The Message Of The Markets

I am sure that you listen to the various investment programs on national TV. I do, because I want to know the prevailing, majority view. Invariably, what most analysts think is going to be wrong.

The most often heard opinion now is that the economy is doing very well, interest rates are very low, and inflation is low. They conclude, "the stock market has always done very well under these conditions." And then they list their "pigs," or do they mean "picks"?

As long-time subscribers know, it's usually wise to listen to "the message of the markets." If the market is behaving contrary to what the obvious fundamentals tell you it should be doing, then maybe the "obvious" is wrong. The markets have been declining since the beginning of the year. A decline of two months or so could have been excused as "profit taking" after the strong year end rally. But we are now in the sixth month of the correction. That's a little long.

As you know, in the May 31 issue, headed "What Can Go Wrong?," I gave you my view of the unexpected. It wasn't pretty, but based on what I was seeing, and what was not being seen by all the Wall Street guys you see on TV. The past week or so we have been seeing some negative economic news. Yesterday's "Beige Book" report from the Federal Reserve concluded basically that many of the sectors in the economy were soft and softening.

Today's reports showed a big decline in retail sales of 0.9%, much greater than expectations. Furthermore, the PPI (producer price index) had a big decline of 0.4%, which means "deflation." As you know, I have been warning that deflation is now a much greater danger than inflation. Almost every economist is warning about inflation. Big problems usually come from the opposite direction of where everyone is looking.

What is the great danger of deflation, and what accelerates it? Massive loan defaults. We already have the bonds of many of the country's largest companies being downgraded to junk status. Others have defaulted. Looking at the dire state of the huge telecom companies worldwide, we could see bond defaults in the tens of billions of dollars. The former best corporate credit risk in the U.S., AT&T, has already been downgraded from the top investment grade. Within a year or two, it might be down to junk status. This is just an example of what is happening in other sectors.

As an example, telecoms are stuck with huge infrastructures which are basically outdated. The world is tired of waiting in vain for DSL connections, so people are going to wireless broadband. Till now, the range was very limited. The next step, already being tested by small firms, is one with a range of 30 miles or more. As people go to broadband, they disconnect their dial-up phone lines. By the end of the year, voice over IP (Internet) will be much improved in quality. The cost of delivery will be 90% cheaper than over the old, residential phone lines.

You get the idea. Huge credit defaults are a possibility. However, contrary to some of my very bearish colleagues in the business, I think the situation can be handled without causing an economic collapse.

Until now, Wall Street economists have been predicting an imminent hike in interest rates by the Fed. One is even urging the Fed to raise rates. But recent economic news is causing them to scramble in revising their forecasts. Now they say rates won't be raised till September. Of course, then they will revise it again, and say not till next year.

Here is a chart of expectations for the fed funds rate, as expressed in the futures markets by big traders, in April and now. Note that on April 4, astute market trader expected the fed funds rate to rise to 3.25% by December. Now the expectation is down to 2.10%. Quite a change!

Funds Futures Effective Rates

What about the stock market now? The economy and the stock market are different animals, which makes you wonder why they always ask economists for their predictions of the stock market. The economy may continue to grow at 2%-3%, but stocks could go down another 50% or more. Why? Because that's where fair valuation is.

As you know, I am not a fan of "fair valuation." However, I have always said that the markets, or a stocks, sell at "fair valuation" twice in a market cycle: once on the way up, and once on the way down. Well, we have not yet hit fair valuation on the way down. Stocks usually go from over valued to under valued. The later has not yet occurred.

The S&P 500 is selling at about 23 times earnings. That of course is an average. There are many stocks in the index selling at fair value. But the large ones are too expensive. A P/E of 12 would be much closer to fair value, especially if earnings expectations do not come in because of slower-than-expected growth. That means a 50% decline in P/E, or in price if earnings do not grow.

Market expectations about the economy have already been substantially reduced. Remember, early this year, almost everyone expected the Fed to raise interest rates very soon in order to slow the economy. I was virtually alone is saying they would not, and in fact their next step, even if it comes next year, may be to lower rates.

Well, the major indices are very close, or at, major support levels. Some are back to the September crash lows. On a strictly technical basis that should produce a rally.

For the longer term view, however we should look at the advance/decline ratios for the NASDAQ. They are already well below their September lows. That means that these stocks are doing much worse than the indices.