Markets & Economy

Stocks have no reason to go higher

In the past five weeks, the US equities have rallied 8%-10%, as the earnings in the 2^nd quarter were better than expected. Obviously, layoffs, pay cuts and thereby productivity increases, have given a boost to the bottom line of many S&P companies. Another boost came from banks across the pond—EU banks have passed the well-negotiated “stress tests” without much difficulty. So, bulls have come out after the recent lull, and they are ready to give bright forecasts. Everything is going to be rosy again!

Not so fast. None of the problems this economy faces have disappeared. They are very much intact. However, there is a concerted effort by the governments and the central banks of the world, to delay the inevitable, in an effort to beat the dreaded “deflationary” forces in the economy. I have no desire to doubt their motives, but I really doubt whether “kicking the can down the road” will help solve this crisis.

Right now, we are witnessing a cyclical burst of activities in the economy, after a panic halt, in response to an economic Armageddon experienced in the wake of credit crunch. This, however, is only a short-term phenomenon. Excesses of the last two decades across the developed economies have finally come home to roost; it is going to need more than just two years to even get to the so-called “new normal.” Debt levels, both private and public, are quite high. Big banks carry plenty of toxic assets and there is no way to know how much they will have to write down if these assets don’t appreciate in value. So, these financial institutions are very reluctant to lend. If there is no new debt formation (I am not recommending that, in fact, de-leveraging is good), how are businesses and consumers, the engines of growth, going to drive this floundering economy higher?

Here are my reasons why I feel equities will go down:

• Consumers, after this cyclical revival in spending, will once again hibernate. Fear of losing jobs, loss of equity in their homes, higher taxes, reluctance to take on more debt (only if banks are willing to lend!) will be the factors driving this big change in American consumer.

• Despite the liquidity pumped into the system by the Feds, it is really not changing the credit dynamics for the small businesses and consumers. If new debt is not created in the economy, GDP will not grow. Aggregate demand is a function of changes in GDP and debt level. With all the de-leveraging in the economy and banks refusing to lend, aggregate demand will shrink. Right now, private debt is close to 3 times the GDP and a small percentage drop in the debt levels, will adversely affect the aggregate demand.

• I don’t think there will be another massive economic stimulus from this administration. That means one cannot hope for government to continue to spend. In 2010, the budget deficit is expected to be close to $1.5 trillion. Despite rosy forecasts, deficits will continue to rise (www.usgovernmentrevenue.com forecasts total tax revenues, states & federal, to be $5.4trillion by 2012, but expenditure will be $6.8trillion, hence a deficit of $828B; GDP will be $16 trillion and national debt will reach $19.5 trillion!). So, muted GDP growth, debt-to-GDP at 120%, higher taxes and higher interest rates (despite lack of economic growth, interest rates will rise, as our creditors will not be willing to lend us at lower rates anymore), struggling job market and stagnant housing sector…there are only headwinds. How can equities prosper under this scenario?

• European banks are headed down the path of Japanese banks. They will be more like “zombie” banks. The farce that was on display with the bank stress tests will only exacerbate the banking woes. What I hear is that, these big banks in the EU zone were not required to recognize losses on their sovereign debt portfolio, as they were allowed to “hold it to maturity”! Many of these nations whose debt these banks are holding in their balance sheets have huge debt-to-GDP levels. If the economies don’t grow due to austerity programs and assets don’t appreciate in value, plus, unemployment remains high, how will these nations come good on their service of debt? So, with the threat of “sovereign default” very probable, banks need to be very vigilant and will be forced to hoard cash. That’s how they become Zombie banks—idle cash that cannot create new debt because of the fear of existing debt going sour!

• The thing is, this is not one of those routine boom-bust cycles to expect a normal recovery. This is a consequence of two decades of excess leverage and asset bubbles. It will unravel slowly and will hamper growth globally. Despite the economic miracle in China, India and Latin American countries, if US, EU and Japan stagnate (US, EU zone and Japan account for a staggering 60% of the world GDP!) there will be negative consequences worldwide. Equities just cannot perform in such a scenario. And, this downtrend will be long lasting, as the psychology of the markets will suffer. In the absence of higher expected return projects or investment vehicles big investors will shy away from risking their capital. Preservation of capital will be the most followed strategy across the globe.

Markets are mostly driven by animal spirits. If market participants feel confident and upbeat, the markets will go higher. If more investors anticipate growth, then they are willing to part with their cash, as they see higher returns and creation of wealth. If not, they will try to remain liquid by hoarding cash. Liquidity is everything. The so-called “liquidity on the sidelines” will refuse to come into the market or economy, if the psychology is negative. As the sovereign debt crisis and the havoc it can cause in the financial world become more obvious to big investors, the liquidity will dry up. It is as simple as that. Consequently, economy will suffer. When most realize, that in this cycle of journey to the bottom, over-leveraged nations, businesses and consumers are not going to be back on their feet for a long time, even the most daring investors who kick-start the faltering economies (the real risk-takers with big bank balances) because they see value in distressed assets, will refuse to get into the game. That starts a self-sustaining death spiral to the bottom. This is one of those times. This is a “black swan event” as my favorite author Nassim Taleb would frame it. Many in the policy circles and big investment houses have still not figured it out. So, am I smarter than these brilliant minds on all these big places? Not really. However, my intuition alerts me that the possibility of a long drawn downward move is highly probable. When I see all the data, I don’t see anything that inspires confidence that all the bulls see. That doesn’t mean that I am pessimistic. I just feel it in my gut that one has to be prepared to face this period in which everything is going to be tough to come by. If my gut feel is wrong and this is just a temporary phenomenon, then I have nothing to worry, because in good times, things will work on their own; there will be lot more opportunities and those who are willing to take risks, I am sure, prosperity will be in the reckoning with fewer hurdles.

I hope my intuition is wrong, just this time.