August represents the sixth month in a row in which the equity markets have posted positive returns. Has the rally been built upon a solid economic foundation? Does the rally have even further to run? Is it too late to get in? Should investors be more cautious at these levels?What do the numbers on Wall Street mean for people on Main Street? How are the powers that be in Washington responding to the markets? What do we learn from international and emerging markets?
Let’s review the monthly performance, look beyond the numbers, and project what may lie ahead.
Equities
Unlike the explosive performance in July (equities up 8-10%), the market had a much more subdued performance in August. Be mindful that August is the heaviest vacation month for market participants. Over and above that, total volume in the equity markets has been rather light. A large percentage of market volume has centered on those stocks in which Uncle Sam is heavily involved (Citi (C: 5.00 0.00 0.00%), AIG (AIG: 45.33 0.00 0.00%), BofA (BAC: 17.59 0.00 0.00%), Freddie (FRE: 2.29 0.00 0.00%), Fannie (FNM: 1.93 0.00 0.00%)). I view these particular stocks as very speculative in nature. That said, there are large short bases in these stocks. The shorts were punished during the month. The stocks did trade off significantly on the last day of the month.Are we supposed to make assessments of our future economic health and overall market performance based upon stocks in which Uncle Sam holds anywhere from a 40-80% equity stake? I think not. I view trading these stocks as pure gambling, not investing. I challenge any analyst who would say otherwise.
I am concerned about the equity markets going forward. Why? What sector has led the equity markets overall? Emerging markets, specifically China. What is happening in those market segments? China sold off close to 6% on the last day of the month and is down over 20% from its high. That decline is technically termed a ‘bear market.’ Analysts I respect view China’s market as an asset bubble. Emerging markets overall have had an unbelievable run but appear to be losing momentum as both the U.S. markets and developed markets outperformed the emerging markets this month. What drives the emerging markets? Primarily the exporting of commodities. Let’s review that segment.
Commodities
The DJ-UBS Commodity Index is also showing signs of losing momentum. In fact, the index was down -.6% for the month while it is off a full 4-5% from the highs seen in July. While oil is approximately 7% off its highs, natural gas had a significant decline this month (down approximately 30%) and corn also sold off hard early in the month (down approximately 10%) before stabilizing.The Baltic Dry Index is a good indicator of activity in the commodity space and as a link to activity in the emerging markets, especially China. What does the trend line on the BDI look like? Not very good. The BDI closed today at 2686, down approximately 20% from the highs seen in July.
Interest Rates/Bonds
Ben Bernanke announced in August that the Fed will leave the Fed Funds rate unchanged at a range of 0-.25% for an extended period. There is little doubt that Ben knows there remain major hurdles on the economic landscape. Clearly, both Bernanke and Geithner view improved financial markets and an improved financial industry as a pre-condition to a healthy economic recovery. Against this backdrop, U.S. Treasury debt rallied while other sectors of the bond market added marginally positive returns.Does it make sense that both equities and bonds would rally in sync? No, but equity and bond markets both continue to trade more on technicals (that is, excess liquidity provided by Big Ben and his friend Uncle Sam) than pure fundamental value.
U.S. Dollar
The U.S. dollar continues to gradually erode in value. Is this any surprise? Every major trading partner of the U.S., from China to Japan to France, is calling for lessened dependence on the greenback as the international reserve currency.
Economy
While the industrial segment of our economy appears to be stabilizing, from my perspective the consumer (remember 70% of our economy is tied to the consumer) remains severely stressed. Delinquencies and defaults continue to run at a record pace across almost every form of debt (mortgages, credit cards).
The next shoe to drop is in the commercial real estate space.
I particularly like Sense on Cents‘ Economic All-Star Bob Rodriguez’s characterization of our economy. Bob views our economic landscape not as a “V,” or a “U”, or a “W” but rather as a caterpillar. What does he mean? He believes the economy will slowly move up and down for the foreseeable future. I concur.
Summary
While it has been foolhardy and painful to fight the Fed and the massive liquidity pumped into the system, I see some real signals in a variety of sectors that this rally is running out of steam. The markets have not truly had a meaningful correction in the last 6 months. Are we due for one? I personally think it would be very beneficial. Why? The disconnect between Wall Street and Main Street has never been greater. I do not view that gap as healthy.Call me crazy, but I project September will have a 5-7% retraction across the major equity market averages based on reading the tea leaves as highlighted in this review.
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