Posted by Shyam Moondra
In the past few days, the stock market has been very volatile, up 200 points one day and then down 200 points the next day. Some of this volatility may have been caused by the year-end window-dressing by mutual and hedge funds whose fiscal year ends in October. The market had gone up quite a bit since it bottomed out last March, so it was inevitable that some investors would want to take profits and short sellers would move in aggressively to create a downward momentum.
There are people who think that the market correction of the last few days may in fact be an exceptional buying opportunity for the long-term. Some of the stocks, that did exceedingly well since March, have been hammered down in recent days by as much as 25%. The bulls point out the following positive trends that suggest that the market is headed much higher:
· The recent quarterly earning reports exceeded analyst expectation by a wide margin. Most companies increased their guidance for the future.
· The latest GDP report showed that the economy grew at a faster rate than anticipated.
· The corporations have strong balance sheets, hoarding a lot of cash to support future capital investments.
· The corporations did a marvelous job in managing their cost structure during the recession and they have never been more lean and mean. That means their profit margins will expand rapidly as the economy recovers.
· The inventories are at historically low levels, suggesting that the industrial production may move into a higher gear (even if demand does not increase significantly), which means more jobs down the road. Recent industrial production report, showing better than expected increase, supports that belief.
· The stimulus spending was back loaded; as much as $585 billions worth of stimulus still remains to be spent through 2010.
· The Federal Reserve Board has indicated that money supply will remain bountiful and interest rates will remain low for the foreseeable future. Historically, liquidity and low interest rates have always favored the stock market in general and the financial sector in particular.
· Weak dollar has enhanced competitiveness of multi-national corporations that will garner a bigger market share as the global economy recovers. Weak dollar is also helping to reduce the trade deficit.
· Recent labor force reductions have considerably improved productivity that will expand the profit margins of the corporations in the near future.
· Since the capacity utilization remains low and demand is still weak, inflation is not going to be a problem in the foreseeable future. This gives the Fed some flexibility to keep interest rates low at least until the second-half of 2010.
· Recent housing reports suggest that the housing market has bottomed out, as indicated by the recent increases in home sales and home prices.
· The consumers have done a much better job in controlling their spending and saving more during this recession than any other recession in the past. This bodes well for the economy because as soon as the economy picks up some speed, the consumers will be ready to start spending freely again.
· The stocks are by no means over-valued with the average forward PE ratio in the low 10's. Recent merger and acquisition activity and share buyback announcements (e.g., by IBM) affirm that equity valuations are very attractive.
The bears have their own reasons for being pessimistic for the near-term. They cite the following trends that make them cautious:
· The stock market has gone up over 50% since March, making it the largest up move in a short period ever. It should be kept in mind though that the market went down too much in March because of the fear that some of the biggest financial institutions could go bankrupt, causing a systemic breakdown of the entire financial sector. However, that never happened and we are past that possibility now. One could argue that the market should not have gone down so much in the first place, and, therefore, it's misleading to keep harping on the 50% appreciation. Had market not gone down as much as it did because of sheer panic, the resulting appreciation would have been quite modest and considered normal in the aftermath of a severe recession.
· The unemployment rate will remain high at least through 2011, making it a jobless recovery. High unemployment rate will keep consumer spending in check. Since consumer spending fuels two-third of the economy, we may not see a quick recovery from recession any time soon. The counter argument would be that, while it's true that the lagging employment indicator would be slow to recover, the consumers are not going to wait for full recovery before they start spending again. All they are waiting for are the signs of a recovery-trend which will become obvious within the next six months, a lot earlier than 2011.
· Recent government spending (e.g., stimulus package and bailouts) has significantly added to the federal debt and budget deficit is widening. This will eventually lead to higher interest rates, choking off the economic recovery. We should, however, note that as the recovery takes hold, treasury revenues will increase and the budget deficit will eventually abate. Nevertheless, President Obama and the Congress would have to come up with a credible plan to address the issue of debt and budget deficit through a combination of spending cuts and tax increases for the wealthy individuals and corporations (shutting down off-shore tax havens and closing tax loop-holes).
· Weak dollar will lead to higher inflation because imports will become expensive which, in turn, will induce the domestic producers to increase their prices.
· The credit card losses and commercial real estate losses will keep the financial sector under pressure for the foreseeable future.
The stock market always looks ahead and most economic indicators (GDP growth, corporate earnings, housing sales and prices, industrial production, etc.) point to economic recovery from the worst recession of our times. While the recovery may be erratic, its direction is not in dispute. Early this year, industrial production was declining which led to layoffs, which, in turn, led to lower consumer spending, and that led to lower corporate profits, thereby creating a downward spiral in which each economic calamity was feeding into the others. But now we are in the process of an upward spiral that will restore employment, corporate profits, and stock prices over time. While there are very few plausible hazards that could choke off the recovery, there are many more potential catalysts on the horizon that could in fact propel the stock markets to new yearly highs in the coming months. The Dow Jones Industrial Average at 11,000 before the end of 2009 is not a far fetched possibility. One thing unique about Americans is that they are driven by a sense of optimism and hope. They thrive in adverse conditions and turn calamity into opportunity.
