Bear market looks like a long one

by Levi Folk | July 5, 2008

The days of reckoning are finally upon the U.S. economy, and the world’s most indebted nation is in the midst of a transition that promises a slow grind for the U.S. economy and further weakness for U.S. equity markets.

The U.S. economy is being buffeted on several fronts by various contractionary forces, many of its own making, and monetary and fiscal policy makers will prove no match for what it is facing:

• A severe decline in the housing sector that has seen house prices fall 15.3% year over year.
• A credit contraction precipitated by losses on formerly overpriced mortgage debt.
• Record high oil prices caused by rising demand from emerging markets and a weak U.S. dollar.
• Rising inflation caused by rising oil prices and a weak dollar policy by the U.S. Federal Reserve Bank.

This could be the year that the U.S. consumer finally retrenches. The U.S. savings rate has been in steady decline for well over a decade, and despite numerous calls for an abrupt end to its profligate ways, the average American has confounded its critics and kept on spending.

U.S. consumers have been living beyond their means for some time, and the U.S. housing boom was their lifeline. Rising house prices allowed for hundreds of billions of dollars in mortgage refinancing for the purpose of home-equity extraction. The aftermath of that financial mania—mortgage defaults and collapsing house prices—has left U.S. consumers treading water.

Staying afloat is all the more challenging for the average American who is feeling the pull of record high oil prices on his disposable income. I am inclined to agree with Jim Grant, editor of the eponymous Grant’s Interest Rate Observer, who argues with "no great predictive courage" that the U.S. savings rate is due for a rise from its current low of close to zero.

Grant ballparks an impending 3.3% rise in the savings rate, equivalent to roughly $350-billion of disposable personal income, or in the parlance of the U.S. consumer just shy of a full year of sales at Wal-Mart stores.

The U.S. economy will grow “below trend” for some time according to an excellent report entitled “U.S.: Slow Credit Growth—A Threat to the Economy and Stock Market” by Smithers and Co. Ltd. of the U. K. A weak banking sector has implications for the broader economy because banks are the primary source of credit creation

Profits in the banking sector have turned negative since last summer due to significant writedowns on mortgage securities.

Falling house prices have led to mortgage defaults and hundreds of billions of dollars in losses on associated securities that the banks created. Bank lending and money growth will not expand at the rate to ensure trend GDP growth over the next year.

The U.S. Federal Reserve is now caught between a rock and a hard place. The U.S. economy and ailing banking sector demand low interest rates. The weak dollar, rising oil prices and inflation require an entirely different policy response. The Fed must now choose to keep rates steady or even raise rates to defend a weak U.S. dollar and prevent inflation, now running at over 4% annually, or to cut rates to prop up the economy. Either response is negative for the stock market.

A more restrictive monetary policy is not desirable given the current weakness in the economy. The labour market has contracted for six straight months, and the Fed has cut rates to address the economic slowdown.

On the other hand corporate profitability is eroded by inflation, and there is a strong negative historical correlation between inflation and market valuations. Rising inflation tends to be associated with falling valuations and vice versa.

The P/E ratio on the S&P 500 declined from a high of 22 in 1961 with inflation hovering at 1% to a low of seven in 1980, the same month inflation peaked at 14.6%.

Either way you slice it, the U.S. stock market, already in a bear market, is likely to remain there for some time.