What Will Happen To Stocks And Oil If The US Economy Fails To Show Any Sign Of Recovery Over The Next Six Months?

In the conclusions to my latest newsletter I noted that, “Nearly every analyst is saying the market has come too far too fast and needs a pullback.  Great, let’s have one.”  Today I want to consider the pullback scenario further.  While it’s true that when “nearly every analyst” says something that thing is probably wrong, still  I think it might be reasonable for investors to take steps to protect the portfolio gains of the past couple of months in preparation for a potentially serious pullback.

Let’s hope that it is truly “always darkest before the dawn” because the real economy to which the stock market is eventually linked is looking fairly dark right now.  U.S. consumer spending, employment and business cap. ex. are all still falling, the auto industry contraction has further to go [it's not clear to me that G.M. and Chrysler won't ultimately be liquidated], and in Europe things actually look worse than they do here.  In the northeast real estate agents tell me the standard bid for a house is 20% - 30% under the asking price, which bodes poorly for a leveling off in housing prices any time soon. The only positive indicator I know is the rising Baltic Dry Index - plus recent stock market gains.

Whether or not the U.S. economy can turn positive during the next 6 - 9 months is looking increasingly like a race between

1. reflationary forces, mainly spending by the Federal government, continued spending by wealthier Americans from their savings, and the growth of China and some other developing economies (Brazil, India, and Singapore maybe) against

2. deflationary forces including weak consumer spending by the growing number of unemployed and the worried-they-are-about-to-be-unemployed, cutbacks by state governments that must balance their budgets, the continuing downsizing of the auto industry and other businesses and downsizing by the even more desperate economies of Europe (especially Eastern Europe), Russia, and the third world.

It’s not clear to me that the forces for re-flation will work quickly enough and be strong enough to outweigh the deflationary forces of continuing job losses and continuing consumer de-leveraging.   If not, then a return to economic growth may simply take a lot longer to achieve than anyone wants to think.

What de-leveraging means for economic recovery is that consumers will not use new borrowing to increase their expenditures and thus will not compensate for the continuing growth of unemployment that takes place during the last part of a recession and the early stages of a recovery.

John Mauldin said it well in his most recent weekly newsletter.  Here’s an excerpt that concludes with his key point (in my opinion) that “we have not seen a deleveraging recession in the US for 80 years.”

From John Mauldin 5/16/09:  The typical pundit keeps telling us unemployment is a lagging indicator, and that the recovery will be well under way before it shows up in the job numbers. Therefore, you should buy what they are selling, because the recovery is on its way. But that may not be the case this time. One of my favorite reads, when I get to see it, is the economic analysis from Bridgewater. They are among the best thinkers anywhere, and everyone who follows them gives them a great deal of credence. This is what they wrote about unemployment being a lagging indicator last month:

“Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts [my emphasis]. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions [my emphasis].

… The deterioration in employment markets will continue because companies’ profit margins are so deeply damaged that a little bounce in growth won’t do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion.

This again illustrates the problem of using past performance to project future results. You have to look at the underlying conditions in order to get a real comparison, and we have not seen a deleveraging recession in the US for 80 years. [my emphasis] Using the past data in today’s world is statistical masturbation: it may make you feel good, but it is not producing anything really useful, and may be harmful to your portfolio.

I would point to another factor holding back growth of OECD employment: the continuing impact of globalization.  Competing with China, Mexico and other low-labor-cost countries for jobs (in the name of “free trade” which may be free but is certainly not fair) has been extremely debilitating to U.S. job creation for many years.   It is still a headwind that the OECD worker must fight against.

Many simple souls (not PhDs in economics who know all about “comparative advantage”) have long asked how developed countries can compete against poor countries that have no social safety net or environmental controls without ultimately bankrupting the developed economies.  Well, we may be finding out that such competition is not feasible on a sustained basis and that the developed countries will in fact be bankrupted in the long term if they keep exporting their jobs.

Implication for equities and oil

It’s always difficult to draw causal relationships between some forecasted economic scenario and the actions of the stock market.   But it seems pretty clear that if the economy fails to show any sign of recovery over the next six months stocks are not likely to do well.

In sum, stocks rose after mid-March on relief that the banking system is not going to collapse. They kept going up on the hope for a V-shaped recovery.  But the market will be disappointed if growth fails to appear in Q3 and Q4.  If that turns out to be the case  I suspect the market will get wind of it before it happens and will decline well in advance of the economic data being released.  Such a decline could re-test of the March lows.   If we get a re-test and it fails….ooops.

In terms of oil, a failure of the economy to start expanding has a less predictable impact.   Yes, there is quite a bit of speculation to the $60 price of oil.  A withdrawal or reversal of that speculation could bring oil down into the mid- to low-$40’s.   On the other hand there are factors beyond the economic fate of OECD economies that could boost the oil price.   They include political tensions - particularly in Iran and Nigeria - continuing rapid declines in existing oil fields, continuing lack of investment in new production, and the continuing growth of China, the Middle East and other developing economies that increases oil demand.

Bottom line:  I’d still hold some equities related to oil, China, and “future energy needs” but I’d also add some hedges against potential broad market declines.  I would sell cyclical non-oil stocks.  I would not add to positions until there is some evidence that the economy is starting to stabilize.  Simply having a lower rate of decline is no longer comforting to stockholders.

Whether or not markets do retreat over the next few months, it’s always good to remind ourselves that the amount of equities held in a portfolio should relate to one’s “tolerance for risk” - which means the amount of the portfolio that one is willing to see disappear in the short term in order to obtain the potential for it to appreciate significantly in the long term.

Here’s one way to quantify the issue: Assume that the downside risk to equity holdings is 33% from here (or you pick a number you like better).  Visualize your current un-hedged holdings being worth 33% less.   Would you still be sleeping well?   If not, cut your un-hedged stock holdings back to the amount that would let you be comfortable or add hedges to the portfolio (stocks or options that will rise in a falling market).

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