One year ago this week the S&P 500 hit its nefarious 666 level. Since that historic day, we have enjoyed a 68% gain in equities. Not only has the bounce caused a chorus of perma-bulls to claim the worst of the recession is behind us, but they have also declared that the bull market is here to stay.
These pundits are overlooking an important point: A viable and sustainable bull market can only exist if the underlying economy - and especially consumers - also enjoys the same good health.
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One of the hallmarks of a vibrant economy is a consumer with access to credit, expanding employment and real (after-inflation) income growth. None of those conditions currently exists.
Last week the Bureau of Economic Analysis announced that personal income decreased 1.7% in 2009, whereas real disposable income increased by a paltry 0.9%. The only way the BEA was able to come up with this slightly positive reading on real income for the year was to claim that personal current taxes decreased by 23.1% and inflation posted just a 0.2% increase in 2009. (For more insight, see Jobless Growth: Are You Prepared?)
That's correct. Although other inflation gauges, like the Consumer Price Index, increased 2.6% last year, the BEA claimed inflation was just only slightly more than flat. Even if you assent to this corrupted read on inflation, it's abundantly clear that income growth for consumers was absent. This lack of income growth is continuing into 2010, too. The BEA announced real disposable income dropped 0.6% in January.
Last Friday the Bureau of Labor Statistics (BLS) announced that the U.S. economy shed another 36,000 jobs in February. That number added to the 8.4 million jobs lost since the recession began in December of 2007.
In other words, the economy is failing to produce new jobs despite the help of 15,000 newly hired census workers, 30 months of Federal Reserve interest rate cuts and the 17 months since Congress passed the Emergency Economic Stabilization Act of 2008.
Perhaps the most damaging blow to consumer spending is the paucity of credit. It's important to point out that the need for consumers to deleverage has never been more acute and is exactly what is needed for long-term growth. However, the short-term effect of reduced consumer outlays puts downward pressure on economic growth.
That said, total loans and leases at commercial banks were down 8.3% in the week through Feb. 17 from a year earlier. One reason consumers don't have access to credit is that they have no inflated asset class to tap. Another is that consumer debt has reached the equivalent of 95% of gross domestic product, vs. 50% in 1985.
Both businesses and consumers will face a myriad of challenges ahead. In the second half of 2010 the economy and markets will begin to digest rising interest rates - the result either of direct Fed action or, more likely still, from a rise in yields on long-term Treasuries as they face challenges from increasing inflation and supply. Other headwinds will include higher taxes on dividends and capital gains, which are set to increase at the end of this year.
Finally, the market bounce off the March 2009 lows and subsequent rebound in GDP has coincided with stabilization in home sales and prices. The real estate market brought the economy to its knees in 2008 and has been primarily responsible for its nascent recovery. Unfortunately, government intervention (via tax credits, takeovers of government sponsored borrowers, Fed purchases of Mortgage Backed Securities and other means) has created, or pulled forward, a tremendous amount of demand. Now, even before the termination of the government's meddling, we are witnessing a decline in home sales.
Existing home sales dropped 7.2% to a seasonally adjusted annual rate of 5 million units in January, according to the National Association of Realtors. Purchases of new single-family homes dropped 11.2% in January from December to a seasonally adjusted annual rate of 309,000, according to the Commerce Department. The drop in new home sales was the biggest decline in nearly 50 years.
Renewed weakness in housing will be exacerbated by the retreat of artificial government stimulus. Increased interest rates, taxes and regulations will place additional pressure on the consumer.
Corporate profits have been on a tear and GDP grew at a 5.9% annual rate in the fourth quarter of 2009. Those two data points have abetted the view that the economy and stock market are on sound footing.
In truth, it took consumers and the government two decades to accrue the mountain of debt they now stand upon. That fact, along with the Fed's decades-long manipulation of money supply and interest rates, has caused the economy to become more addicted to inflation and debt than ever before.
Now we are told by the same geniuses who missed the entire credit crisis that all our problems have been solved. Their faith is based on the fact that we have followed the same paradigm that created this debacle in the first place.
If a country can tax, print and spend its way into prosperity, then going long the market here makes sense. If, however, you think low taxes, low interest rates, a stable dollar and low debt to GDP ratio make for a strong consumer and a sound economy, then this may be a better opportunity to at least sell some covered calls. Investors should start by selling calls on some of their bank shares like Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C) that have soared since the lows reached a year ago.