The S&P500 index, the broadest measure of the U.S. stockmarket, has almost recovered 50 percent from its low in March this year.
That’s a remarkable achievement when you think about it and testament to the power of the human emotion of optimism, or as some might call it ‘blind faith.’
It seems hard to believe that the market could swing from fear of an outright depression, then recession through to unbridled confidence in a complete recovery…and progress through all those stages in less than six months.
But when you examine the fundamental data, it seems hard to justify any suggestion that this rally is built on solid foundations.
For one thing, the advance has been too quick. Investors should automatically be sceptical of any market that just keeps on rising based on a belief that things “seem” to be getting better.
The approach should always be: show me the evidence and based on the earnings reports so far its simply been cost cutting rather than top line revenue growth that has allowed companies to beat what were already very low estimates.
Of course, it’s easy to get sucked into the hype of the markets. ‘Green shoots’ is a very engaging line with its connotations of new life and growth. After two years of losses investors are almost impatient to see markets move higher.
But there’s a risk that investors are also showing signs of petulance by effectively wanting to ‘push’ markets well beyond where they should be, as if making up for lost time is seemingly their only objective.
It’s almost become a case of ignore the fundamentals and follow the herd.
But as any investor knows, that becomes a very dangerous strategy when everyone decides they’ve got it wrong and there’s a headlong rush for the exits.
When you actually go looking, the facts reveal a situation that is clearly not being well reported, yet alone understood by investors, and there is now a real risk that the U.S. markets are, once again, priced way beyond where the fundamentals say they should be.
After all, there has been scant evidence of a recovery and more a case of the news being less bad than it was before. As one commentator recently pointed out: the markets ability to avoid consideration of these issues reflects Mark Twain’s observation that: "Ignorance more frequently begets confidence than does knowledge".
Just consider the following:
The US is expected to issue $US2 TRILLION in new debt this fiscal year and a further $1.4 TRILLION in the next fiscal year to fund its stimulus programme and other financial bailouts. It’s expected that borrowing will make up HALF of total U.S. federal spending this year.
Just think about that for a minute. The U.S. plans to raise $3.4 TRILLION in debt in the next 18 months. How on earth does it plan to service that debt?
But the real problem here is that the rest of the world doesn’t have $3.4 TRILLION in spare cash lying around. And even if it did, would it seriously consider lending it to the U.S. knowing what we do!
So this raises the very real possibility that in the near term we could well see a U.S. Treasury auction fail. Of course, the U.S. Federal Reserve will be forced to step up to the plate but how will the markets react to that news when they eventually find out that the Fed is having to purchase its own debt with funds that don’t actually exist in the first place. That is, it’s borrowing to service its own debt. It’s a bit like getting a new credit card to pay for the debt owing on the last one. Eventually, you run out of options and it’s game over.
The recent meeting between top level officials from China and the United States to hammer out the continuance of China buying U.S. Government debt, though not widely reported, seems to have reached a tacit agreement based on two important principles.
Firstly, that the U.S. moves to reduce its deficit (read: no more spending!) and secondly that the value of the U.S. dollar is maintained (read: no attempt at letting inflation reduce the value of the debt it owes.) The U.S. has had its final warning; it’s now officially on notice and China is watching. Breach one or both of these principles and China will effectively turn off the funding taps.
Now consider this:
1) Tax receipts in the U.S. have fallen by 18 percent this year, the biggest single annual decline since the Great Depression. Individual income tax receipts are down by 22 percent from a year ago, while corporate tax receipts have fallen 57 percent.
This will require the U.S. Treasury to borrow $1 TRILLION over the next six months just to cover the shortfall.
2) The US budget deficit is expected to reach $1.85 TRILLION this year equivalent to 14 percent of the economy. That’s four times its previous record.
2) The Fed estimates that household net worth of Americans has fallen by a record $14 TRILLION between October 2007 and March this year. That’s one whole years worth of American GDP to place it in context.
3) Wages and salaries in the U.S. fell 4.7 percent in the 12 months to June, the biggest drop since records began in 1960 according to the U.S. Commerce Department. We are seeing the beginnings of deflation (falling prices) really starting to take hold.
4) The savings rate in the U.S. has gone from virtually zero to more than 6 percent in a little over 12 months. That’s a good thing long term. But in the current situation savers are not spenders and 70 percent of the US economy is based on consumer spending.
4) Total U.S. commercial paper, the major funding mechanism of commerce, has declined by $US616 Billion so far this year, falling at an annualised rate of 64 percent, one of the steepest declines on record.
5) NAFTA (North American Free Trade Agreement) reports that trade using surface transportation between the United States, Canada and Mexico fell 35 percent in May – the largest year-on-year decline since the agreement came into existence.
6) Factory production in the U.S. in May was 15 percent below its level a year earlier. In fact, its overall operating rate decreased to a new historic low of 65 percent in May. Put another way, one in three factories in the U.S. are effectively shut down.
7) State governments, which are prevented from running deficits, have budget ‘gaps’ totalling $160 Billion as has been well publicised in the case of California. Their only option is to cut services and therefore spending.
What is being forgotten is that stimulus doesn’t create new capital. It borrows from the future to pay for the present in the hope that the situation will improve.
The global economy is facing a shortage of capital on an unprecedented scale. Those that have it (Asia and the Middle East) are reluctant to lend it to those who most desperately need it (Europe and the U.S.).
But while most of the focus is on the U.S. right now, China has its own set of problems, but at the opposite end of the economic scale:
1) New lending has increased 40 percent in just one year. How’s that for credit expansion like no tomorrow!
2) In just the first half of this year, China’s bank loans increased by more than 300 percent from a year earlier, equivalent to 25 percent of China’s GDP in 2008.
3) China’s M2 (total) money supply is up 29 percent in the year to June.
4) In Shanghai, stocks are up 79 percent this year.
5) Stocks on the Shanghai index trade at almost 39 times reported earnings. That’s almost back to the pre-crash levels of October 2007.
Right now, China’s markets are hugely inflated and will crash in spectacular fashion. That’s a given when borrowed money is being invested in anticipation of profit. History has proven that too many times before.
How this will all play out offers market watchers a front row seat at a performance never before witnessed in global financial history.
Somehow America must simultaneously grow its economy, increase its exports, pay down its debt, and restore discipline to government spending…while running an overdraft that is already well over its limit.
However, China must maintain growth at 8 percent, continue to increase exports even though demand has dissipated, strengthen its domestic market despite growing unemployment and avoid its stock market from over heating. And all the while it has to keep looking over its shoulder at the U.S. making sure it’s plays by the “new” rules.
To use that baseball analogy, the bases are now all fully loaded.
Now the U.S. really does have to hit a home run…and China is just hoping that it doesn’t run out of batters before it does so!
Acknowledgment: Some data from the latest issue of ‘The Privateer’ has been reproduced in this article with permission.