David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).
Does the Stock Market Rally have Legs?
April 11, 2009
Is this rally real? Does it have legs? Questions like these are now raised daily by investors and by TV anchors on the financial shows. The CNBC Power Lunch fearsome foursome panel called me a “dodger” when I wouldn’t take their bait last week.
Our response was then and still remains: the answer is a definite, 100% “Maybe!” You can see the interview on www.CNBC.com . Search under “kotok”. All three segments are listed under April 6.
Ok, let’s go back to the rally question raised on CNBC’s Power Lunch. Stocks seem to have established a serious interim (if not permanent?) low on March 9, when the S&P 500 index hit 666. We initially thought the November 20 low would mark the interim bottom but we were wrong. The question now involves 666.
Since the March 9 low, the S&P 500 has rallied strongly. Using the ETF that is supposed to track that index, with the “spider” symbol SPY, we note that from March 9 to the April 9 pre-holiday close, SPY has delivered a total return of 26.9%. Perhaps more importantly, the equal-weighted S&P 500 ETF, symbol RSP, has outperformed the cap-weighted SPY by ten points. Since March 9, RSP is up 36.2%. This is a continuation of the broadening market trend we have seen since the November 20 low. A widening acceptance of stocks and broadening buying is a very favorable sign. Note that Cumberland has switched from SPY to RSP in our “core” ETF strategy for the US market. We did that after the November low and as soon as we saw the market broadening. When the stock market is broadening, you want to be more equal-weighted; when it is narrowing out of fear, you want to restrict to the very largest caps, which are viewed as the safest.
Okay, so the answer to our rally question is “so far, so good.”
There are many favorable signs. Elements in the credit markets (like commercial paper rates and money market funds) are functioning and improving. Where Fed policy has been applied with enough size and precision, the result has been to ease the market and repair some of the damage. There is every reason to believe the Fed will persist in this approach and enlarge it. Consumer finance and housing finance are the current big targets; hundreds of billions will be thrown (lent) at those sectors.
On the list of unfavorable signs, we note that other sectors that have improved from their worst case are still not fully functional. LIBOR at 3 months is still nearly 100 basis points higher-yielding than the 3-month Overnight Indexed Swap rate (OIS). Banks still do not trust each other when it comes to default risk. Many banks are electing to lend excess reserves to the Fed at a yield of 25 basis points rather than to each other at a yield of 125 basis points. We see this distrust in the very wide spreads between bank debt backed by the FDIC vs. debt of the very same bank that is not FDIC-backed. The spreads are huge.
Last week’s Wells Fargo-led rally aside, markets do not trust the banks. They trust the FDIC. For proof, watch the rates on CDs between $100,000 and $250,000 as the maturities go beyond the existing temporary FDIC insurance on the higher amount. Markets also do not trust the government programs when it comes to durability and consistency. Who can blame them? When it comes to the rules, the government seems to change its mind every week.
Another unfavorable sign is found in the corporate credit spreads. A study of longer-term, lower-risk corporate bond spreads confirms the predictive ability of credit spreads in this sector. They were an early warning sign for the 2007-8 crises. Indications today are that we are headed for a worsening of the employment situation. In fact, the statistical work from this excellent research suggests that as many as another 7 million jobs will be lost before the recession ends. That is on top of the 5 million already lost. We will have more to say on the employment situation below. The study is to be published in the Journal of Monetary Economics and is written by Simon Gilchrist and Vladimir Yankov.
This study has us concerned, because the biggest open question for us is in the jobs arena. Normally the employment statistics are considered to be lagging indicators. Normally the unemployment rate continues to rise as the economy bottoms and commences a recovery. Likewise, the unemployment rate tends to hit its lowest point after the growth rate of the economy has peaked. Normally, there are corresponding movements in profits.
The most robust profit growth comes at the time the economy is exiting a recession and beginning to recover. Firms that are still survivors have become lean and mean and experience rapidly widening profit margins as business picks up. They do not immediately hire back their furloughed workers. Instead, they deploy their capital investment in the sector that gives them the fastest payback with a productivity gain from the remaining workers. That is why the tech sector does so well coming out of recessions. Note that Cumberland his overweighted the tech sector and many of its subsectors, with software being the most intense overweight.
So history would say that jobs are lagging indicators and that this March 9 low was “the” low. But we worry that this time may be different. We are investing as if the rally is real and will have legs. We think we are seeing a V and that March 9 was the bottom. But we worry that it may really be a W. Remember, the upward leg of the V and the first upward leg of the W look the same when you are in them. We are prepared to reverse our position if our fear is further supported by forward-looking data.
V or W? Here is the fear.
The unemployment rate is now about 8.5% and still rising. Most of the forecasts we respect have it peaking at between 9.5% and 10%. That peak is another six months to one year in the future. After that, the unemployment rate declines very slowly. Remember, this measure of recession has doubled in the last year. The unemployment rate in the US was 4% only a short time ago. This is a huge shock, and it is the size of the shock that worries us. And if the corporate bond spread forecast mentioned above is correct, we may see the unemployment rate above 10%.
There is another issue that hides below the radar screen. We have numerous anecdotes about the 7 to 12 million undocumented workers who can be seen in our construction and service businesses. They produce a driver’s license and ID and they get a paycheck. They appear in the payroll surveys and in data compiled from payroll tax filings. When they are laid off, they tend not to apply for unemployment benefits, and they tend to avoid surveys. They are afraid of deportation. That means the employment statistics are deceiving us, because they are counting these folks in the payroll data when it is positive but are not capturing the same workers in the unemployment numbers.
Ned Davis Research has attempted to reconcile this and other gaps. NDR concluded on April 3 that “Adjusting the household survey to the payrolls concept resulted in a large loss of nearly one million workers (ouch!), narrowing the gap between the two surveys, and eliminating a potential positive.” If NDR is correct, the recent employment report was really ugly, and markets have misread it as moderating.
Many of the employment statistics are very bad. The “underemployment rate” is about 16%. Remember, if a mid-management executive loses his $80,000-a-year job and finds another one as a $15-per-hour administrative staff person, he is counted as employed in either category. Clearly his household has been hurt by the loss of income. The underemployment statistic is an important one to watch. It is at a record level.
Barclays (April 3) notes that “A turn in job growth does not always last: in the long 1982 recession, there was a double bottom in employment growth, and in the 2002-2007 expansion, there was a mini-jobs recession in the run-up to the war in Iraq.” Clearly there can be Ws instead of Vs.
We will sum up. The stock market may be in a V or it may be in a W. We cannot tell. There are favorable signs that support the March 9 low of 666 as the bottom of a V. There are unfavorable signs that suggest this is a W and that after this rally another downward leg lies in our path.
Our current strategy remains at about 50-50 stocks and bonds in balanced accounts. We think the stock market has an upward bias in the near term. We also believe that Treasuries are richly priced and should be sold. Higher-grade corporate bonds and taxable municipal bonds are desirable. Tax-free Munis are very cheap and are our most favored, risk-adjusted asset class for American investors in high income tax brackets.
David R. Kotok, Chairman and Chief Investment Officer, email: email@example.com
Copyright 2009, Cumberland Advisors. All rights reserved.
The preceding was provided by Cumberland Advisors, 614 Landis Ave, Vineland, NJ 08360 856-692-6690. This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness.