Market at a crossroads

Bears and bulls both have reasons to feel time is on their side..
The Bull case for stocks:

  1. Earnings, earnings, earnings. They’re doing fine (at least so far). The world economy is growing mostly because stellar performance from developing countries. The rich world (minus Australia) looks tired. Profits there come mostly from cost cutting, top-line growth mostly comes from abroad (unless you’re Apple). But one can make the case that as long as earnings growth keeps up, the markets will be ok.
  2. QE2: The Fed will almost certainly be buying more bonds and crediting some bank accounts in the process. This new base money will not go into new lending for business, but it will go directly into the markets, and it has the dollar running for cover, which helps translating those overseas earnings into a better bottom line.
  3. Interest rates remain extremely low and housing is in a funk, so what’s the alternative?

The Bear case for stocks:

  1. The mortgage mess could very well depress the housing market even more and lead to serious holes in balance sheets of financial institutions
  2. The stimulus has mostly ran it’s course. taxes will go up, states and municipalities are still in a financial funk, cutting back spending
  3. Interest rates can’t be lowered and a new stimulus package is extremely unlikely (for political reasons, needless to say). Most observers argue QE2 will not move the economy all that much, if at all (although expectations of QE2 already have moved the markets)
  4. Unemployment is very high and will remain high for a considerable time to come. Capacity utilization is low (in the low 70%s) so there is a very significant ‘output gap’, that is, underutilized capacity. The economy could easily produce more if there was more demand
  5. With capacity utilization so low and demand so weak, business has little incentive to invest in building new domestic production capacity, that is, of the categories of demand, consumption, investment, and public spending are all unlikely to grow significantly. This leaves only (net) exports as a route for expansion and the lower dollar certainly helps in that department.
  6. But relying on exports has its limits (the US is way less dependent on exports than China, for instance) and the lower dollar is already creating havoc on some of our trading partners. Some even talk of a looming currency war which will only have losers
  7. That European debt crisis isn’t over by any means. The rescue operation has bought time, but that’s all. Interest spreads for numerous countries (vis-à-vis Germany) are very high and austerity (except from Ireland and Greece) is yet to kick in in any comprehensive fashion
  8. Does anyone really know what’s happening in China? Investment and exports are such an extraordinary large part of GDP, that can’t continue into eternity. Luckily enough, the Chinese themselves have recognized that and are embarking on letting consumption play a more important role.

For now, we think the bulls have it. But only just. It remains to be seen whether the effects of low demand, spare capacity, de-levering consumers and the kicking in of austerity (or expiring stimulus) can be compensated by the growth in developing economies. And then there are those risks of turmoil, from the mortgage situation, from financial institutions, from indebted European countries, from violent currency moves, from possible Chinese bubbles (investment, housing, regional loans, take your pick).

It’s a very treacherous environment, this. Asset classes are ever more correlated. Keep an eye on:

  • Guidance in the ongoing earnings season
  • Dollar movements, especially sharp reversals
  • US-Chinese tensions escalating
  • European debt, CDS rates and interest spreads
  • Read up on the mortgage mess, robot signers and all. The limbo there is exactly what we don’t need.

So don’t be complacent and be prepared to move fast if any of these shows signs of escalation. If one of these does, hoping it will all blow over doesn’t seem a good option to us.