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.

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Why Stocks Will Rise

The Only Way the Stock Market Breakout Will Hold

By Mitchell Clark, B.Com

I continue to be dumbfounded by the actions of Greek politicians. Just when more certainty was returning to currency and stock markets, they screw it up again. Make no mistake; today’s stock market woes are largely due to the European debt crisis. I’m totally unimpressed by how this is being handled.
The stock market did a great job breaking out of its correction trading range. The question is, can the breakout hold? If Greece would get its act together, then this is a stock market that wants to go higher.
Everyone knows that corporate earnings tend to be managed by companies and Wall Street analysts. But corporate earnings have been decidedly strong this quarter and all throughout the year. I’m certain the stock market would be a lot higher today if it wasn’t for Europe’s sovereign debt crisis.
We’ve seen very solid corporate earnings from the technology sector, basic materials, healthcare, and industrial goods. Stock market investors revised their corporate earnings expectations lower going into 2012 and this is setting up the stock market for a new advance, providing that the debt crisis or some other shock doesn’t take place. It’s a tricky time to be a stock market investor—with the age of austerity comes a great unknown. There will be growth in the future, but will it be like it was before? It’s tough to imagine Main Street corporate earnings taking off without a new up cycle in the real estate market.
The current stock market is well set up for a decent rally. Valuations are reasonable, visibility for corporate earnings is mostly solid and there is lots of cash sitting on the sidelines. The key going forward will be renewed certainty on the European debt crisis and renewed spending from consumers. With confidence comes hope and with new hope for the future comes renewed consumer spending.
One thing that’s seems quite unlikely, however, is a speedy return to normal economic growth rates. We’re still coming off a major period of debt-fueled excess and both Main Street and Wall Street (banks in particular) are trying to establish a new normal for operations (see All Global Investment Risks Point to a Steady Dollar & Mediocrity in Stocks & Metals). I have to say that, if it weren’t for emerging markets, interest rates being low, and a weaker U.S. dollar, corporate earnings would not be so robust. Policy-wise, the Federal Reserve is making progress domestically. It’s Europe that’s holding things back.
The stock market was due for a little rest after such a strong breakout, but the Greek news was a real surprise. The expectation for the fourth quarter is for another round of solid corporate earnings and, accordingly, the breakout should hold. Any return below 1,200 on the S&P 500 Index would not be good technically. The stock market is muddling through the tough times. It’s time now for Greece to get its act together.

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Stock Market Got You Nervous? S&P 500 Says Smooth Sailing

By Michael Lombardi, MBA

Yes, I know all the news today is about the audacity of a Greece Referendum on getting free money (I talk about that in “Michael’s Personal Notes” below), but there are two stock market-related important news items I want to share with my readers first.
The third quarter ended September 30, 2011, marks the 11th straight quarter that the corporate earnings of the S&P 500 have beat analyst expectations.
Abby Cohen, senior U.S. investment strategist at Goldman Sachs Group Inc. (NYSE/GS) said yesterday that the S&P 500 is trading at a 33% discount to past periods of similar inflation. I’m not one to put much faith in the forecasts or statements of other analysts, but we need to put into context what Cohen is saying relative to corporate earnings at the S&P 500.
The S&P 500 is trading at 14.9 times current corporate earnings; not cheap, but not expensive either. However, the S&P 500 is trading at only 12 times estimated earnings for the 12 months ahead. With the S&P 500 beating analyst’s corporate earnings expectation 100% of the time over the past 11 quarters, achieving estimated earnings in the current quarter and the next three quarters of 2012 is not a stretch.
Dear reader; this is what I’m saying to you about stocks, as we enter the final two trading months of 2011:
The S&P 500 is priced at 12 times future earnings, an historic bargain. The dividend yield for the S&P 500 is presently 2.2%, better than what you can get on a 10-year U.S. Treasury (I’d rather own the S&P 500 than a 10-year U.S. Treasury for the next 10 years).
No, stocks are not a screaming bargain. But when you look at the interest rate environment today, when you look at the alternative investments to the S&P 500 and the Dow Jones Industrial Average, you realize that stocks are not a bad place to be, especially when the S&P 500 continues to surprise analysts and investors with corporate earnings that consistently beat estimates.
Please, don’t let the daily gyrations of the stock market influence you. Historically, stocks are undervalued compared to their corporate earnings and the present interest rate environment. Bullishness does not prevail amongst stock advisors and investors; in fact, bearishness does (see Forget the Economy: These Companies Are Still Earning Big Money).
These big daily losses and gains for the S&P 500 and the Dow Jones Industrial Average are a way for active traders to make a lot of money. While I realize it’s nerve-wracking to see the value of your investment portfolio fluctuate so much on a daily basis; but remember the more the daily markets fluctuate, the more money the day traders make. Traders want markets that move one percent to two percent a day!
For investors like you and me, there is very little evidence that the bear market rally that started in March of 2009 is over (see Strong Corporate Earnings and the Bear Market: How it Will Play Out).
Michael’s Personal Notes:
All the financial news this morning and yesterday was focused on the Greek Prime Minister’s idea for Greece to have a referendum on the Europe Union’s financial rescue package.
It’s a good thing.
The euro, my dear reader, is in jeopardy. When I travel to Europe each year (twice so far in 2011), I can’t understand how 17 countries, all with different goals and aspirations, can share the same fiat currency. It’s quite unbelievable how economically rich and poor countries share the same money.
Italy’s primary goal these days is to increase tourism. Germany’s goal, from what I can see, is to become the leading economic growth engine of Europe, with the headquarters of all the major European manufacturers (think cars) located in Germany.
The obvious is the obvious. Under the pressure of German Chancellor Angela Merkel and French President Nicolas Sarkozy, European banks agreed to take a 50% haircut off the value of their loans to Greece. Merkel and Sarkozy spearheaded an unprecedented European Union bailout of Greece.
And what does the Greek Prime Minister do? He throws a big wrench in the plans: he wants his people to vote on it! He wants his people to vote on getting free money!
While frowned upon by equity analysts and the media, a Greek referendum is sheer genius.
Here’s what a Greek referendum on the proposed European Union’s bailout of Greece does: it signals that democracy is important in Greece, it solidifies the Greek Prime Minister’s popularity (Andreas Papandreou’s popularity among voters plunged after he introduced so many austerity measures), and it confirms that Greece wants to be part of the euro currency. And that is what it’s all about…making sure the euro survives.
Greece has a sweetheart of a deal: Greece will receive about $180 billion and enjoy a 50% write-down in the value of its debt. It literally is free money. The Greek voters are not stupid. They know the severe repercussions if Greece doesn’t accept the European Union-led bailout. What this vote really does is strengthen the euro, something that will make the Chinese “lenders of last resort” very happy.

Where the Market Stands; Where it’s Headed:

Nice way to start a month…
The Dow Jones Industrial Average plunged 297 points in its first trading day of November. For the record, the Dow Jones Industrials gained 12.5% in October…one of its best months on record. In October, the stock market rebounded from the severely oversold level I had been writing about the past few weeks.
No, the bear market rally in stocks that began on March 9, 2009, is not over. The stock market doesn’t roll over and collapse when stock advisors are bearish and when investors are so worried about the economy and the stock market.
We are still in a Phase II bear market. During this phase, the stock market moves higher during a rally that can last three to four years. The purpose of the rally is to bring stock market investors back into stocks with the false sense that the economy is recovering.

What He Said:

I’ve been pushing gold bullion and gold shares for over a year now. Bank in January 2002, I personally started buying gold shares.” Michael Lombardi in PROFIT CONFIDENTIAL, December 13, 2002. Gold bullion was trading under $300.00 an ounce when Michael first started recommending gold-related investments. Many gold stocks recommended in Michael’s advisories have experienced spectacular gains.
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