How Sustainable is this Rally?
(July 23, 2009)
Dear Subscribers and Readers,
Virtually every secular bull market in the US since the dawn of the Industrial Revolution has been driven by some productivity-enhancing technologies that would ultimately reshape the US economy. As the dramatic increase in productivity growth sets in, many major sectors in the “old economy” would undergo a deflationary boom – as the capital and labor input costs undergo a dramatic decline (due to productivity growth). As the CPI declines, this is usually accompanied by monetary expansion, whether the national monetary regime was under the “Gold Standard” or under the modern-day Federal Reserve System (as the CPI declines, the Federal Reserve will typically ease monetary policy). The railroad boom from the late 1840s to the 1850s, the automobile, radio, and the mass production boom in the 1920s, and the PC/internet boom during the 1980s and 1990s (combined with two global “regime changes” when interest rates went on a secular decline in 1980 and when the Berlin Wall fell in 1989) were all prime examples of productivity-enhancing technologies that fundamentally changed the US economy. Such “paradigm shifts” also ultimately captured the public's imagination, resulting in a classic stock market bubble.
Just like the 1990s boom in technology and telecom stocks, the speculation (and the appreciation) in the 1920s bull market was concentrated in the technology stocks of the day. The “old economy” stocks, such as textiles and coal mining stocks – just like the “bricks and mortars” businesses of the 1990s – were thrown aside and ignored. Quoting Liaquat Ahamed's “Lords of Finance: The Bankers Who Broke the World” on how the 1920s stock market bubble began:
The bubble began, like all such bubbles, with a conventional bull market, firmly rooted in economy reality and led by the growth of profits. From 1922 to 1927, profits went up 75 percent and the market rose commensurately with them. Not every stock went up in the rise. From the very start, the 1920s market had been as bifurcated as the underlying economy – the “old economy” of textiles, coal, and railroads struggling, as coal lost out to oil and electricity, and the new business of trucking bypassing the railways while the “new economy” of automobiles and radio and consumer appliances grew exponentially. Of the thousand or so companies listed on the New York Stock Exchange, as many went down as went up.
The title of this commentary says it all: “How Sustainable is this Rally?” The October 2002 to October 2007 bull market in stocks ran out of steam for a variety of reasons – but the major reason, if you will, was simply investor's exhaustion. By October 2007, every major technological tailwind and benign “regime changes” in the world – such as the mass adoption of the PC/internet, the “opening up” of China in 1978 and India in 1991, the fall of the Berlin War, and the 25-year secular decline in interest rates (by late 2006, credit spreads were at an all-time low) – had all played out. Short of a major discovery such as a general cure for cancer or the commercialization of cheap, limitless solar power, no productivity-enhancing tailwind was on the horizon. On the US consumer side, consumer spending as a percentage of GDP peaked at 70%. Households' balance sheets were leveraged at a record high and were straining at the seams. Even the 55-year US consumer debt boom has ended – and investors knew it.
So is the current rally in the stock market sustainable? We will only know in hindsight, but given the reluctance of the stock market to correct yesterday (despite overbought short-term conditions), the outlook remains bright for at least the next couple of weeks. Most notable is the 11th consecutive up session in the NASDAQ Composite, fueled by the continuing rise in large cap technology stocks. Since almost all major US bull markets have been accompanied by a bull market in technology stocks (or what counted as “tech stocks” of the day, such as General Motors and RCA in the 1920s), the 11-day rise in the NASDAQ Composite is certainly encouraging (note that eBay traded up nearly 5% in after-hours trading last night). In addition, the most recent technical action in the NASDAQ Composite has also been strengthening, as shown in the following chart, courtesy of Decisionpoint.com:
As mentioned in the above chart – based on the percentage of NASDAQ stocks above its 200-EMA – the technical condition of the NASDAQ Composite has been gathering strength over the last two weeks. More importantly, this percentage has just risen to its highest level since July 2007 – or three months prior to the peak of the October 2002 to October 2007 bull market. If this percentage rises above 50%, then the odds of a sustainable breakout – with the potential to lead to a multi-year bull market – will increase substantially.
From a fundamental standpoint, there are technologies on the horizon (within the next 3 to 5 years) that could fundamentally change the US economy and result in significant and sustainable productivity growth. More importantly, both the Obama administration and the Chinese government have placed significant emphasis (and monetary resources) on both “hard science” and technology investments. Specifically, the Chinese government has set its sights on being the “technology leader” in electric vehicles in the next few years. Two days ago, the Chinese government announced it would provide a 50% subsidy to solar investments. With this public policy decision (plus the fact that the Chinese economy is still growing at an impressive rate), installed solar capacity in China should outpace that of the US by 2012. Of course – as the “supercomputing space race” has shown – the US is not resting on its laurels. On the biotech side, both Amgen and HGSI have recently announced encouraging results in their drug pipelines – shattering the investor perception that there has been no biotech (large molecule) innovation in the last few years, despite the record high R&D spending. In addition, Exxon Mobil has just announced a $300 million investment in Craig Venter's algae fuel company, Synthetic Biology. This is a significant turning point in the alternative energy sector, as Exxon Mobil is known for its conservatism and strict adherence to investing in high ROIC projects. Combined with the continued R&D on more efficient solar and battery technologies, I would not be surprised if the US is able to slash its oil imports by up to 30% in just the next five years.
In addition, the P/B ratio of the S&P 500 sunk to a 25-year low of 1.2 (according to Ned Davis) at the March 9th lows. With earnings projected to be positive both this year and in 2010, I seriously doubt the S&P 500 could ever break through its March lows again, unless: 1) the global economy succumbs to a deflationary depression, 2) the US experiences double-digit inflation sometime in the next 12 to 24 months. As of today, I don't see either scenario panning out (if I have to pick, double-digit inflation will be my choice given the significant amount of retirement and Medicare liabilities that will be borne by taxpayers over the next 30 years). However, should we ever experience a “Black Swan” event (such as a regional war in the Middle East), then all bets are off.
In the meantime, the battle between the bulls and the bears lives on. For now, I still expect a significant correction later this year. But if the technical condition of the stock market remains healthy – and if the Federal Reserve continues with its quantitative easing policy – then we could potentially stay 100% long in our DJIA Timing System for the rest of this year. Subscribers please stay tuned.
Henry To, CFA