Despite What the Bears are Saying, We're in the Market Sweet Spot

By , Contributing Writer, Money Morning •

Why is it important to have government and central banks on your side? Let's take a look.

The most important ingredients for rising stocks prices are not corporate earnings and global economic growth. Instead, the key elements are interest rates, inflation and sentiment along with help from government fiscal and tax policy.

Right now, we are living in golden times for the "Big Four:" Inflation is low, interest rates are very low, governments around the world are pouring money into the economy and sentiment is still well below bull market peaks. Historically, analysts at independent BCA Research say, this is the environment in which stocks prices have done their best.

As long as a recovery remains anemic with lackluster job growth, it remains the subject of tender mercy by policymakers desperate to placate an unhappy electorate. And so it is weakness that keeps the government from withdrawing assistance by applying higher interest rates, raising taxes and halting loan support programs.

The recent fall in China stocks is a perfect example of this theory in action. The declines come amid new evidence of economic strength. Traders were spooked by Beijing's efforts to tighten runaway loan growth and tighten monetary policy -- not by any evidence of economic weakness.

And remember that rocket launch out of March was fueled in part by the U.S. Federal Reserve's announcement it would directly purchase $300 billion worth of U.S. Treasury debt through its Permanent Open Market Operations. Is it any coincidence that stocks are beginning to weaken as that initial allocation begins to run dry? According to my calculations, more than $276 billion has already been spent. At current spending rates, the remaining funds will only last another two weeks or so.

My guess is that a new allocation will be announced after the next Fed meeting on Sept. 23, especially if the stock market remains on shaky footing. More easy money, along with continuing signs the global economy is moving slowly in the right direction, will likely reenergize the bulls later this month. As shown in the chart above, Credit Suisse Group AG (NYSE ADR: CS) economists are projecting a synchronized global recovery in which it will take nearly a full year for global gross domestic product (GDP) to recoup its losses - the weakest recovery in the three global recessions since 1970.

If recovery is indeed drawn-out, this is paradoxically great news. It seems backwards, but a long, slow, U-shaped recovery is exactly what investors should want to see. The robust, V-shaped economic recovery that politicians seem to want would be the worst possible thing to occur.

The Week in Review

Stocks jumped higher on Friday in spite of a slightly weaker than expected jobs report. A brief dip into negative territory during early trading was quickly reversed before the major indices finished near the session highs. It was the largest victory for the bulls in two weeks and hit bears like an elbow in the face after they had achieved a 4.6% multi-day decline through Wednesday.

The Dow Jones Industrial Average gained 1%, the Standard & Poor's 500 Index gained 1.3%, the Nasdaq Composite Index gained 1.8%, and the Russell 2000 gained 1.4%. Over the last two days of the week, the S&P 500 was up 2.2%.

Volume was light, with slightly more than 1 billion shares trading on the New York Stock Exchange (NYSE: NYX) - the lowest level of activity since the middle of August. This is typical behavior heading into a long summer holiday weekend, as traders leave the office early to prepare for a few days off.

Bulls obviously weren't distracted by their vacation plans: Breadth was positive, with up volume accounting for 86% of total volume. Buying power jumped four points while selling pressure fell five points, providing more evidence that the recent pullback has been driven more by a withdrawal of buying interest than a resurgence of short selling and profit taking. This is one reason we believe the current decline will be limited in scope and should be taken as an opportunity to add to long positions in the context of a new bull cycle.

All of the major sector groups finished in the green on Friday. Industrial and consumer discretionary stocks led the day. General Electric Co. (NYSE: GE) gained 3.1% while heavy equipment maker Caterpillar Inc. (NYSE: CAT) gained 2.4%. Resorts and casinos caught a bid Friday, with Las Vegas Sands Corp. (NYSE: LVS) rising 8.2%, Wynn Resorts Ltd. (Nasdaq: WYNN) rising 5.9%, and MGM Mirage (NYSE: MGM) rising 5.5%.

Airline stocks were also big movers Friday after Southwest Airlines Co. (NYSE: LUV) reported a slight increase in demand for August as businesses relax travel bans and vacationers return to the skies.

Technically, the bulls were able to fend off the bears after Tuesday's big 90% down day - but they haven't exactly covered themselves in glory either. Although Thursday and Friday saw decent rallies, both failed to cross the 90% up volume threshold.

The bottom line is this: Skeptics of the post-March rally still abound. Bears were comforted last week by the fact that they have managed to defend the critical 80-week exponential moving average of the S&P 500, shown above. The 80-week EMA was a bloody battleground for two months in the summer of 2003 before bulls emerged victorious. Bulls then defended the 80-day MA six times through late 2007 before it giving way in December that year. In April 2008, bears repelled buyers following the rescue of The Bear Stearns Cos. And finally, late last month, the bears defended the 80-week EMA again for the first time in 16 months.

Bears know they must make their last stand here right now. If the 1,035-1,055 defense on the S&P is breached, short-sellers will be forced to cover in droves and bulls will march the index straight up to 1,200. This will be the most interesting fight of the third quarter. I believe that bulls will win for the simple reason that this line has already been breached in emerging markets, and the U.S. market has been the follower, not the leader, in all upside moves for at least the past six years.

Job Market on the Mend

Friday's big news was the August employment situation report in which the unemployment rate jumped from 9.4% to 9.7% (the highest since June 1983), while payroll declines came in at a loss of 216,000 jobs compared to the 247,000 that were lost in July. Revisions to June and July resulted in an addition net loss of 49,000 jobs. While the elimination of nearly a quarter million jobs is still terrible, it does manage to continue the steady decline in the pace of job losses that we've seen since the beginning of the year. Compared to the rapid acceleration in job loss last fall, the healing process is proving much more gradual.

Gluskin Sheff + Associates Inc. economist David Rosenberg, who remains ferociously bearish, immediately ripped into the numbers as yet another example of how the U.S. economy "remains fundamentally weak." He finds that, despite the heavy doses of stimulus administered by the White House and the U.S. Federal Reserve, "there is nothing they can really do about employment, barring legislation that would prevent companies from continuing to adjust their staffing requirements to the new world order of credit contraction."

I bet he's fun at parties.

Rosenberg goes on to feature some disturbing facts. A full 65% of all companies are still in the process of slashing their headcounts. The adult male unemployment rate has expanded to 10% as male-centric jobs in construction and manufacturing are slashed while sectors traditionally dominated by women, including education and health care, remain less affected. Manufacturing employment, which is showing some signs of stabilization, cut 63,000 jobs and now has its lowest level of employment since April 1941.

And there is also the problem of the rising ranks of long-term unemployed as more job losses are permanent rather than temporary layoffs. A full 54% of the unemployed are not temporarily laid off, while 33% have been looking for a job for six months or more.

The longer people are out of work, the more skills are lost and the harder it is to reintegrate into the work force. Not only is this socially damaging; but it reduces the potential growth rate of the economy. This is the effective speed limit at which the economy can grow without causing inflation.

A slightly more optimistic take on the employment numbers comes courtesy of Philippa Dunne and Doug Henwood of the Liscio Report. They find a few nuggets of good news: Private services lost just 62,000 jobs, the smallest drop since April 2008; Retail lost just 10,000, its smallest drop since January 2008; and most of the construction losses are coming from finishing vocations, not basic construction.

But they find bad news too. The employment-to-population ratio has fallen to 59.2% - the lowest since March 1984. The probability of an unemployed person from July finding work in August fell to 19.8% - the lowest in 51 years of data.

Let's end on an optimistic note. Since the recession started, 6.9 million jobs have been lost. This is roughly 5% of total employment - the worst showing since the demobilization following World War II. According to an International Monetary Fund (IMF) study, the average employment loss in recessions caused by financial crises is 6.3%. According to this metric - along with the declining pace of job losses - it appears we're nearing the end of this frightful chapter of economic history.

And if you'll allow me - the cynical capitalist - to express a point of view, it's this: The more companies cut jobs, the more their expenses drop and the more their earnings (corporate profits) rise. The reason that unemployment persists long after recessions end is that companies become addicted to headcount reductions once they realize that the market always rewards cost-cutting. While policymakers and citizens complain that a reduction in workers will lead to a reduction in sales, the market persists in preferring the productivity gains of slimmed-down, more motivated labor forces.

Last Week in Review

Now let's check in on what happened last week that moved the market and may important implications for our outlook.

Monday: The Chicago Business Barometer Index increased to the 50 level from a prior reading of 43.4 -- signifying no change in business activity from July to August. For the important Midwestern region, which is heavily dependent on the manufacturing industries, it was an important indication that the recession is ending. Overnight, the Shanghai Exchange dropped 6.7%. Commodity stocks weakened as the major indices fell out of their trading ranges near rally highs.

Tuesday: The S&P 500 dropped 2.2% in the first 90% down day since Aug. Risk aversion increased with financial stocks showing weakness as the CBOE Volatility Index jumped 12.1%.

Stock market weakness arrived despite a solid 52.9 reading for the latest Institute for Supply Management manufacturing index. With a reading over the unchanged level of 50, the result was the highest reading since June 2007 and indicates manufacturing activity expanded in August compared to July. Nearly a 10% jump in new orders drove the result -- which is the largest increase since 2004.

Motor vehicle sales jumped 21% to a 10.1 million annual rate, versus 8.3 million in July. The increase was underwhelming as expectations of the effectiveness of the government's "Cash-for-Clunkers" program were riding high. Chain-store sales were weak, as it appeared the back-to-school season was off to a rough start. Backing up other indications of renewed strength in housing, residential construction spending bounced 2.3% higher in July, after a 0.4% drop in June.

Comment: We are seeing early signs of a rebound in construction as the inventory of new homes continues to fall. This will provide a boost to the construction component of GDP for the rest of the year.

Wednesday: Stocks traded flat on high volume after Tuesday's big spill. Conservative assets like gold and U.S. Treasury bonds found eager buyers. Factory orders jumped 1.3% in July, the largest increase since June 2008. The result was caused by a 5.1% jump in durable goods orders. In turn, this was led by an aircraft-related 18.5% increase in orders for transportation goods.

Minutes from the August meeting of the Federal Reserve exuded confidence that the economy is healing and that the recession is ending. Still, participants believe that the recovery will be quite slow. It appears the Fed believes monetary and fiscal stimulus measures will continue for some time.

Comment: A feeble recovery combined with accommodative Fed policy is the perfect recipe for stock market gains. The longer the economy is weak, the longer inflation and interest rates will remain low.

Thursday: The bulls ended a string of four consecutive down days by pushing the S&P 500 up 0.9%. Retailers reported a 2.9% decline in August sales as frugal customers continued to cut spending. Monster's Employment Index, which is based on online job postings, posted its largest monthly increase in four years. The Institute for Supply Management's non-manufacturing index increased to 48.4 for an improvement of two points. Yet, with a sub-50 reading, the result indicates a contraction between July and August. There is room for optimism as the business activity sub-index increased to 51.3, signifying a possible turnaround of the services sector.

And finally, the Federal Reserve reported that the money supply continues to contract slightly. After last fall's credit crisis, the Fed brought the rapid increase in the money supply to a screeching halt in January. Changes to the money supply act on stock prices with a lag of approximately eight months. This is one of the reasons we expect to see some choppy trading over the next few weeks.

Comment: With a late Labor Day holiday this year, analysts will be closely watching September's retail sales numbers to get a better read on the back-to-school season and what it means for holiday shopping later this year.

The Week Ahead

Monday: Markets closed for Labor Day.

Tuesday (Today): We will get an update on consumer credit for July. Previously, a $10.3 billion contraction was reported in June as households continue to increase savings and pay down heavy debt burdens. Currently, the household debt-to-income level stands at 131%, versus the 91% ratio that prevailed in the 1990s.

The Dow Industrials have been up for 12 of the last 14 post-Labor Day trading sessions. Two highlights: a 3.4% increase in 1997 and a 5% rise in 1998.

Comment: According to Merrill Lynch economists, a return to the 91% ratio would require the elimination of $4.35 trillion in debt. This works out to a 15% debt reduction each year for the next two years. A less-severe scenario would see debt levels return to the long-term trendline - requiring a total reduction of $1.75 trillion, or a 4.5% reduction for each of the next two years.

Wednesday: The Federal Reserve releases its latest Beige Book summary of economic conditions.

Thursday: The latest trade balance figures will be released.

Comment: The 11.2% slide in the dollar since March has provided a boost to U.S. exporters. Along with a slide in oil prices, an improved trade balance helped support GDP growth in the second quarter.

Friday: Latest consumer sentiment numbers from the University of Michigan's survey are due.

Market Direction

Another potential head-and-shoulders reversal pattern is being traced out. A similar reversal pattern appeared between May and July, but was ultimately invalidated by the huge rally that started just after a neck-line violation. Still, we saw a significant 6% decline as stocks fell from the right shoulder. Could we see a repeat performance this month?

The odds still seem to favor a short-term decline. Breadth continues to narrow. Although we've returned to the levels that prevailed in early August, fewer stocks are holding the market up. In other words, while we haven't fallen far from recent highs, the market's foundation is slowly weakening.

Again, I want to stress that I don't believe we're on the verge of a major market top, despite the breathless proclamations of the bearish strategists and commentators you might see on CNBC. Paul Desmond of Lowry's notes that measures of the supply-and-demand for stocks continued to move in favorable directions as the rally reached its high on Aug. 27. Normally, in advance of a significant top, institutional traders start to trim their long positions. Such an action would be reflected in rising measures of selling pressure. We didn't see that in August, so the odds still favor bulls.

My expectation is that there may be a lot of skirmishes over the next few weeks, as optimists and pessimists battle over 80-week average and estimates for third-quarter earnings. Unlike last year at this time, I expect the optimists to emerge victorious as they have central banks and global governments on their side and credit markets are healed and back in business.

[Editor's Note: Analyst Jon D. Markman is a veteran financial columnist and is the editor of the Strategic Advantage Newsletter. Anthony Mirhaydari was the researcher on this report.]

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