount-Rate Increase Illustrates Exit-Strategy Challenges That Await the U.S. Central Bank
- Conference Board:
The Conference Board Consumer Confidence Index® Declines Sharply