Opinion: How resilient is the bull market?

By Neville Bennett As October ushers in, investors' thoughts turn to the resilience of the stock market. It is the anniversary of many of the biggest crashes, and while I am not predicting another crash this month, I do think there is evidence that the market is fully priced and poised for a correction. The three biggest daily falls in the Dow in percentage terms occurred in October, 22% in 1987, two consecutive 12% falls in 1929, another 8% fall in 1987, and 7.8% in 2008: that is half of the top ten falls. The 11th, 13th 15th, 16th greatest falls were also in October. There were also a lot of near misses: the 4th biggest was on November 6, 1929; the 17th was on September 17, 2001, the 18th on September 24, and the 20th was on September 29, 2008. The 1987 crash occurred on Monday, October 19. It started in Hong Kong, raced across Europe and hit Wall Street a devastating blow, wiping 22% off the Dow. The next day is seared Australia and New Zealand. By the end of the month Australia was down 41% and New Zealand was down 60% from their 1987 peak. 1987 was devastating for me. I lost almost nothing in the crash being able to sell everything promptly. I lost money when I re-entered the market, believing shares were a "once"“in-a-lifetime opportunity" and saw my investment slowly wither. That experience increases my skepticism of the market today. Overpriced The P/E on the S&P 500 is calculated by Schiller over 10 years' earnings. This perpetuates the preposterous notion that the P/E is now 18; it is actually over 100 on current earnings. Market vulnerable As the S&P500 has risen over 55% since March investors are torn between fear and flight, greed and caution. Vast pools of money are sitting on the sidelines getting very little yield because investors fear a correction. Trade is high volume disproportionately in "trash": zombie banks like Citi, Freddie Mac and AIG. The situation is a bubble when, the BBC remarks, "bellboys are handing out stock tips in the lifts". Stocks have prospered on cost-cutting and lay-offs. Having shrunk their revenue, firms must now grow it to keep their promises. They are priced for a robust recovery that may not materialise. As I have mentioned before, there were strong rallies in the Great Depression and in Japan in the 1990's but they ended in more crashes. This situation looks like a bear market rally, a real recovery will be obvious when GDP grows, firms make money, the unemployed and also money is put to work. At present money is not being put to work. The Bank of England is thinking of negative interest rates to persuade banks to divert their deposits in the BOE into productive channels. Money is still piling into US Treasurys: the yield is now lower than at any time since the 1930's (except when the Fed "fixed" yields in World War 2). The bond market looks like the 1930's with its double dip. This month has begun badly with a US jobs report much worse than the market expected. It is also the beginning of earning season, and I anticipate that this quarter will see another fall, making 10 successive quarters of falling earnings. The US media is discussing the need for a second stimulus to avoid a "w" shape recession. Treasury Secretary Timothy Geithner whistles in the wind, saying that the US economy had "recovered dramatically" but undermines that with "conditions for a sustained recovery led by private demand are not yet fully established". Jobs US non-farm jobs have fallen for 21 months, and the size of September's losses startled markets. Weaker employment obviously lessened hope for the recovery, and immediately impacted on sensitive indicators:  oil dropped 2%. There are now officially over 15 million unemployed or 9.8% of the US workforce. A record 35% have been unemployed for more than six months. An alternative gauge which includes part-time and discouraged workers rose to 17% of the workforce. The average work week dropped to an all-time low of 33 hours. There is mounting concern that once the stimulus package, the "cash for clunkers" program and the impact of the inventory cycle has run its course, US GDP growth will slow down very substantially. The stimulus package was designed to keep unemployment below 8% but 10% now looks inevitable. Earnings A company share is essentially a claim on the future earnings of the company. This fact has often been overlooked in the desire to lock into capital gains. Capital gains were overvalued before the recession, and while still important, will depend more in future upon solid performances to which earnings are the key. But earnings have been much deflated. On average earnings of S&P 500 firms are expected to be down 24.8% y-o-y, marking 9 consecutive declines. The market has ignored this decline but seized upon results that exceeded expectations. A cynic might add that 73% of companies topped expectations, fueling the rally. It is desperately optimistic. Year-on-year earnings vary remarkably. The materials segment fared worst, expected to be 68% down, energy 65% down because oil came off its huge spike, followed by industrials where earnings are expected to be down 45%. Finance has recovered with earnings 59% higher (despite about 100 banks going into receivership). Nevertheless, earnings will probably beat the (low) expectations of the market. A lack of earnings will not, apparently, dent its euphoria. A low dollar helps earnings as 76% of S&P500 firms earn overseas revenue. An interesting question would be "who sets the expectations bar?" The outlook The market operates in an uncertain economy.  The recession is bottoming out but investors need tangible evidence that any recovery is sustainable. Many respected authorities predict anaemic growth, below trend in the short term. Moreover, a double-dip recession is possible as well as a market correction. Contributing factors include the risks associated with removing stimulus and easing which will shake financial institutions and reduce aggregate demand. Another concern is that oil, energy and food are rising because of speculative forces. High prices in these commodities could deliver a terrible shock to the global economy and extend the recession. The CEO of HSBC predicted a "w" in an interview with the Financial Times and many columnists support this view. ____________ * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared. neville@bennetteconomics.com www.bennetteconomics.com