Let’s take a look at a quick snapshot of the economy at this critical juncture, leaning on the work of the analysts at Capital Economics in Toronto.
The sickening decline in U.S. home prices in the first quarter has provided further confirmation that this housing crash has been larger and faster than the one during the Great Depression. On the Case-Shiller index, for instance, the 1.9% quarter over quarter fall meant that since the start of 2006 house prices have fallen by 33%, eclipsing the 31% fall in the late 1920s and early 1930s.
The only comfort is that the latest monthly data show that toward the end of the first quarter prices started to fall at a more modest rate. Nonetheless, prices are likely to fall by a further 3% this year, resulting in a 5% drop over the year as a whole.
This is a lousy time for this to occur because the economy does appear to have hit a soft patch that has undercut job growth — the most important element in economic advancement. CapEcon analysts point out that the sharp falls in the ISM non-manufacturing and ISM manufacturing indices in April and May, respectively, suggest that the weakening in GDP growth in the first quarter continued into the second. The manufacturing index is now at a 19-month low.
Part of the slowdown was due to temporary disruptions caused by the earthquake in Japan. Parts shortages triggered an 8.9% month/month fall in motor vehicle production in April.
So let’s just hand-wave manufacturing for a moment. More worrisome is that job growth has seriously stalled out. After rising by an average of over 200,000 in the previous three months, non-farm payroll employment expanded by just 54,000 in May. The weakness was broad based with outright falls in manufacturing and retail employment.
Now unemployment is 9.1%, rather than the more hopeful 8.8% in March — and still twice the level before the 2008 recession.
And finally, there are no smoke signals coming from Washington that the Federal Reserve will respond to any of this. In a speech last week, Fed chief Ben Bernanke provided no hints or winks that the current bond-purchasing program, scheduled to conclude at the end of this month, will be followed by another round of quantitative easing.
The only positive, and it is a big one, is that the Fed also shows no signs of tightening interest rates either, and that is supportive of the economy.
Bottom line: The economy is really showing no flashes of hope for a second-half turnaround. And the stock market is showing very few signs of developing a sustainable low to go along with the low in sentiment.
The current oversold level of both economic and market sentiment can still combine to create at least a flat spot in which stocks can sort of scrape along in a flat and narrow range within 3% of the current level — scaring people into thinking it will materially break down below 1,200, and then erroneously elating people into thinking it will materially break higher.
If such a trading range does develop, they are very hard to navigate because of the swings in emotions that they generate. You can’t really go long, you can’t really go short; you’re just kind of stuck. Those are great conditions for trading, but not great periods for most mainstream investors.
The best you can say about a period like this is that it gives you plenty of time to decide what you would like to buy in the event that a rally does materialize.
Yet I need to say that if a rally does not materialize fairly soon, a lot of investors will tune out and move more funds into bonds where they can at least generate income from yield. This is why tops really take a lot of time to build. It takes time for investor sentiment to get worn out. This is what creates the catalyst for much lower stock prices, and make the possibility of a decline toward the 1060 area, discussed last week, an increasing possibility.
We have been through this type of period several times in the past decade, and know how to prepare. We can still do very well, it just takes more skill, focus and neves. We’ve got those, right? I am actually looking forward to it, in a way, as these are spans in which you can truly distinguish yourself from the crowd.
For now, we just need to keep holding a lot of cash in our portfolios, stay calm and keep scanning the horizon rather than looking down or backwards.