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The Worst of this Bear Market Lies Ahead

By Hans Parisis
Tuesday, 21 Apr 2009 11:52 AM Current | Bio | Archive

Observing a lot of optimism around, I first want to say that I see the current situation as a bit like the market rally towards the end of 2001.

At that time, the market had rallied 25 percent and was underpinned by "green shoots" and hope. That rally vanished in March 2002 and quickly plunged 34 percent. That move down did indeed hurt hard "hope"-based investing.

I also see a widespread belief that the recent production cutbacks have been so deep that they have run off unwanted inventory, and many believe (that is, they hope) that therefore GDP will bounce back in the second half as production schedules adjust back upwards.

It's a fact that U.S. inventories have continued to decline sharply over the past year. That has created the false perception that inventories are lean. Unfortunately, that's not the case.

U.S. inventories have indeed declined 3.5 percent year-over-year, but nominal sales growth has collapsed 13 percent. That means that inventories will need to be cut substantially further.

If history can be of any help, production cutbacks always have tended to continue in response to excess inventory until demand begins to bottom out. Take care, though, as a fall in the inventories-to-sales ratio back to low levels is historically not a precursor to economic recovery. It is a lagging indicator.

If retail demand picks up on a sustained basis, it will ultimately ripple its way through the production chain. Indeed, looking into the sector composition of U.S. business inventories, the retail sector has managed to get its excess inventory problem under control far quicker than either wholesalers or manufacturers.

Now, the good news has been that retail sales recovered in January and February, with retail inventories declining some 7 percent year-over-year while wholesalers and manufacturers declined just 2 percent.

But, if as March retail sales data now suggest the recent buoyancy in consumer demand is an aberration, then there remains a big problem of excess inventory backed up in the production process. Don't forget, U.S. manufacturers still carry more inventory than either retailers or wholesalers.

Another area where the market seems, in my opinion, excessively complacent is revenue growth. Despite the unusual depth of the current recession, companies and their analyst mouthpieces are still being caught out on the downside with regard to profit growth.

Why? The answer is in the 13 percent nominal collapse in business sales. Nominal profit growth overlays nominal revenue and nominal GDP growth, not real GDP growth.

It is the year-on-year declines in nominal GDP that are so shocking and that investors and their advisors should be focusing on — not just the slump in real activity.

Despite the massive monetary stimulus that is passing through the system, deepening deflation is continuing to catch out both investors and companies. And with capacity utilization at unprecedented lows and output gaps so large, it is wholly unsurprising that nominal quantities are contracting so rapidly.

That was one of the problems in Japan during in the 1990s. Companies didn't have a clue what was happening to them as nominal GDP collapsed. It was new.

No wonder, then, that U.S. small businesses are still so bearish and the bad news has even crawled its way up to their CEOs. On this measure, things are far worse than they were in early 2002 with no rebound in optimism yet evident.

That is why jobs and investment continue to be slashed. Companies are fighting hard to restore nominal profitability.

As an investor, not a trader, I have totally missed the strongest five-week rally in U.S. equities since the Great Depression. That said, I also see that some of the key leading indicators I monitor have begun to turn upwards.

The well-respected Lakshman Achuthan at ECRI said last Friday, "With the upturn in Weekly Leading Index growth continuing for over five months now, growth in U.S. economic activity will begin to improve in short order."

Yet, compared to the late 2001 upturn, I see the uptick in lead indictors remains just that for the present, an uptick.

Regarding the fundamentals, I want to point out two things:

First, the household sector borrowing requirement, although massively lower than during the excesses of the past few years, still remains in slight deficit (defined as income minus consumption and investment).

That means the deleveraging, which is the paying down of excess borrowing of the last decade, has not even begun.

Second, U.S. house-price deflation is still rising and not, as some people suggest, bottoming out. In my view, it is still too early to be bullish.

But for those who disagree, I would certainly caution piling in with technical indicators so very overbought.

Unfortunately, few believe that the worst of the bear market still lies ahead.

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HansParisis
Observing a lot of optimism around, I first want to say that I see the current situation as a bit like the market rally towards the end of 2001. At that time, the market had rallied 25 percent and was underpinned by "green shoots" and hope. That rally vanished in March 2002...
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