Where Are We?
July 20, 2009

From March 9th until mid-July, the stock market has zoomed 33% higher.

Is this the beginning of a new bull market? Are the “green shoots” the talking heads have been telling us about at every opportunity real? Are there indeed signs of economic recovery?

There are really two questions here:

- Is the economy starting to recover?

- Is this bear market over?

We could spend days on the answer to each of these. I am not going to. I propose to give you my simplistic view of both but rooted in my understanding of past economic and market cycles.

We know they are interrelated. The stock market is a discounting mechanism for economic activity and earnings. In short, the stock market increases before the economy because it anticipates recovery and improvement in earnings. So, is this bear market over? Is the recent strong upward trend likely to continue?

Let’s look at what past stock markets cycles tell us before we turn to what the economy is doing. I like to look at market history from a long-term perspective. The following schedule gives you the long expansion and long contraction phases of the stock market since 1920.

The Dow Jones Industrial Average peaked out at 14,164 on Sept 7, 2007 and bottomed out, so far, at 6547 on March 8, 2009. This is a decline of 54%. The Dow has recovered some from its March low and at mid-July stands at 8712, up 33%.

A bear market is defined as a decline of 20% or more in stock prices. We have had 19 bear markets since 1920. Most of them have lasted months, not years.

The bear market we are in is already a year and half old, similar in magnitude and duration to the bear market of 1973-1974. If this bear market follows the pattern of the last two major bear markets, we are closer to the end than the beginning.

If normal conditions prevailed, that is, if the excesses of this market and economy were allowed to correct themselves we would indeed be toward the end of this bear market.

However, the easy money and near zero interest rate policies of the Federal Reserve Bank and the determination of the current administration to prop up and sustain failed organizations and extended voters is delaying the natural correction forces in both the economy and the stock market.

The money supply has expanded tremendously in the last year, much more than economic activity justifies. This money is finding its way into the stock market and holding up prices.

From a technical perspective, the market is still in a long term downtrend and this bear market is not over. Do not bet against this bear.

Now, how’s the economy doing? In a word, lousy. Capacity utilization is hitting new, all time lows of 68.3%. Worker layoffs continue at a high level every month. So far, in this recession, we have laid off almost 6.5 million workers. Unemployment reached a 26 year high in June at 9.5%. Thirty seven percent of US firms have frozen worker salaries.

The median home price in America is now $168,000 down 28% from its peak in mid 2007 of $232,000. Residential foreclosures continue at record levels. And the foreclosure data excludes the almost 1 million homes that are not listed as lenders are waiting for a price recovery. Forty five banks have failed so far this year, almost double the 25 that failed for all of 2008.

Earnings are declining and costs are rising, not a recipe for economic health. Second quarter earnings estimates for public companies range from down 17% to down 35%. Costs of many items are rising, putting a severe squeeze on family budgets. Five hundred and fifty four cities and towns have increased fees and taxes in the last year. I just looked at my phone bill…22% of it was taxes and fees!

I assure you your utility bills are going higher, if they have not already. The “cap and trade” legislation currently in Congress is just an excuse to punish our cheapest and most plentiful source of electricity, coal. But none of this should be a surprise. In January, President Obama promised his attack on greenhouse gases would double our utility bills.

Does this sound like a fertile environment for entrepreneurship and risk taking? Clearly the answer is no. I ask myself just two questions about this economy. “Who’s hiring?” and “Who’s buying?” And if I can answer these positively, then I continue the search for the illusive green shoots the media promises us are there. The answer to these questions right now is “Nobody!” At least nobody in their right mind.

The breathtaking volatility in commodity input prices, the huge and costly governmental administrative burden of hiring workers, and the likelihood that your profits will be heavily taxed are all weighting down potential risk takers. You can’t plan and you can’t make enough of a profit to justify committing capital to a new business venture.

Our Portfolio

I am not convinced this 33% bounce off the bottom since March is real. Earnings and dividends are still declining, and I can see no forces that will arrest and reverse this trend yet. We will take a strong protective stance. We will keep our asset allocation at 50% in cash and 50% in recommended investments. Any dividends or distributions will be accumulated in cash. Do not be aggressive in buying your positions. Let the prices come to you.

Live long and prosper,

Mike Williams, CFA

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