What’s the Next Shoe to Drop?

The stock market has turned schizophrenic this year as periodic new highs have been consistently met with selling pressure.  An increasing number of market strategists are saying that our inability to break out of this malaise is a signal that a correction is at hand.  Many point to the fact that the sectors that had previously led the market higher are now selling off, one by one.  Indeed, this does seem to be the case.  The biotechnology sector was the first crack to appear.  Using an exchange-traded fund as a proxy, the biotechs are down 16% from their highs in late February.  Next, the internet and small-cap sectors started to sell off.  Since early March, these sectors are down 17% and 9%, respectively, from their highs (also using ETF’s as proxies).  And now, the retail stocks are starting to experience some aggressive selling pressure following first-quarter earnings reports that left a lot to be desired.  Based on the SPDR S&P Retail ETF, the retailers are now off 6% from their 2013 high in early March.

So what is going on?  Initially, the rotation out of bubblicious biotechs, internets, and small-caps appeared like a healthy development for the overall market.  Based on the standard valuation metrics, these sectors had developed a significant amount of froth following years of strong outperformance. However, the contagion into the retail sector is, if it continues, a more troublesome development.  Why? Because the consumer represents about 70% of our economic activity.  If consumer spending remains subdued, it means that the powers that be have not yet succeeded in priming the economic pump.  It won’t have been for lack of trying.

Since the beginning of 2008, the Fed’s balance sheet has increased by over $3.4 trillion to $4.3 trillion. Over that same time period, the US Treasury has run deficits totaling well over $6 trillion.  What have we gotten from all this monetary and fiscal stimulus?  Well, since the end of the recession in June, 2009, GDP growth has averaged just over 2%.  The unemployment rate has dropped dramatically from a high of 10.0% to 6.3%, but much of the improvement has come either from folks dropping out of the labor force or folks accepting low-paying or part-time work.  Income growth remains anemic, and the income and wealth disparity between the haves and have-nots continues to expand.  The one indisputable positive side effect of Fed monetary easing has been that asset prices have soared.  Increases in housing and stock prices have led to a $25 trillion increase in household net worth since the first quarter of 2009. Household net worth currently stands at an all-time record of $80.7 trillion.

Our consistent message throughout this “recovery” has been that it must become more balanced, with more of the benefits accruing to the middle class rather than just those at the top.  If the recovery does not become more balanced, we are much less likely to achieve the elusive escape velocity that will allow the Fed to extricate itself.  As we scour the landscape for evidence of a broadening in economic well-being, we continue to be disappointed.  The most recent evidence of continued middle-class struggles comes from first quarter earnings reports from the retailers.  Yes, extraordinarily cold and stormy weather had a major effect on first quarter sales and profitability.  But we knew this going into earnings season. Why are so many earnings reports from major U.S. retailers being met with such negative reactions in the stocks?  Retailers heavily dependent on low- to moderate-income customers – such Wal-Mart, Target, TJ Maxx, Dick’s, PetSmart, and Staples – have all gapped lower this earnings season.  Stocks in the two largest dollar stores, Dollar General and Family Dollar, have been weak all year.  Which retail stocks are rallying on earnings news?  Well, one in particular stands out: Tiffany’s.  What is the market telling us?

The Fed’s trickle-down monetary policy becomes less impactful every day.  Yet the risks of creating monetary-policy-induced asset bubbles continue to grow.  We suggest that it’s time for the Fed to get lost.  The economy is recovering, albeit slowly.  This portends, as all recoveries from debt bubbles do, to be a long and slow climb that may last several more years.  As markets flirt with new highs and fears abound, we counsel both cheer and fear.  New highs mean that patient, disciplined investors are being rewarded.  Investors learned in 1998 that, though expensive, shares could go a good deal higher.  At the same time, if the rule is to buy low and sell high, this isn’t low!  Market timing doesn’t work, but caution is a great companion for the long haul.  Strong, well-managed, well-capitalized multi-national companies with strong cash flow make sense to us.  This is not a time for adding incremental risk.  As David Tepper said, “I’m not saying go short, just don’t be too freakin’ long.”

Peace,

Michael