Feb 11, 2010

Are More Stumbling Blocks Just Around the Corner?

By Andrew Mickey, Q1 Publishing

The last few weeks have not been good for the markets.

If you’ve enjoyed the recent rally and, like we’ve urged, stopped arguing with the market and just rode it out for all its worth, you’ve been caught up a little in this correction.

The downturn was inevitable. We all knew it was going to come. And we wanted to prepare ourselves for the cost of riding out the rally.

But right now, the markets are acting like its 2008 all over again and investors and traders are running for the exits.

Fears of a Greece debt contagion are starting to wane. At this point it looks like the cash will be handed over to Greece and in return he Greek government will make some promises to slash spending over the next three years which, of course, will never materialize.

But hey, that’s long-term and this is Wall Street. But after the Greece solution is revealed the markets will likely face three headwinds which must pass before the markets make another big move upwards.

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Looking for a Good Crisis

As most of you know, your editor has been cut off from almost all communication for the past few weeks.

I was on an extended research junket to a country the U.S. government officially urges all citizens to “defer all travel” to because “an increased number of Americans arrested without clear justification, and heightened tensions.” And the U.N. recently slapped sanctions on it too.

It truly is a near crisis situation and we were looking at some exceptionally cheap assets.

While there, your editor had the chance to get away from all the day-to-day noise and refocus on the big picture. After all, any individual stocks movement is driven 50% by the overall market, 30% by the sector, and 20% by individual company fundamentals. That’s why we believe you’ve got to get the “big stuff” right first.

And as I spent the weeks traveling a countryside that eerily resembles Mars in some spots via bus, train, and Soviet-designed and built helicopter (future reference: not for those with weak stomachs), the lack of communication and media (the Internet went out the first day and never came back and only local phones could hook into the country’s own closed network), the short-term market fluctuations just faded into the background.

That, however, helped me single out the three major headwinds the markets must make it through before the next leg up:

Market Headwind #1: Patience is a Virtue

Throughout the recent market rally, the market seemed to focus on the near-term future.

Wall Street’s “Not as bad as expected” mantra reigned supreme. As we focused on, this type of mentality can last far longer than most everyone expects, but it won’t last forever.

Lately, it looks like the clock has struck midnight on that kind of thinking. The market was willing to be patient and now it’s starting to get very impatient.

No place is this sea change in mentality more evident than in employment.

The chart below shows why the market is starting to get pretty impatient when it comes to jobs numbers:

As you can see, the current recession is by the worst in both magnitude and duration.

The thing is: the market knew it was bad this whole time. What was a “lagging indicator” is now a concern especially considering the economy is still losing jobs two years into the downturn.

Market Headwind #2: Carbon Regulation: By Any Means Necessary

It’s not just jobs though, there’s another more important factor that has the market spooked – energy prices.

Now, we’re in the middle of a feeble “recovery” and oil is holding steady above $70 a barrel, a gallon of gas is at $2.66, and natural gas is above $5 per Mcf.

Basically, energy prices are still high despite the weak economy and the next leg up is now only a few months away.

But this isn’t the kind of energy price rise where we can load up on oil stocks and turn it into our gain - it’s one where government intervention increases the costs of energy.

Last week the Environmental Protection Agency (EPA) declared its timeline for implementing top-down carbon dioxide emission regulation. With the Senate stalemated over cap-and-trade legislation, the EPA said it will be enforcing carbon emission regulations on stationary sources of carbon (i.e. coal-burning power plants).

As you might expect, the market doesn’t like policies that will increase costs and drive down earnings for companies.

And don’t think that the EPA is about to hold back because Congress or the majority of the public greatly opposes the rules. EPA Assistant Administrator Gina McCarthy recently explained, “I am more than a little distressed that the American public is more confused about climate science than when we began our discussions at EPA about what is the science of climate.”

They’re going forward and willing to use any means necessary.

Market Headwind #3: Risk and Reward

The biggest headwind of all comes down to investors attitudes towards stocks.

Last year most investors proved they don’t want much to do with stocks. The asset class which attracted the most new capital last year was bonds.

Frankly, that attitude isn’t about to change soon either. The market is still expensive. The price-to-earnings ratio of the S&P 500 is currently at 18. That’s 20% above its long-run average of about 15.

Basically, there are a lot of things to like in this market – agriculture, commodities, and a few beaten down sectors – but it’s tough to find an idea where the risks far outweigh the rewards.

And in a market like the one we’re going to be going through over the next few years, you better get used to a disciplined approach which demands the best opportortunities where the potential rewards far outweigh risks.

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Clearly, there are a lot of headwinds that will help limit any market-wide upsurge.

Whether it’s the monthly unemployment report, new tax scheme proposal, or costly regulatory intervention, there’s always bad news around the corner.

That’s why this earnings season, which has turned out to be a very good one for companies, has proven to be disappointing for most investors.

Consider this. Since companies started reported earnings, 73% of S&P 500 beat analysts’ expectations. That’s the second best performance since in the past 17 years. The S&P 500 index, however, is down 8% from its highs before most companies started reporting earnings.

There are a lot of reasons to be bearish and most investors have been shaken hard. But we still continue to believe it is times like these, when fear is high, that the best opportunities exist to get into position to benefit from the long-term trends of rising interest rates and inflation.

Good investing

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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