By Eric Sprott And David Franklin, Sprott Asset Management
Wither Green Shoots
With the summer now upon us, the "Sell in May and Go Away" adage has proven itself true once again. The major market indexes are all turning downward, and while they haven’t dropped enough yet to warrant panic, we certainly want to be positioned properly if this trend continues into the fall. The market tea leaves are no longer sending mixed signals either – most of the new data is decidedly bearish. So what happened to all the ‘green shoots’? What happened to the strong recovery the market rally was promising?
Economic data released over the past two weeks have decimated any remaining belief in a lasting economic recovery. Slowdowns are appearing in the US, Europe, Japan and even China. Auto sales, housing starts, employment, consumer confidence, factory orders, consumer purchase intentions - just about every aspect of the economy that can be measured, is showing decided weakness.
Of particular interest to us over the past year has been the GDP forecasts released by The Consumer Metrics Institute in Colorado ("CMI"). CMI caught our attention with their real time tracking of consumer retail sales data. Consumer spending represents 70% of GDP, and that spending can provide great insight into the workings of the underlying economy. CMI’s retail sales data has indentified a long, negative contraction in the economy based on their data set for the last 180 days. This was confirmed most notably in Walmart’s poor first quarter sales results when CFO Tom Schoewe stated, "More than ever, our customers are living paycheck to paycheck."1 If that sentiment applies to other large retailers, it doesn’t bode well for 2010 GDP.
CMI also predicted 2010 Q1 GDP growth at 2.62% all the way back in November 2009. It took nearly seven months for the actual US GDP data to eventually be released, but when it finally did (after three revisions, no less) it turned out that CMI’s prediction was bang on. Interestingly, when the real data came out, CMI founder Rick Davis noted that the inventory component underlying the 2.7% Q1 GDP growth figure had moved from 1.65% up to 1.88% – meaning that the bulk of GDP growth, almost 66%, actually came from inventory swings rather than consumer demand. No wonder factory orders fell out of bed this past week! With the re-stocking complete, there aren’t enough new orders to clear the fresh inventory. And if two thirds of Q1 growth came from inventory swings (or just plain re-stocking etc.), it makes us wonder what we can realistically expect from the next two GDP announcements. CMI provided the following guidance for the balance of the year, stating that "We expect GDP growth to be flat for the second quarter, but with inventory adjustment reversals absolutely killing the reported ‘growth’ number just four days before the U.S. mid-term elections." If that turns out to be correct, it will be unfortunate timing for the elections.
An important question to ask is whether the March ’09 rally was really justified at all. Were the green shoots real? Or was the market just looking for a way to justify the effects of government-induced ‘easy money’? The stock market is supposed to be an efficient, forward-looking indicator after all – and the rally that began in March ’09 was supposed to signal a robust recovery. So where’s the recovery? From the time the term ‘green shoots’ was first uttered by Ben Bernanke on March 15, 2009, the S&P 500 rallied 36% to June 30, 2010 and by as much as 60% to April 26, 2010. If the green shoots were really just the early indications of weeds, was the market wrong to appreciate so dramatically?
There is little doubt that much of the stock market action during the past 12 months has defied traditional market rules. Nowhere is this more evident to us than in the banking stocks. We’re still scratching our heads on the whole sector. Readers may remember an article we wrote in November 2009 entitled "Don’t Bank on the Banks" in which we discussed the hazard of leverage in the banking system. If you gauge our conclusions by what actually transpired in the banking sector as a whole, we were essentially correct. Of the 986 bank holding companies in the US last year, a total of 980 of them LOST MONEY.2 And that’s even after all the government bailouts the sector received. Hmmmm. Robust banking recovery? Not a chance. However, the remaining six banks, all of which are "too big to fail", did manage to earn a combined $51 billion in 2009, sending their stocks soaring as a result. So despite 980 out of 986 bank holding companies returning nothing but red, the sector actually fared pretty well from a market perspective. Does this make any sense to you? Here we have an entire sector that is essentially broken; where a mere handful have maintained profitability not from their own strength but thanks to the taxpayers’ bailouts; and where the government is now aiming the most powerful of their regulatory reforms – and the market decides to pile into their respective equities?
The banking sector isn’t the only equity space that confounds us – the housing stocks are as equally absurd. Despite what you may have heard from your local real estate agent, the fundamentals for US housing are looking dismal. Ever since the tax credits have rolled off, new home sales are now running at 300,000 on a seasonally-adjusted annual rate ("SAAR"), representing a new all time low this past May. For comparison, this is down from an all time high of 1,389,000 new home sales made in July of 2004.3 Reading this, you may expect the home builder stocks to have performed poorly. But no, not in this market! As you can see in Chart A, from the day that Bernanke first saw his ‘green shoots’, the home builders index appreciated by 47% to June 30, 2010, peaking at 104% on April 23rd – all while new home sales were down 14% over the same time period on a SAAR basis.4 ‘The Market is Always Right’, as they say, but it simply can’t be with regard to these stocks. The housing ‘green shoots’ were the product of government initiative, rather than true fundamental improvement, and were thus short term in nature. Now that the government program has ended, the whole sector looks poised to fall apart.
At the end of the day, nobody should be surprised by the recent economic data. The stock market rally that began in March ’09 was driven by monetary phenomena rather than anything fundamental, and based on data from CMI for 2010 it appears that we have already entered an economic contraction phase. The market is now beginning to reflect the fact that the green shoots were actually just the early signs of weeds, and it would suffice to say that virtually all the major world governments have some serious gardening to do. The recent contractions don’t necessarily mean that we’ll experience a repeat of 2008’s stock market performance in 2010, but it does suggest that investors should question the real fundamentals underlying their investments, lest the market begins to trade on them again.
1 Bustillo, Miguel (May 19, 2010) "Wal-Mart Same-Store Sales Fall" The Wall Street Journal. Retrieved on July 8, 2010 from: http://online.wsj.com/article/SB10001424052748703957904575252092724864622.html?KEYWORDS=wal-mart+struggles+to+to+keep+shoppers
2 Lenzner, Robert (June 3, 2010) "Six Giant Banks Made $51 Billion Last Year; The Other 980 Lost Money" Forbes. Retrieved on July 8, 2010 from: http://www.forbes.com/2010/06/03/goldman-sachs-citigroup-markets-lenzner-morgan-stanley_print.html
3 US New One Family Houses Sold Annual Total SAAR (Bloomberg: NHSLTOT)
4 As measured by the Dow Jones U.S. Select Home Construction Index (Bloomberg: DJSHMB)