The Stock Market Approaches 11,000: Watch Out

Morris Segall      business landscape, Capital Markets, currency devaluation, Economic Growth

Today the stock market rallied almost 200 points on the Dow Jones Industrial Average and all major averages moved up by 2% or more. What happened. First, the Bank of Japan cuts interest rates overnight to zero and infuses another $400 billion in liquidity via asset purchases. Second, the ISM non-manufacturing index for the month of September rises to 53.2% from 51.5% in August. Conclusions: Bank of Japan continues worldwide reflation measures of industrialized countries to stave off double dip recessions. ISM non manufacturing index shows U.S. economy is growing and not going into a double dip recession.

Reality: Japanese economy is weakening and in danger of falling back into recession. Added liquidity and lower interest rates will delay it but unlikely to stave it off completely. Further liquidity additions may be necessary. These actions are not an indication of economic strength and results in another industrialized currency (yen) devalued.

Yes, the ISM index improves in September led by gains in imports, exports and employment.

BUT: At 52.3% the index is below the 55.4% levels of March, April and May of this year. The Business Activity sub-index declined to 52.8%, down from 54.4% in August and a peak of 61.1% in May. The New Orders sub-index increased to 54.9% in September from 52.4% in August but has not recovered to the 57%-62% levels of March, April and May of this year. The Inventories sub-index in September contracted at 47.0%, down from the expansion levels of 53.5% in August and a peak reading of 62.5% in May. Inventories are being reduced. The backlogs sub-index in September contracted to 48% from a peak reading of 56.0% in May. As we reported in our October 2nd blog article on the ISM manufacturing index, backlogs are now declining from the extended weakness in new orders versus shipments. Declining backlogs usually precede declining shipments going forward.

The news from Japan and the ISM indices portend economic weakness, not strength.

The stock market is now trading at more than 15 times estimated corporate earnings for 2010. Wall Street estimates for corporate earnings in 2011 range from 15%-20% growth next year. Given our weak economic outlook for next year (see our website articles of August 30 and September 7, 2010 and our Economic Update of September 28, 2010) , we expect much weaker corporate earnings growth of 5%-10% in 2011. If we are correct, Wall Street earnings estimates will have to be reduced and the stock market will not be perceived to be as attractively valued as the Street currently believes. Lastly, the rise in the stock market since Labor Day has been led by commodity and materials stocks. These are “plays” to offset the dramatically declining U.S. Dollar over the same period. With the accompanying surge in gold, the upward move in “hard assets” belies the attractiveness of “paper” assets represented by common stocks. The technicals and upside momentum in the stock market are strong and will add to gains short term. However, we continue to believe the decline in the value of the Dollar and the weakening economic trends portend a peaking in corporate earnings by the early part of next year and a major risk to the current stock market trend. As we have said previously, momentum driven stock markets can “turn” quickly. We think this market move is fraught with danger.

Morris R. Segall, CFA, CIC