Reasons the rally could be over Posted Apr 20 2009, 11:03 AM by Anthony Mirhaydari
All that has gone right over the last six weeks could be unraveling.
There was renewed optimism about the health of the global economy, especially in China. Japan announced another $154 billion stimulus package. A cordial G20 meeting came and went without fractious in-fighting between countries. We got new details on the Public-Private Investment Program. We got more clarity about proposed changes to the financial regulatory system. Refinancing activity is up. Home sales are up. And the big banks are reporting profitable first quarters, even if the numbers are a bit suspect.
In short, after a dreadful winter, suddenly the springtime was all sunshine and lollipops. Through Friday, the Dow was up 23% since the first week of March, the best six-week performance since the summer of 1938. Bank stocks, as represented by the Financials Select SPDR (XLF), have led the way with an 82% gain. Consumer discretionary, industrial and materials stocks were up 30%+.
But as I warned last week, my intuition and research told me that government manipulations have left a lot unsaid and undone. The trouble is that just under the surface there are many signs of economic weakness and degradation that have been pushed aside. Although one day does not make a trend, Monday's heavy selloff could mark a negative shift in sentiment and the beginning of another harrowing stock market slide. Here's why.
It's disheartening and exhausting to think about it, but all the recent energy expended has only returned us to levels last seen in February. It's been like running on a treadmill: Investors and policy makers are out of breath, sweaty and a little light-headed, but haven't really made any forward progress.
Look at the Q1 earnings the banks just reported. Patched up with duct tape and twine, all the major banks are reporting results that rely heavily on profits from fixed income trading, commissions on client trading, optimistic loan loss estimates and currency translations. Since these results are engineered and reported by the same characters that chopped mortgages backed by Miami and Vegas condos into AAA-rated bonds, do you really trust them?
And don't forget the vicious cycle of unemployment-foreclosure-home price decline-credit crunch that policy makers have yet to arrest despite dropping the Fed Funds rate to zero and 30-year mortgages to 4.5%. Although the jobs report came in better than expected last week, at 610,000 initial jobless claims vs. 654,000 the previous week, the improvement was largely because from the shortened Easter week. A less volatile measure is the four-week average, which remains above 650,000.
And this weekend brought word that government officials are disinclined to allow the likes of Goldman Sachs (GS) and JP Morgan (JPM) to repay TARP funds they've received unless it's determined to be in the "national interest." The banks want to repay those funds as quickly as possible to get out from under federal restrictions on compensation, so if the Treasury Department won't allow them to do so it will be seen as a sort of confiscation of private shareholders' interests. The government, on the other hand, is worried about the continued slide in bank lending. This could get ugly.
For these and other reasons, we need to remain cautious and alert. The glossy shine that bank executives, opportunistically bullish traders, and the Obama administration put on the broken wreck that is our economy is in danger of wearing away. What lies beneath isn't pretty.
In fact, it's downright scary. The bank stress-test results are due soon, and Bloomberg is reporting that there is still "no set plan for how much information to release, how to categorize the results or who should make the announcements." The new bank rescue program remains to be implemented and will likely need additional funding the Congress won't want to give. Another big batch of mortgages, this time the Alt-As and option- ARMS, will start resetting in a few months, as shown above, as many people find themselves ineligible for the government's mortgage assistance plan because of negative equity. And finally, the situation with the automakers remains highly fluid. Debt holders like Goldman Sachs are likely to balk at an all-equity offer General Motors (GM) is offering, setting the stage for a bankruptcy filing.
Moreover, a recent report from the International Monetary Fund points out that the current recession is not only accompanied by a financial crisis, but is also highly synchronized across the globe. History tells us that both of these conditions in isolation results in a severe, protracted recession followed by a slow and feeble recovery. Now we must contend with a combination of the two.
The key to recovery isn't monetary policy courtesy of the Federal Reserve, since the conduits by which that stimulus is transmitted to the real economy is through the banks. Instead, the IMF is prescribing more fiscal stimulus from the government. Unfortunately, with populist anger towards taxes and bankers fomenting tea party protests, it's unlikely the economy will receive the second dose of adrenaline it really needs.
Disclosure: The author does not own or control a position in any of the funds or companies mentioned.
Anthony Mirhaydari is a researcher for the Strategic Advantage investment newsletter. He can be contacted at anthony.mirhaydari@live.com.
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