Is the economy improving or not? If it isn’t improving, why are so many people bullish? If it is improving, why is there talk about QE3?
Before you think about the last two questions, I’ll have to warn you that this article is a bit longer than usual, but I believe it will be worth your time.
Now that you’re done pondering the above questions, you’ve probably come to the conclusion that there’s only one “rational” reason to buy stocks right now:
Hope that the Federal Reserve will use another round of QE to bid up stock prices. We’ve seen how well QE1 and 2 worked (if they worked, there’d be no reason to talk about QE3), so it’s more than fair to ask, could QE3 mask all the fundamental problems of an “improving” economy?
So “Good” – It Hurts
Eurozone finance ministers rejected an offer made by private bondholders to help restructure Greece’s debt. The agreement, another attempt to avoid a disorderly default, would have equated a $170 billion bailout, as private bondholders (mainly banks) were expected to take a 50% haircut.
Last week we saw nine European countries downgraded. One rating agency (Egan Jones) cut even Germany’s rating. JP Morgan and Citigroup missed earnings. The United States is above its debt ceiling again. Chinese GDP was the worst in 30 months. Oh, almost forgot, the IMF says the world economy is in such great shape, it needs another $1 trillion to provide life support to whichever country chokes next.
Much of the problems we’ve been hearing about stem from Europe, but let’s forget about Europe for a moment and focus on the United States of America. A consensus has been building that the economy is improving, but is it really?
Is the U.S. Economy Improving?
No doubt there’ve been some encouraging reports, but there’s a difference between the kind of report that’s encouraging and the kind of reports that put an end to economic recessions.
There were encouraging reports in April 2011. Below are a few:
Wall Street Journal: “World revs up U.S. profits. Manufacturers boom on global demand, spurring stocks to 3-year high.” – April 21, 2011
AP: “GE CEO Immelt says global economy is improving” – April 27, 2011
AP: “Sales growth the big surprise on Wall Street” – May 1, 2011
We all know that the major U.S. indexes a la Dow (DJI: ^DJI), S&P (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) topped just about when the economy “was turning around” and slipped some 20%. Ironically, U.S indexes performed much better than the 30% reduction in developed markets (NYSEArca: EFA) and emerging markets (NYSEArca:EEM), which dropped as much as 34%.
Contrary to the encouraging economic reports, the April 26, 2011 ETF Profit Strategy update warned that: “The S&P closed above the upper Bollinger Band. Further short-term gains were limited on prior occasions when the S&P exceeded the upper Bollinger Band.”
This warning was in line with the April 2, 2011 ETF Profit Strategy update, which pointed out that: “The 1,369 – 1,382 range is a strong candidate for a reversal of potentially historic proportions.”
The Core of Growth
Economies around the globe are predominantly measured by one benchmark – GDP, or gross domestic product. However, judging an economy based simply on its GDP is like buying a car based on color. GDP is probably one of the most used and misunderstood economic measures in the financial world.
Just because your car is blue (or pick your favorite color) doesn’t mean it’s a good car. Just because GDP is up, doesn’t mean a country is doing well. U.S. GDP for the second quarter of 2011 came in at $15 trillion, an all-time high. Does this make sense?
Here’s how GDP is calculated: GDP = private consumption + gross investment + government spending + (exports – imports).
Government spending factors into GDP. In fact, government expenditures hit an all-time high of $5.47 trillion a few months ago. Government spending now accounts for 36.44% of GDP (see chart below). In other words, government spending masks the lack of growth in the private sector.
The United States just blew above its debt ceiling once again. President Obama has asked for another $1.1 trillion debt ceiling raise. Raising the debt ceiling is mortgaging the future and will force the government to stop spending. If the government stops spending, GDP will likely fall.
The GDP Reporting Sham
Despite massive government spending, the third quarter GDP has been revised lower twice. On October 27, third quarter GDP was reported to be 2.5%. On November 28, GDP was revised down to 2.0%. On December 22, GDP was revised down to 1.8%. If GDP can’t grow with massive government support, what will it do once the government has to face its debt problem and curtail spending (and increase taxes)?
The Unemployment Report Sham
Unemployment has fallen from above 10% to 8.5%. That’s a great story but it’s not the truth.
Since the bear market started in 2007, the population of the U.S. has increased by about 3.7 million people. Since then, the labor force has increased by only 254,000. The Bureau of Labor Statistics reports that the employment population ratio (percentage of population able to work) is 58.5%.
This means that the labor force should have increased by more than 2 million people, not a mere 254,000. The smaller the labor force, the better the headline U-3 unemployment rate (currently 8.5%) gets. If you adjusted the labor force to calculate the unemployment rate, you’d arrive at 9.6%, which is no improvement.
The Liquidity Sham
Imagine going to Las Vegas and getting the hotel to comp your losses. If you win, you’ll get your winnings; if you lose the hotel will pay the bill. The hotel, of course, gets its money from the poor saps that don’t get their losses comped. In other words, other people’s losses pay for your fun time and free drinks.
Obviously no Vegas casino is dumb enough to offer such a deal. Dishing out “no loss privileges” to a select few would keep away the “dumb” crowd who ends up having to pay for their losses.
Unfortunately, the U.S. government via the Federal Reserve is offering big banks (NYSEArca: KBE) and financial institutions (NYSEArca: XLF) such a “no loss provision.” The Fed’s essentially telling banks, “you can keep all your gains and we’ll flip the bill if you get too greedy and start losing money.”
Unfortunately, taxpayers don’t have the choice (unlike gamblers) not to participate in the sham. Banks have already devoured billions, possibly trillions of dollars, because their gamble on real estate ended badly.
Hopium vs. Reality
The market isn’t stupid and has shown its displeasure with the Fed’s shenanigans already a few times. September/October 2008, May 2010 Flash Crash and July – October 2011 are proof that the concept of “you reap what you sow” isn’t completely dead.
Stocks performance in late 2010 and early 2011 on the other hand confirms that liquidity (QE2) can buoy stocks. But how far did the Fed’s hopium get the economy?
At best, it bought some time; at worst, it made a bad situation even worse. The summer of 2011 was very painful for any investor who put his trust in the Fed.
Keep in mind that the Fed did not spark the current rally. The October 2, 2011 ETF Profit Strategy update stated the following: “I’ve been expecting new lows followed by a tradable bottom. I define a tradable bottom as a low that lasts for a few months and leads to a bounce that (in this case) should propel the markets around 20%. Therefore the recommendation is to buy once we’re near the low.”
The U.S. stock market bottomed two days later and recorded the strongest and fastest gains since the March 2009 low. The chart below, also published in the October 2 update, outlined the market’s ideal journey to about S&P 1,300.
Balancing Hopium and Reality
Obviously the S&P has moved a bit past the initial target surrounding 1,300, but that target was provided at a time when Wall Street expected financial Armageddon and deserves some leeway. After all, who thought we’d see S&P 1,300 or Dow 12,700 a few months ago?
The rally from the October lows has created an overbought condition that’s reflected in bullish sentiment readings. While momentum keeps pushing stocks higher on one hand, trading volume and breadth have failed to confirm the technical breakout on the other.
Just like a car approaching a hill as it’s running out of gas, the S&P is approaching major technical resistance (similar to the one at 1,369 in May 2011) in a stretched condition. Such a condition is generally dangerous.
The ETF Profit Strategy Newsletter identifies this strong technical resistance along with a short, mid and long-term outlook and the one strategy that will reduce investment risk to as little as possible.