Since the previous edition of the Sterling Weekly, the Dow Jones Industrial Average rose 12.55 points or approximately 0.1%, to finish at 10,185.53 The lack of volatility in those numbers actually masks the deterioration in the overall market that occurred between the 22nd of January and the 1st of February. During this period of time the vast majority of the sector indices I track developed bearish chart patterns, and the stocks with the highest trading volume all saw increased volume as they moved lower. Combined these are typically very bearish trading signals.
While I really wanted to write up a sector index I hadn't talked about in quite a while, when looked at the charts of the various sector indices I track I couldn't find one that looked positive. Normally there would be some sector indices that are moving lower, there would be some tracking sideways, and some that are doing well. However, since the financial crisis of 2008 all the various sector indices have been moving together in the same direction, whether that is up or down. The lack of divergence can make life tougher than it normally would be, not to mention finding a topic to write about every week tougher on some weeks than others. So I find myself looking at a chart of the Dow Jones Industrial Average and asking myself where does the market go from here?
Unfortunately I do not see the overall market making any significant gains from these levels. For more information as to why please see the November 23rd, 2008, December 7th, 2008, and the January 25th, 2009 editions of the Sterling Weekly for my thoughts on this. What I see is a combination of macro economic factors including increasing federal deficits, rising taxes, higher inflation, and higher interest rates slowing the economic growth. Lower growth rates will result in a lower Price to Earnings (P:E) multiples for the overall market and individual stocks. Rising interest rates and inflation will do the same. While I won't tire everyone with the math behind the formula; it all has to do with the time value of money and the fact that higher interest rates reduce the current value of future money, additionally higher inflation has the same effect, what it is worth today will be worth less today due the cancerous effects of inflation.
A lower Price to Earnings multiple for the overall market will ultimately increase the cost of capital for companies, or in layman's terms make it more expensive for them to finance future projects. This will in turn further slow the growth of the economy. Once economic growth drops below the population growth people will begin to feel real economic pain.
Since we can short stocks forever, the next question become what do I think will ultimately perform well under these conditions? If I am correct in my assessment of the the factors that will be weighing in on the economy, then all those factors with the exception of inflation will be a depressant on the economy. Historically commodities perform the best in periods of rising inflation. However, in reviewing the various commodities I don't yet see any of the major commodities setting new highs. Which leads us to the question of when does inflation start to kick in? And how high will it get? If you believe inflation is a function of increasing the money supply, and that it typically takes 12-24 months for the effects of monetary expansion to be reflected in the economy, which last week's GDP report reflected, then we expect to see rising inflation in the second half of this year. If that is the case, then the market should start to anticipate the rising inflation sometime in the second quarter of the year, and move lower as a result of the anticipated rising inflation. Or so I think.
I am going to do some research this week and see if I can find an estimate of future economic growth that I feel comfortable with and I'll run the calculations to see what the P/E ratio will be under the conditions I foresee.
Please note that this is heavy week for corporate earnings announcements, and that an earnings surprise always has the possibility of reversing an existing trend.