Some Thoughts About the Pullback in Equities

Good Evening: Global equities suffered a broad retreat today, with most of the damage centered in Asia. China in particular has been a standout to the downside of late, a situation I tried to call attention to last Wednesday. Including Monday’s 6% drubbing, the major Chinese indexes have declined 15% or more (the CSI 300, for example, is down almost 17.5%) since their intraday highs on August 4. The major U.S. averages have been slower to correct, with the benchmark S&P 500 down less than 4% since setting its high on August 7. Economically sensitive equities have been leading the way lower, and, with risk appetites are suddenly on the wane, I will offer some thoughts as to why the storm clouds of correction seem to be gathering in what was only last week a seemingly crystal blue sky. My preliminary conclusion would be that it appears sentiment has leaped ahead of the fundamentals.

With Chinese demand for commodities and the resulting economic growth figures in that nation increasingly under question last week, Thursday marked a bit of a turning point in perception. July retail sales in the U.S. were very disappointing, especially in light of the tailwind provided by the “Cash for Clunkers” program. Since U.S. consumption is the final resting place for much of the world’s excess production, the retail sales figures were particularly unwelcome in markets outside the U.S. Our markets would probably have retained their early losses on Thursday if not for some euphoric hoopla surrounding John Paulson’s reported purchases of certain financial stocks.

Mr. Paulson did indeed see the credit crisis coming — and profited handsomely from its arrival in 2007/08 — but the fanfare given his purchases of Bank of America, Regions Financial, and others seems a bit misplaced. After all, these purchases were made during the quarter ending June 30, and we have little to no idea what has become of them since that date. Furthermore, Mr. Paulson set up a separate fund vehicle in late 2008 with the expressed purpose of buying distressed financial companies. It’s hard to draw performance fees from T-Bills these days, and those investing in his new fund were likely happy to see Mr. Paulson add some fallen angels during Q2 to what might have previously been lightly populated quarterly statements. Thus, the names that caught this smart investor’s fancy are likely less a commentary about Mr. Paulson’s bullishness on the whole financial sector as it might be on the relative attractiveness of the specific companies in which he took a stake. Whatever the real story may be, the averages re-tested their August 7 highs with the ringing of Thursday’s closing bell.

Friday brought a surprising decline in the University of Michigan’s consumer sentiment survey, a fact which only underscored the nascent concern surrounding retail sales and the health of U.S. consumers. The major averages took a 1.5% tumble early Friday morning, only to have a late rally halve those losses at the close. But investors in Asian securities handled these two economic data points with far less aplomb this morning. Adding to the angst in the Far East was a less than stellar GDP report for Japan. The resulting damage then spread to Europe, and our stock index futures were indicating losses of more than 2% early this morning. Lowe’s, itself a model of retail spending, then laid an earnings egg before trading commenced in New York. Neither the first positive reading in months for the Empire manufacturing survey, nor a surprisingly decent TIC report could stem the tide of selling at today’s open.

U.S. stock market indexes were 2.5% the worse for wear within minutes this morning, and they never did recover this lost ground. The rallies were as tiny as they were brief, and an uptick in the Housing Market Index was quickly dispatched. The 50 mark is neutral, so when the wire services hailed a reading of 18 as “a new high for 2009!”, the news was properly viewed as being little more than the tallest of this year’s 8 dwarves. When the Fed later released a survey showing bank loan officers continued to tighten lending standards last quarter, it overshadowed all the other economic data points (see below). If credit is the lifeblood of economic activity, then the U.S. looks set to remain a couple of pints short until lenders once again start saying “yes!” to loan applicants.

After the early drop, stocks mostly went sideways for the rest of Monday’s session. The vaunted late day rally was a no show today, and the major averages went out with losses ranging from 2% for the Dow, to 3.5% for the Dow Transports. Treasury investors were already in fine spirits (last week’s auctions went well), and the weakness in equities further enlivened them. Yields fell between 3 and 9 bps as the yield curve flattened. The dollar enjoyed a knee-jerk, flight to quantity rally of 0.5% today, and commodities continued to sink. Hit hard last week, prices fell in every sector of the CRB today as that index posted a loss of 1.6%.

Stock Market Has Gotten ‘Overly Optimistic’: El-Erian

As I left for home last Thursday evening, I really felt that what I was going to write about that night would prove useful for some readers. I had lined up both articles and data to support a conclusion that would be evident from the title alone: “Investor sentiment is way ahead of the economic fundamentals”. Alas, due to a last second change in my family’s social calendar, the bulk of the piece went unwritten. I toyed with the idea of trying to send out a brief version of it on Friday morning, but PIMCO’s Mohamed El-Erian beat me to it. As you’ll see from this story and its accompanying video, Mr. El-Erian’s comments rendered mine to somewhere just above copycat status. Given today’s worldwide downdraft in equities, however, I’ve decided to give last week’s thoughts another chance.

Massive headwinds restrain Consumer
Retailers massively disappoint

By the middle of last week, most economists and pundits were declaring the Great Recession over. Happier times lay dead ahead, at least in the eyes of the many economists who never saw our credit crisis coming. But I think U.S. consumers will be challenged to spend as much as they did when they had swollen amounts of equity in their homes and their stock market portfolios — not to mention access to overly easy credit. Now that equity values of all types still pale compared to those fetched only a year ago, and with credit standards still Scrooge & Marley tight, I have to agree with both Mr. El-Erian and the economists at BAC-MER when they conclude the 70% of the U.S. economy devoted to consumption will hobble GDP growth in the quarters ahead.

Investor Survey Results (an AAII exclusive) — Released August 17, 2009

Reported Date Bullish Neutral Bearish
August 13: 51.00% 16.00% 33.00%
August 6: 50.00% 14.84% 35.16%
July 30: 47.67% 20.93% 31.40%
July 23: 37.60% 20.00% 42.40%
July 16: 28.68% 24.26% 47.06%
July 9: 27.91% 17.44% 54.65%
July 2: 37.84% 17.57% 44.59%
June 25: 28.00% 23.20% 48.80%
June 18: 33.33% 20.24% 46.43%
June 11: 39.25% 21.50% 39.25%
June 4: 47.56% 15.85% 36.59%
May 28: 40.37% 11.01% 48.62%
May 21: 33.72% 20.93% 45.35%
May 14: 43.81% 20.95% 35.24%
May 7: 44.09% 22.58% 33.33%
April 30: 36.09% 20.30% 43.61%
April 23: 31.82% 29.55% 38.64%
April 16: 44.14% 20.00% 35.86%
April 9: 35.71% 20.00% 44.29%
April 2: 42.66% 20.28% 37.06%
March 26: 39.13% 18.48% 42.39%
March 19: 45.06% 16.67% 38.27%

Stock Bulls Increase as Survey Shows Most Optimism in Two Years

If the foregoing analysis about the disconnect between the economic facts on the ground and the quoted prices for so many securities in the ether is on target, then what does investor sentiment tell us about the potential for a reversal of what have heretofore been growing risk appetites since March? I submit the table and article above. The table, courtesy of the American Association of Individual Investors (AAII), is meant to measure sentiment among individual investors. Unsurprisingly, this latest reading depicts the highest level of bullish sentiment since this bear market grew claws. The Bloomberg article you see below it attempts to measure the sentiment levels among institutional market participants. Here, too, are new highs, though still quite a bit below peak readings. If individuals and institutions are getting more bullish as the market goes higher, then who, pray tell, will be left to turn bullish?

Cramer: Why Media is Wrong About Market

Enter CNBC’s Jim Cramer. Faced last week with what he considers undo pessimism in the media about the market in general and some of his favorite stocks in particular, the video above in defense of S&P 1000+ is nothing short of a rave. Cramer squawks so much about why everyone should be bullish that I think he should co-host with Mark Haines and Erin Burnett every morning. Cramer screams and rants that the media is simply too negative about the stock market, that investors should be thankful many of the companies mentioned aren’t going bankrupt. Agreed, Mr. Cramer; we’re all grateful. What price should we then feel safe in paying for a business where revenues are down and earnings exist only due to the type of cost cuts that can neither easily be repeated nor can be called a macro positive for the rest of the economy? His rant is a great example of just how market prices can become disconnected from reality — at least in the short run. No wonder sentiment measures peaked almost as soon as this broadcast aired. I guess no price is too high when a market is going higher, but there’s an old saying on Wall Street: “When you’re yelling, you should be selling”. Cramer was yelling last week at the highs. Hmmm; what should we at least think about doing next?

— Jack McHugh

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