Thursday, January 31, 2013

Morning Market Analysis: Is It Time To Turn Bullish? Part IV; the Fundamentals

First, let's review the first three installments of this series.  In the first, I noted that in general the broad averages were in a bullish posture.  However, there are some concerns with market breadth that indicate the market rally is probably overbought at these levels.  In the second, I noted that the five largest ETFs were all very strong.  In the third, I noted that money was already flowing out of the corporate bond market, but that the Treasury markets were still hanging on, although the long end is right at technical support.

Stopping right here, there is plenty of information backing a bullish case.  The primary drawback to this argument are the breadth indicators, but they can either be overlooked, their importance downplayed relative to the other chart data or that a sell-off at these levels represents a buying opportunity. 

That leads to the fundamental economic argument.  And here is where I have problems.

Let's start with the US, whose economy has been stuck in a below par recovery for several years during which the year over year percentage change in GDP hasn't crossed 3%.  Unemployment is still at 7.8%.  Incomes are weak and wage growth is occurring at a snails pace.  Employment growth is occurring, but not at a strong clip.  In short, we're doing OK, but certainly not going gangbusters. And while it does appear that housing is finally coming out of its recession (which could have a decent multiplier effect for the overall economy), that re-emergence is countered by the fiscal follies in Washington, and the imminent impact of the first sequester on March 1.  The negative balance is made worse by the slight contraction in US GDP in the fourth quarter, largely as a result of government spending.

As I noted earlier this week, it appears that the UK is about to enter another recession, its third since the end of the Great Recession leading economic writers to coin the phrase triple dip.  Most importantly, there is little evidence suggesting that the UK government is willing to change its austerity loving ways, despite the fact that it doesn't work or that UK GDP has been more or less stagnant since it came out of recession.

The EU still has unemployment at 11.8% and rising with an overall economy in a recession.  There are signs that the economy has at least bottomed: deposit growth is increasing, Spanish and Portuguese bond yields are low and declining, business sentiment appears to have stabilized (although at very low levels), some money is being repatriated to the periphery, and bullish future market bets on the euro are at some of their highest levels in over 6 months.  The emerging consensus is that the worst of the crisis is over, largely thanks to the EUs July 2012 speech where they said they would to whatever it takes to save the euro alliance.  But, a recovery probably won't happen until at least the end of the second quarter if not later. 

Japan is facing extremely difficult economic headwinds.  On the good side, the yen is finally dropping.  This is extremely good news, as the Japanese experienced a balance of payments contraction during several months over the last year and half, creating a huge problem because the positive BOP was probably the only good things going for the country.  However, the country is still stuck in a deflationary economy with the new Prime Minister forcing the BOJ to publicly state the bank would (finally) accept a 2% inflation rate.  This is in combination with a fiscal package to encourage GDP growth.

The other emerging economies (Russia, Brazil and India) are now firmly in slower growth mode.  Russia is painfully hard to analyze thanks to a remarkable lack of consistent and transparent economic data, while Brazil is suffering from lower growth and higher inflation.  India recently lowered rates and reserve requirements because of growth concerns.  In short, the BRIC story has clearly lost steam and shows no signs of re-emerging as the predominate growth story.

That leaves China as the sole engine for global growth.  And here we run into intersecting issues.  First, they have clearly moved into slower growth mode, targeting GDP expansion in the range of 7%-8%.  Secondly, they are looking to slowly change their GDP model from an export  driven model to one that is consumer driven -- a process that is already taking place.  This means the Chinese growth will  not have the ancillary effect of increasing growth in raw materials exporters such as Brazil and Australia, but will instead lead to more internally led growth with Chinese company A selling goods and/or services to Chinese consumer B.  The former situation will still exist, but not to the same degree as before.

To sum up the national and international position, I just don't see strong enough overall growth in any economy to warrant a strong long position right now.  The best reading of the data is that we'll see a stronger second half, with the US housing market providing sufficient domestic stimulus combined with a more settled fiscal situation.  This would also allow the EU to continue strengthening or bottoming. The stronger second half argument leads could lead into the fact that the market is a leading indicator of anticipated future activity -- a fair point as far as it goes, but I just don't see the overall underlying strength to support the rally long term.

It could be that I'll miss the first part of the new rally while the fundamentals strengthen, meaning I miss the first leg.  That's fine.  It could also mean that we've got a different type or rally relative to the fundamentals going on -- an analysis I doubt as I'm not a strong believer in the, "this time it's different" economic argument.  However, while I'm not seeing an imminent collapse, I'm also not seeing growth to support a long and sustained meaningful rally.