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June 10, 2012

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Bob Brinker took this weekend off Monetalk.  In his absence, I thought it might be helpful to use Bob’s framework of analyzing whether a bear market is coming for purposes of this weekend’s newsletter.  It seems timely given that the correction has spooked a lot of investors, and in the past couple of weeks I had more than a few subscribers e-mail me and ask if I thought the correction was going to slip into a bear market.  As set forth in my weekly newsletters and special alerts, I haven’t seen evidence that a bear market is on the near-term horizon.   But let’s go through the analysis together and see what the data suggests.BEAR MARKET ANALYSIS

Back in the days when the secular bull market was coming to an end, Bob was asked what factors he would look at to forecast whether a bear market was coming.  At that time, Bob discussed the five factors or "root causes" as he refers to them that foretell a bear market.  Those five root causes include the following:  (1) tightening monetary policy by the Federal Reserve; (2) rising interest rates (especially short-term rates); (3) rising inflation; (4) rapid economic growth; and, (5) over valuation in the market.   Bob has said that these factors "have the potential to influence the future course" of his stock market timing model. 

1. Tight Money. 

The phrase “tight money” is a loose reference to when economic conditions are such that obtaining credit is difficult and interest rates are high. 

The Federal Reserve monitors the growth of the money supply because of the effects that money supply growth is believed to have on real economic activity.  Over time, the Fed has tried to achieve its macroeconomic goals of price stability, sustainable economic growth, and high employment in part by influencing the size of the money supply.  The Fed publishes weekly and monthly data on two money supply measures, M1 and M2.  The narrowest measure, M1, is restricted to the most liquid forms of money; it consists of currency in the hands of the public; travelers checks; demand deposits, and other deposits against which checks can be written.

M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.  Incidentally, last month the Federal Reserve changed the web site and format under which it is reporting M2.  If you are interested in tracking this stuff, here is the new URL:


Two weeks ago, the New York Federal Reserve Bank published a research paper that studied how the Fed’s large–scale asset purchases together with its basically zero interest rate policy have impacted the monetary aggregates.  Their conclusion?  Both M1 and M2 have grown quickly recently — especially, M1.  They attribute most of the recent high money growth rate of M1 to the low current interest rates as well as the growth in bank reserves that has resulted from the Fed’s asset purchase programs.  M1 has been growing at an annual rate of 20% which is very high by recent historical standards.  M2 has also increased significantly in the last year.  From May 9, 2011 to May 7, 2012, M2 grew by 9.6%.

If we look at just this year, the growth rate is slower, but still at a pretty good clip.  From the beginning of the year through May 7, 2012, M1 and M2 have growth rates of 6.3% and 6.5% respectively.  But that growth is relative to the fourth quarter of 2011 and does not reflect the full extent of money supply expansion over the last few years.  

Looking at loans in general, bank lending had declined in 2009 and 2010, but commercial and industrial loans have picked up this year, growing at an annual rate of 15.8% in April.  Total loans and leases grew at 4.1% due to weakness on consumer and real estate lending.

Still, the main determinant of faster money supply growth is reserve growth.  According to the New York Fed, “Recent growth in M1 and M2, particularly the former, is explained primarily by the Fed’s expansion of reserve balances” and that “reserve growth consistently increases money growth.”   Read the paper, “What’s Driving Up Money Growth” at the following url:


All in all, I don’t think we need to be worried at all about tight money at this juncture as a contributing factor to a bear market.  The authors of the foregoing paper point out that “it’s unlikely that the current high growth rate will continue in the long term....as both low interest rates and the Fed’s expansion of bank reserves will likely be reversed as economic growth accelerates.”  That brings about another worry, and a frequent starter of bear markets.  Our next indicator...

2. Rising Rates.   
US Treasury Rates at a Glance

Most advisors, from the most famous bond investor, Bill Gross, to yours truly, has at some point in recent years been spooked by the threat of rising rates.  So far, that simply has not panned out.  Short-term rates remain at record lows.  Treasury yields are at record lows.  Rising rates have not been a problem.  Here is a web site that provides a great snapshot of rates, including a daily updated chart of the yield curve:


Federal Reserve Chairman Ben Bernanke testified before the Congress this past Thursday.  Investors were looking to see if he would give clues that the latest jobs report among other financial data, would signal any change in policy and/or rates.   While Bernanke acknowledged that the risks to the U.S. Economy have increased and the Fed is prepared to take action if things deteriorate further, he gave no sign that the Fed was going to change course at its next monetary policy meeting that is scheduled for June 19-20th saying it was “too soon” to speculate on any Fed action at that meeting for now.  Here is the link to the speech Ben Bernanke gave on the Fed’s Economic Outlook and Policy before the Joint Economic Committee, U.S. Congress:


If you look at the Fed-funds futures traders, the view among traders is that the fed funds rate will remain near zero for another two years.  This is consistent with the FOMC’s statement that it anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate at least through late 2014 — a comment that Ben Bernanke reiterated during Thursday’s Congressional testimony.  The FOMC has held the funds rate inside a record low range of 0% to 0.25% since December 2008. 

Bottom line?  No sign for now that rising rates are foretelling a bear market.

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3. High Inflation. 

We always have to worry about inflation.  It’s the hidden tax, the killer of bear markets and can create huge problems for the economy.  Too much inflation is always bad.  But deflation can be equally bad and don’t get me started about stagflation. 

Going back to Ben Bernanke’s speech Thursday with regard to inflation he said the following:

“...large increased in energy prices earlier this year caused the price index for personal consumption expenditures to rise at an annual rate of about 3 percent over the first three months of this year.  However, oil prices and retail gasoline prices have since retraced those earlier increases.  In any case, increases in the prices of oil or other commodities are unlikely to result in persistent increases in overall inflation so long as household and business expectations of future price changes remain stable.  Longer-term inflation expectations have, indeed been quite well anchored....For example, the five-year forward measure of inflation compensation derived from yields on nominal and inflation-protected Treasury securities suggests that inflation expectations among investors have changed little, on net, since last fall and are lower than a year ago.  Meanwhile, the substantial slack in U.S. labor and product markets should continue to restrain inflationary pressures. Given these conditions, inflation is expected to remain at or slightly below the 2 percent rate that the Federal Open Market Committee judges consistent with our statutory mandate to foster maximum employment and stable prices.”

That pretty much sums it all up.  I could give you a bunch of different data points on inflation and such, but Bernanke spoke very specifically to inflation and seems pretty satisfied that for the moment we are good on the inflation front.

I did want to mention the Economic Cycle Research Institute’s future inflation gauge since it is designed to forecast where inflation is going and because ECRI has been outspoken on the forecast for recession (more on that in fifth indicator).  ECRI released its May readings for the U.S. Future inflation gauge which rose to 102.3 from an upwardly revised 101.4 in April.  Still, those numbers aren’t that notable.  According to ECRI’s Chief Operations Officer, Lakshman Achuthan, “Though the USFIG increased in its latest reading, it remains below last year’s cyclical high. Thus, U.S. inflation pressures are still somewhat subdued.”   Quote obtained from article at this url:


High inflation is not on the radar right now.
4. Rapid Economic Growth (Or Recession)

The  fourth “root cause” of a bear market analysis is rapid economic growth. One of my sharp subscribers who manages money had suggested it would be helpful to modify this to include recession – the opposite of rapid economic growth which can also cause a bear market.  I concur wholeheartedly.

About a week ago, the Bureau of Economic Analysis said their second estimate of Gross Domestic Product adjusted for inflation for the second quarter of 2012 increased at an annual rate of 1.9%.  This was a downward revision of 0.3% from April’s estimate of 2.2%.  GDP for the fourth quarter of 2011 was 3.0%.  The growth in the last quarter was supported by gains in private domestic demand which more than offset a drag from a decline in government spending.  These numbers evidence neither rapid growth nor recession.

The jobs report last week seems to be causing the most immediate concern relative to the overall health of our economy.  But many economists (including Bernanke), believe that the slowing in the labor market of late might have been exaggerated by issues related to seasonal adjustments and the unusual warm winter we just had as well as some catch-up in hiring that employers had been doing that had pared their workforces aggressively during and after the recession.  No doubt, we need to create more new jobs, but when you look at the overall economic picture, things seem to be on a stable yet slow-to-moderate growth rate for now.   While things in Europe have been volatile, the demand for our nation’s exports has held up well.  And U.S. based corporations have become more competitive in the international markets, with their bottom line profits (as the next indicator addresses) have been doing quite well. 

In Bernanke’s testimony this week, he concluded that “Economic growth appears to continue at a moderate pace over coming quarters, supported in part by accommodative monetary policy.  In particular, increases in household spending have been relatively well sustained.  Income growth has remained quite modest, but the recent declines in energy prices should provide some offsetting lift to real purchasing power...”

All in all, I certainly don’t see rapid economic growth.  On the other hand, I don’t see a recession either.  But there are that do — most notably, the Economic Cycle Research Institute which is in the business of forecasting recessions.  Ironically, Bob has cited them quite frequently in his own newsletter and stock market timing work, although he has publicly distanced himself quite clearly form their recession forecast that was made in late September of last year when they published the article, “U.S. Economy Tipping into Recession” at this url:


Has the ECRI backed off on its recession call since September of last year?  No. They have a video and an article posted on their web site (http://www.businesscycle.com) defending their view.  They point out that for the last three months year-over-year growth in real personal income has stayed lower than it was at the beginning of each of the last ten recessions and they don’t believe the Fed can stop a recession even if they continue to “print money” or do just the right thing policy wise.  Their conclusion is quite clear:

“As students of the business cycle, we admit to being hopelessly biased in our belief that it is simply not possible to repeal recessions in market economies.  It is not whether there will be a recession, but when.  And ECRI’s indicators are telling us that a recession is likely to begin by mid-year, if not sooner, though this may not become obvious until the end of the year.”

Read the article, “Revoking Recession: 48th Time’s the Charm” at this url: http://tinyurl.com/83ea52s
I’m not really in ECRI’s camp right now.  I am not saying we won’t have another recession, and it might be sooner rather than later.  There is a lot Congress needs to address such as tax policy before next year, and there are forces outside the U.S. that can undermine our economy.  And unexpected events (e.g. 9/11) can change everything.  But right now, I don’t see a bear market happening because of a recession in the near future.
I would be remiss if I didn’t mention the Presidential elections.  Not quite sure which indicator to put this under, but history suggests that the stock market isn’t going to crater during a presidential election year.  Don’t you think that if you were an elected official trying to keep your seat, you would do everything in your power to stave off a recession?  Not that they can do all that much perhaps, but I would think they would try pretty hard.  Incidentally, one of my subscribers (thanks again Bill), sent me some data showing that June, July, August are historically the strongest months over the last 21 election years (1928-2008).  So far, June has started off with a bang.

Bottom line on this indicator:  I don’t see rapid growth (which typically leads to inflation and other ills) or a recession which leads to worse set of problems.  This indicator doesn’t suggest a bear market on the immediate horizon.

5. Over-Valuation

The market’s valuation is determined by examining the price of stocks and their earnings.  With 99% of the companies in the S&P 500 having reported first quarter results, operating earnings for the first quarter came in at $24.31.  Of the 498 companies that have reported, 321 beat estimates, 117 missed and 50 met their estimates.  The first quarter’s earnings look to be the third best in history.  Profit margins remain high at 9.06% versus an average of 7.19%.

Earnings over the last year, including the first quarter, came in at $98.11.  If we use Friday’s closing price of the S&P 500 at 1,325.66, that gives us a trailing price-to-earnings (p/e) multiple of 13.51.  Very reasonable in my opinion.  But alas, the stock market looks forward, not backward. 
If we use Standard & Poor’s estimates for the next three quarters through the end of this year, the estimated earnings for 2012 would be $104.54.  Based on the market’s close this week, that would give us a forward P/E ratio of 12.68.  That is a number we can live with. The only problem is that those estimates can change quickly.  The further out you go, the wider the variance.  It appears revenue is not going to be as high as it was in previous quarters.  Second-quarter revenue growth for S&P 500 companies is expected to be just 2.25% compared with an average 7.3% quarterly increase since 1998 according to Thomson Reuters.  But for now at least, I think the earnings estimates justify the market’s valuation.

All in all though, I don’t see any kind of significant over-valuation in the market.


Analyzing the “root causes” suggests they don’t foretell a bear market.  I should be a good financial newsletter writer and put a big caveat in there by saying nothing is for certain.  And perhaps you read along and came to a different conclusion.  The point of the exercise is to do the analysis so that you can understand my position and hopefully gained some of your own insights along the way.  In the next couple of weeks, I’ll take on the analysis of the components of Bob’s timing model as that provides another good framework to analyze where stocks are headed.

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