What if the stock market is lying?
Does the stock market really tell us what the economy will be doing in six months? Not this time, says one U.S. analyst, so proceed with care.
The stock market stands like a beacon, forecasting what the economy will be doing six months from now.
As we wade out of the credit crisis, the market’s ability to be a soothsayer is trotted out by analysts time and time again.
But it may not be true.
Mr. Bob Carlson doesn’t believe it, at any rate. A conservative and patient investor, this U.S. analyst sees cracks in the argument — and advises other investors to proceed with caution.
One of the ways he is exercising caution is staying out of individual stocks. His managed portfolios in Bob Carlson’s Retirement Watch consist largely of bond funds, equity funds and exchange-traded funds.
His goal is simple: to preserve capital.
The time to aim for bigger gains has not arrived. And here’s why that time may come later than the stock market is pretending.
Attitude, not fact
Take a glaring example of the market’s faulty forecasting. In October 2007, stock indexes soared to all-time highs. Two months later, recession raised its ugly head.
The economy did not get better in six months, or a year. Stocks slid down to a low point in November 2008. Then the stock markets rallied, only to tumble down again in the new year of 2009, scraping bottom in March.
So let’s re-state the proposition. It just doesn’t make sense to consider the market an objective observer of the economy. Indexes reflect an attitude, not a statistical fact.
“The correct way to state the adage is that stock indexes register investors’ expectations for the economy and corporate profits,” says Mr. Carlson. “But the forecast isn’t necessarily accurate.”
The consensus of investors can be right, he concedes, but it can just as easily be wrong. And sometimes it’s wrong by a country mile.
The wrong direction
As we know, stocks have been going up since March 9. The Dow Jones Industrial Average went through the 10,000 barrier last week to much rejoicing (although it subsequently did a bit of backsliding).
The rally has strong technical support, the editor says, although trading volume isn’t as high as it ought to be at the start of a bull market. But there’s a more important caveat than that.
Six months have passed since early March, and the economic fundamentals that should support a rally are not in place. “If stocks are acting as a leading indicator of recovery, other indicators should be falling into place by now,” insists Mr. Carlson
But they’re not. In fact, some of those indicators are leaning in the wrong direction.
Never before
In the second quarter, corporate earnings beat expectations. But these were sharply lowered expectations, Mr. Carlson says. Earnings forecasts were much higher in the two quarters before that.
And companies beat those earnings expectations by cutting costs, not by building up their revenues. In fact, revenues remain low. For many firms, they’re still dropping.
“Sharp moves in speculative and junk securities are masking overall market movements,” the editor states. “In the high yield bond market, the worst credits have had the highest returns since the bottom. Likewise, small companies appreciated more than large companies.”
Employment isn’t encouraging, either. It is a lagging indicator, that is, one of the last to fall into place during a recovery. But companies “should have stopped cutting jobs in large numbers by now if the economy is recovering,” Mr. Carlson points out.
In fact, the stock market rose sharply while employment was falling just as sharply, which has never happened before, in this editor’s experience.
There’s one more telling indicator, he adds. If the economy was on the way back, companies should be shipping more goods. UPS, Federal Express and Union Pacific report little or no increase in business at home. FedEx says its only growth is coming outside of the U.S. and much of that, the editor feels, can be attributed to government stimulus spending.
Stocks are not cheap
In the face of all this, stocks are not cheap, Mr. Carlson says. “Investors can debate which earnings measure is the best indicator and whether dividend yield is a better valuation measure. But by any measure stocks are either fairly valued or somewhat overvalued.”
There’s another fly in the ointment as well. The stock market and the economy both grow when interest rates are high and starting to fall. But that equation is upside down right now — interest rates can’t get much lower. The only question is when they will start back up.
“The worst of the financial crisis appears to be behind us,” Mr. Carlson admits. Then he hammers home the point that trumps any pale signs of recovery. “Yet we don’t have the fundamentals that presage a sustained stock market rally.”
So keep a close eye on your capital, this editor warns. The stock market may be making some promises it can’t keep.
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