European Debt Crisis and The US Consumer

Consensus View

As we embark on another year, the financial experts are predicting that 2011 will be an excellent year for GDP growth and global equity appreciation. After a surprising 10%+ return on the S&P 500 last year, of which more than half of its returns were in the month of December, most market strategist believe the overall market will exceed its highs of 2007, and corporate earnings will reach record levels. Hence the extreme optimism most portfolio managers are reporting. In addition, an overwhelming majority of market economists are forecasting over 4% GDP growth for the US. More importantly, the consensus of market forecasters believe that Gold has peaked, residential real estate still has more downside risk, bonds will continue to sell off, and the global equity markets will continue to rise to all-time highs.

Unfortunately, I do not entirely agree with the over-zealous market forecasts. Below are two reason why.

European Debt Crisis

Greece, Ireland, Spain, and now Portugal are all European nations that will need the EU to bail them out of the current fiscal disaster. Many other EU nations are faced with same financial problems, and the true extent of these problems are being ignored by most investors. Ireland and Greece are now paying over 80% of their export revenues toward external debt payments (See the article The Crisis That Isn't Going Away on B1 of the Saturday NYT for more detailsgluskinsheff- Rosenberg Jan 10, 2011 ). It is unbelievable that the financial markets have ignored the adverse affects of a developed country going bankrupt. Sure, the EU is stepping to avoid outright financial failure, but the ramifications are being ignored by investors. Probably, the most alarming is nearly 30% of US imports come from Europe. How can the US avoid a precipitous drop in consumption from Europe? The European debt crisis is not going away anytime soon, and the real problems are yet to be realized. Eventually, the effects of poor fiscal management will be realized and the financial markets will have to reduce equity asset values in order to account for a deterioration in the balance sheets of developed sovereign nations. This problem alone could sink the global equity markets below the levels of March of 2009.

The Consumer: Confidence, Jobs, Rising costs in Food and Energy

Consumer confidence remains well-below its normal expansion level at 52 (100 = expansion). The recent jobs reports showed that the US added only 103,000 jobs in the month of December, which normally at this time in a recovery we should be seeing between 350,000 - 500,000 new jobs being created each month. The consumer is facing adversity on many fronts. Housing prices continue to fall, nearly 20% of the workforce is employed part-time, and household fixed costs continue to increase. For example, oil prices are at nearing $90 a barrel, and gasoline prices are once again approaching $3.00 a gallon. Moreover, the latest reading on food prices have increased nearly 20% over the last year. Never has there been such a discrepancy between the health of the consumer and the stock market. Normally, the equity markets would be testing multi-year lows and PE multiples would be in the high single digits. Instead, equity prices continue to rise and PE ratios are at the highest levels since 2000. Unless these circumstances change for the consumer, the stock market will eventually sell-off significantly.

Why Are Stocks at Multi-Year Highs?

The Federal Reserve Bank has kept interests rates at records lows and intends to do this for the unforeseeable future. Corporate profits continue to rise and their balance sheets are impressive. Investors believe the future will be brighter, because of lower-taxes and the worst of the financial crisis is behind us. Most importantly, the US economy is improving. This is all positive for stocks.

So, why are we so cautious?

The equity markets are overvalued, investor and market optimism are at all-time highs, and yields continue to rise. In short, the market has gotten ahead of itself. There are far too many risks that could easily derail this fragile recovery. Moreover, history suggests that any negative or unexpected event will cause equity markets to sell-off quickly and sharply.

John P. Hussman provides the following instances when the market In the past has reached this type of optimism and market valuation:

• December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)
• August - September 1987 (followed by a 34% plunge over the following 3 months)
• July 1998 (followed abruptly by an 18% loss over the following 3 months)
• July 1999 (followed by a 12% market loss over the next 3 months)
• January 2000 (followed by a spike 10% loss over the next 6 weeks)
• March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002)
• July 2007 (followed by a 57% market plunge over the following 21 months)
• January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks)

This data is overwhelmingly significant. It is not a matter of IF the market is going to sell-off significantly, but WHEN.