Yesterday's 100-point plus blow to the Dow Jones Industrial Average reveals some major chinks in the armor of the current bull market.
When bull markets are strong, they can generally absorb bad news and keep heading higher. But when they're nearing their tail end — which is what I see happening now — any bad news can deliver a knock-out punch.
Yesterday's power punches came on three fronts. First, Citigroup, the nation's third-largest bank, said the fallout from the subprime mortgage debacle is not yet over and could continue to plague the financial industry. Former Federal Reserve Chairman Alan Greenspan agreed with this assessment in an interview yesterday. Regular readers of this column know that I've been warning about this for weeks now.
Citigroup's "unexpected" announcement apparently woke up investors to the likelihood that operating losses for financial companies won't be limited to the third quarter of this year — a quarter during which analysts at Standard & Poor's estimate corporate profits at banks and brokerage firms declined a whopping 14 percent, the biggest drop since 2001.
Meanwhile, Goldman Sachs told investors yesterday to underweight the financials because it thinks banks may reduce their 2008 profit forecasts amid declining revenue from debt trading and underwriting.
The second blow came on reports from the turbulent Middle East that Turkish forces may pursue Kurdish militants in Iraq. This announcement resulted in crude oil prices rising to their highest level ever — above $86 per barrel.
Yesterday's final power punch came from reports out of Europe that central banks there are beginning to pressure the U.S. into taking actions to curb the depreciating U.S. dollar. European officials are concerned that the falling dollar (and their own, rising currencies) limit the ability of European nations, including France, Germany and others, to grow their exports. European exporters are being priced out of foreign markets because of the dollar's descent.
The dollar's rapid decline against other world currencies has placed the U.S. Treasury in a position similar to that of the Federal Reserve — it's now between a rock and a hard place! If the Treasury takes steps to curb the dollar's decline, it will lose its ability to persuade China to let the yuan trade more freely. On the other hand, if the Treasury fails to act, the dollar will likely continue to fall. Such an outcome would bring about further inflation pressures, which in turn could cause the Fed to raise short-term interest rates.
Yet, yesterday's blows weren't limited to "power punches." Additional, more subtle pressures are afoot.
For example, an important announcement that was overlooked by most investors and the talking heads on CNBC was a report from the Congressional Budget Office (CBO) on the U.S. federal budget deficit. Although the shortfall narrowed in the current fiscal year ended September 30, the CBO expects the deficit to swell in fiscal 2009. The Bush administration expects it to widen even sooner as the U.S. economy slows and due to the cost of funding the war in Iraq.
A widening federal budget deficit would place both the Treasury and the Fed in an even more difficult position, since the U.S. government has been relying on borrowing from abroad to fund its expenditures over the past several years.
If the deficit does expand, the U.S. government will likely need to raise taxes or the Fed may need to raise interest rates to encourage foreign investors to (indirectly) fund that spending. Even if the Fed doesn't raise interest rates, long-term rates will still likely increase significantly because the Treasury will need to issue more notes and bonds to fund an expanding deficit. (Remember, when the supply of bonds rises, their prices fall and interest rates therefore rise).
I've been warning you about numerous other negative economic developments over the past month that point to a significant economic slowdown in the U.S. and even an outright recession. Just this month, we've seen weak manufacturing, retail sales, corporate profits, employment, and housing reports — and the month is only half over!
Just last Friday, three less-than-stellar economic reports were released.
The University of Michigan reported that its index of consumer expectations regarding future economic conditions fell during early October to the lowest level in more than a year as rising energy prices and falling home values began to take a toll.
The U.S. Department of Commerce announced that total retail sales in the U.S. rose 0.6 percent in September versus the prior month. That would be good news, but if you look beneath the numbers, you'd see that higher-priced gasoline boosted those sales greatly.
In fact, the vast majority of the nation's retail chain stores actually saw declining sales during September on a same-store basis. Only 30 percent of chain stores reported an increase of at least two percent in their same-store sales during September compared to a year ago. Comparatively, 58 percent of stores reported same-store sales increases during August and 60 percent in July. So, in reality, consumer spending on clothing, general merchandise and other household items slowed significantly last month.
There was also disturbing news on the inflation front last week, as prices of finished consumer goods — goods that were just manufactured but not yet sold to consumers — rose at their fastest pace in September since June 2006.
Various other statistics also show that inflationary pressures are rising. For example, commodity prices rose 20 percent during August, the latest period for which data is currently available, and crude oil prices for November delivery hit an all-time high yesterday. Food prices also continue to rise sharply.
So, as I've repeatedly warned over the past month, I strongly urge you to not get sucked into believing the economy is in sound shape and that stock prices will continue to rally. My research shows just the opposite — that economic growth in the U.S. will slow considerably over the coming months and that stock prices in general will fall sharply.
The good news is that in spite of a slowing economy, you can still make 50 percent to 100 percent profits in the coming year if you get into the right ETFs. In the next issue of our new service — The ETF Strategist — I reveal two funds that are positioned to soar in down markets. Don't miss out.
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