Farrell: Situation Critical, But Not Serious
A client asked me a series of questions that prompted the below reply. I looked at it and thought it was a good summary of where my head is at on a number of issues.
I have been thinking that we needed a 10% correction for some time (I use the S&P 500 average.)
There are few rebounds off a major bottom that don't correct by at least 10% within 14 months of the bottom. I believe we are in that correction now. We are 8.5% off the recent high (as of Wednesday's close) so that would imply we have some to go. I think we will/should try to make a temporary stand around 1100 as that is the 200 day moving average and is also just about 10% off the top. But I believe we will ultimately have a 12-14% total setback.
I would view that as a chance to buy.
We are in a strong dollar time period (even if only because the dollar is the best house in a bad neighborhood) and the sectors that usually do best in a strong dollar environment are groups like restaurants, retail, publishing, software, life insurance. There isn't much room to make money in the US 10-year bond but that would be an OK place to park money for a short period.
I do not believe we are in a new bear market. Corrections are normal and are always scary because they tend to be steep and terrifying. I believe the US economy is firming and while I have lower GDP forecasts than most, I am still positive and find stocks attractively priced. Especially when the low inflation and low interest rates are factored in. I do think we have to "fill in" the downside that was created in the "45 second" crash we had recently , so 1050-1070 is my target right now for the S&P. But as I said above, I hope we can wage a defensive effort at 1102 area.
I do not favor the Euro zone, as I think the risk of a weaker Euro is still present and even the potential for nations dropping out of the Euro. The prospects for a smoother, albeit modest, recovery in the US would make me prefer that area. At best I would have a modest exposure in the emerging markets as their export vitality will be crimped by a weak Europe, but there are far more knowledgeable people about that area than I.
I think the euro will trade at par with the US dollar in the next year or so.
I know purchasing power parity is about 1.15 to 1.2, but such levels are usually exceeded. I think the next currency to be attacked will be the British pound as they have significant debt problems, a still overheated real estate sector, and a difficult political situation. What is to their advantage is the average maturity of government debt is 14 years and Greece's is five, to give a contrasting example.
I am afraid it is only a matter of time before the US dollar and markets are looked at by the international movers and shakers. Our debt and deficit is scary. The advantage is we have an efficient tax gathering system which unfortunately is going to be ramped up to the max by this administration.
One oddity that might alleviate the situation is a lot of consumer debt (mostly mortgages) will be defaulted on and the debt levels thus come down.
With a very steep yield curve, banks are making enough money to be able to reserve for that.
Foreclosures are proceeding at a snails pace as banks would rather have a defaulted mortgage home occupied than not.
Since I have seen some banks release reserves I don't think the defaults on homes will effect predicted profitability and overall consumer debt will look better.
That doesn't improve the government debt level but it will free up consumer cash to help boost the recovery. That is a rose colored eyeglass view. It could be we simply inflate our way out of the situation by monetizing the debt, but the risk of that is still some time away.
Gold should be performing better than it has the last few days. It could be the recent setback in the price of gold is simply a correction. But I think the very low level of both the PPI and CPI has spooked the gold market. With such a low inflation rate, real interest rates are higher and could act as a retardant on growth. (Track Gold Here)
Also, if the Israeli's decide the sanctions against Iran recently agreed to are indeed the joke I think they are, they may feel forced into action against the nuclear facilities. That would be disastrous. If consumer spending fell off a cliff in the US I would have to retreat from my relatively optimistic forecast. I don't think there is much of a risk on the inflationary front for a long time, so it is a double dip in the economy (triggered most likely by a cowering consumer if it were to happen) that represents the greatest risk to the forecast.
There are any number of financial regulatory proposals that could clobber the market, but it looks like the Senate will squeeze out a bill soon. What is on the table can probably be dealt with by the markets. But if the Volker rule were to oust proprietary trading from the banks business mix, or if swap desks were to be "pushed out", then the potential profitability of that sector would be seriously curtailed and estimates would have to come down. Markets don't like declining earnings estimates.
Other that all that -- it's a sunny day in NY and the situation is critical, but not serious.