Why Stocks Will Rise as the Economy Deteriorates Further

By Michael Lombardi, MBA

“Michael, you write about the stock market rising in the weeks ahead and actually ending 2011 higher than it started (see Stock Market: Where it Will End 2011), but on the other hand you often write about the pathetic state of the U.S. economy. How can they differ so much?”
The above is an important question we often receive here at PROFIT CONFIDENTIAL from our readers.
The stock market and the economy…they are two very different phenomena that can often go in the opposite direction in the short term, but that eventually meet in the long term.
Yes, the stock market is a leading indicator of the economy. But in the short term, the job of a bear market and a bull market is to mislead investors as to the real direction of the markets. No bull market goes straight up; no bear market goes straight down. There are peaks and valleys on the way up and on the way down. However, in the long-term, the stock market does lead the economy.
Just look at October 2007. The bear market we are presently in started that month. Stocks came down steadily starting in October 2007, but the U.S. economy was doing fine at the time. By the end of 2008 though, the U.S. economy was well entrenched in the worst recession since the Great Depression.
Stock bull markets tend to move in long cycles of about 20 years in duration. A bear market has a shorter cycle, about five to 10 years, as a bear market tends to deal with the excesses of a preceding bull market more quickly. In a nutshell, greed takes a long time to build up. Fear comes quickly.
Let’s move to today, the markets and the economy.
If you are a long-time reader, you know my opinion about the stock market. We are in Phase II of secular bear market that will move stocks higher, as investors get the false sense that the economy is doing better and stocks are the place to be again. At this very moment, most stock advisors and investors are still very bearish. Hence, I believe this bear market rally will continue to ride “the wall of worry” higher.
Of all the things the stock market has going for it (strong corporate earnings, lots of pessimism out there), the lack of investment alternatives to the stock market is key. When the yield on the 10-year U.S. Treasury is two percent and the dividend yield on the Dow Jones Industrial Average is 2.5%, stocks are attractive.
But, in the long-term, the economy has severe structural problems. I write about them daily here in PROFIT CONFIDENTIAL. The Fed has kept the economy alive the past two to three years by aggressively increasing the money supply. This can’t go on forever.
At some point, the stock market will fall victim to higher interest rates brought about by rapid inflation and Phase III of the bear market will suddenly be upon us. That’s what the 10-year bull market in gold has been all about. At that point, the bear market in stocks and the economy will converge again, just like they did in 2008.

Michael’s Personal Notes:

Yesterday, after the Federal Reserve concluded its regularly scheduled two-day Federal Open Market Committee meeting, Ben Bernanke said the Fed may look at buying more mortgage-backed securities, if the economic situation warranted, loosen up the housing market.
In my humble opinion, the Fed needs to stop forgiving the sins of the past, stop expanding its balance sheet, and start tightening.
Look at the Fed’s actions to date:
-- It has kept short-term interest rates down for years and has told us that the Federal Funds Rate will stay near or at zero until mid-2013…short-term interest rates to stay at zero for two more years!
-- The Fed has purchased $2.3 trillion in debt, including government treasuries in the period from December 2008 to June 2011 (two rounds of quantitative easing).
-- Swapped $400 billion of its short-term securities holdings for long-term debt in order to lower long-term interest rates.
In doing the above, the Fed has significantly increased the money supply. A total of $2.3 trillion has been added to the Fed’s balance sheet. That doesn’t happen without money being created. And the more money created, the less the U.S. dollar buys, the more inflation rises (see Economic Analysis: And Then Came Rapid Inflation), the higher the price of gold bullion goes.
Yesterday, the Fed told us much of what we already know: the economy is growing slower than originally thought; unemployment in the U.S. will remain high; and the European debt crisis is a risk for America.
What the Fed didn’t tell us is that, given its inclination to buy more mortgage-backed securities should the economy weaken further (which it will), another round of quantitative easing is in the cards. In a recent Bloomberg survey of economists, 69% of those surveyed said the Fed will embark on QE3 in 2012.
The government already owns Freddie Mac and Fannie Mae, who jointly own or guarantee half the residential mortgages in the U.S. With the Fed buying more mortgage-backed securities, the government and Fed will get more entrenched in the residential housing mortgage market.
I doubt George Washington ever envisioned a time when the government would own guaranteed loans on homes. This is not what the government was set up to do. It’s this type of Keynesian economics that have gone too far, for too long, and that continue to plunge our country into record debt. It’s also a wonder why gold isn’t trading at $2,000 an ounce today (see Answered: Can I Still Make Money Buying Gold Now?).

Where the Market Stands; Where it’s Headed:

I continue with the belief that we are in bear market rally that started in March 2009. Phase I of the bear market brought stocks down to a 12-year low on March 9, 2009. Phase II of the bear market, which we are presently in, is a rally within the confines of a bear market. This rally could last three to four years. The purpose of this bear market rally is to lure investors back into the “safety of stocks.”
Phase III of the bear market will bring stocks back down to where the bear market originally bottomed; in this case, 6,440 on the Dow Jones Industrial Average. Enjoy the current stock market rally while it lasts!

What He Said:

“Interest rates at a 40-year low: The Fed has made borrowing as easy as possible, resulting in a huge appetite for loans and mortgages. We are nearing a debt crisis.” Michael Lombardi in PROFIT CONFIDENTIAL, April 8, 2004. “We will wish Greenspan never brought rates down so low as to entice so many consumers to have such big mortgages.” Michael Lombardi in PROFIT CONFIDENTIAL, April 27, 2004. Michael first started warning about the negative repercussions of Greenspan’s low-interest-rate policy when the Fed first dropped interest rates to one percent in 2004.

Visit:

Profit Confidential


Why Stocks Will Rise

Why We Can’t Have a Sustained Economic Recovery

By Michael Lombardi, MBA

Things are looking up for the economy again. Unfortunately, things are not always as they seem.

The U.S. Commerce Department said that the U.S. economy grew at 2.5% in the third quarter—the fastest pace in a year. Moody’s Investor Services last week raised the corporate ratings of both Ford Motor Company (NYSE/F) and General Motors Company (NYSE/GM), an indication that the car companies are doing better as well. All of a sudden, people are feeling good about the U.S. economy again.

But it was only this summer that analysts were calling for a second U.S. recession. Some economists said we were already in a recession. The numbers being released on the economy beg to differ. Or do they?

Fickle…that’s the word I use to describe today’s modern economists. The stock market starts heading down (as it did this past August) and all of a sudden we are headed for a recession. The stock market gets close to new high (as we are now), and the economists say we’ve turned the corner and are out of the recession.

What’s the truth? How do we make sense of all these numbers to make the right decision for our investment portfolios and for our businesses?

I’ll get right to the point, my dear reader. We cannot have a sustained economic recovery without a recovery in the real estate market (see Without This Fixed, the Economy Cannot Recover). Job growth in the U.S. will not happen unless the construction industry, housing industry and real estate market in general come back. And, from all sides, we can see that the housing market is far from a recovery.

Consider these facts about the real estate market:

The median price of a new U.S. home fell 10% in September 2011 from September 2010, the biggest drop in two years.

The median price of a resale home, which makes up 94% of the real estate market, fell 3.5% in September 2011 from September 2010.

Cash deals account for 30% of all home resale transactions in the U.S.

The Dow Jones U.S. Home Construction Index, an index comprised of the largest U.S. homebuilder stocks and a great leading indicator of the real estate market, is still down 80% from its 2007 high—the worst performance of all Dow Jones sub-indices

Now here’s the scary part about the real estate market: According to Bloomberg, there are 11 million homes in the U.S. where the mortgages are higher than the value of the homes.

Until we have a recovery in the real estate market, which could be years off, we can’t have a bankable economic recovery. That’s the bottom line. And that’s why we simply continue to be in a bear market rally—a period in which the stock market moves higher as the bear completes its Phase II cycle of luring investors back into the stock market before stock prices fall again.

New Cycle of Rising Interest Rates Closer Than We Think

If there is one thing that keeps me up at night, it is this simple question:

What will happen to the U.S. economy when interest rates start to rise?

The U.S. economy is ever so sensitive, likely the most sensitive it has been since World War II. The Federal Reserve has done an excellent job at keeping us away from a second Great Depression. The Fed has kept short-term interest rates near zero for years. The Fed has bought U.S. Treasuries (an unheard of action) and is trying to keep long-term interest rates down by buying long-term securities.

But we must face the facts: after a 25- to 30-year down cycle in interest rates, the unprecedented expansion of the U.S. money supply will create inflation. This is what the 10-year bull market in gold bullion has all been about. And, as inflation sets in, interest rates will rise (see The Economy? Stocks? This Is a Bigger Risk).

And herein lies the biggest problem with the economy.

The U.S. real estate market is already in trouble (read my lead story for today). If interest rates start to rise, the proverbial final “nail in the coffin” will have been delivered to the already-hurting real estate market.

My historical studies show that interest rates move in 20- to 30-year cycles, either up or down. Given the record increase in the money supply and record increase in the national debt, rising inflation will be the catalyst that leads to higher interest rates.

There is no doubt in my mind that interest rates will start a new 20- to 30-year up-cycle. It is only a matter of when it starts…and it might be earlier than most of today’s economists think.

Where the Market Stands; Where it’s Headed:

Last trading day of the month and it looks like October is going to go out with a bang! What a difference a month makes. We started out October close to 10,400 on the Dow Jones Industrial Average. We are closing the month around the 12,000 level. But, despite the market recent run-up, pessimism still reigns with stock advisors, investors, and consumers.

We are in Phase II of a secular bear market. This phase of the bear market will move stock prices higher, as the bear convinces investors that stocks are a safe investment again. Phase II of bear market rallies can last three to four years. This bear market rally has lasted 32 months thus far and shows no signs of abating.

What He Said:

“A Stock Market’s Obituary: It is with great sadness that we announce the passing of the Dow Jones Industrial Average. After a strong and courageous battle, the Dow Jones fell victim to a credit crisis and finally succumbed on Friday, October 3, 2008, when it fell decisively below the mid-point between its 2002 low and its 2007 high.” Michael Lombardi in PROFIT CONFIDENTIAL, October 6, 2008. From October 6, 2008 to November 27, 2008, the Dow Jones Industrial Average experienced one of its biggest two-month losses in history.
Visit:

Profit Confidential

Profit Confidential Updates on Investment