The idea of "sell in May and go away" certainly seems attractive now after this past month. It was very ugly for stocks. We had the "flash crash" early in the month and the bounce rolled over and plenty of stocks hit new relative lows. Depending on who you listen to or which market you're looking at it was the worst month in over a year and the worst May since 1968 or 1940. Investors were facing a three-day weekend here in the U.S. and no one seemed excited about holding positions over the break.
I don't blame them. Geopolitical tensions are rising. The situation with North Korea has not improved with the country still on "war" alert and looking for a fight. Another hot spot was the Persian Gulf area. Evidently President Obama decided to beef up our military presence in the Gulf and Iran claims they spotted a U.S. nuclear submarine in the Straits of Hormuz. It could be part of the new carrier group sent to reinforce the one already in the Arabian Sea. The U.S. has been gearing up for an offensive in Afghanistan but I fail to see how sending a sub into the Persian Gulf helps the Afghan war. Maybe the situation with Iran is getting worse.
As usual the real story remains Europe, with the debt contagion spreading there, and now to make matters worse the status of the banks. First let's talk about Spain. Credit rating agency Fitch downgraded Spain from AAA to AA+. This was the second downgrade in about a month after S&P cut Spain to AA. Fitch claims that Spain's budget cuts and bank bailouts will put a drag on their economy. You know, that robust Spanish economy that already has 20% unemployment and massive amounts of real estate no one is buying and a budget deficit that's so bad many believe it could be the next debt stink bomb to go off in the EU. Europe is facing some pretty long-term economic challenges. We are too but Europe will have a much harder time facing these obstacles. Odds are probably 100% that we'll be hearing more credit rating downgrades from the EU for months, probably years to come. Better get used to it.
Spain's economic plight is nothing new. What really worries investors is the situation with the banks and how it is deteriorating. European banks don't trust one another and they are reluctant to lend money to each other. This is very similar to what happened during our financial crisis back in 2008 when Lehman Brothers collapsed. We eventually had to have several major banks bailed out and recapitalized. It was extremely painful. The major European banks could be in a similar situation. Some of them are still highly leveraged. Naturally the markets are spooked and investors are quick to hit the sell button after seeing what happened to the U.S. markets.
This past week we had some significant economic data. The Chicago ISM number dipped 4.1 points to 63.8 in May but readings over 50 for this report still indicate growth. The New York ISM reading rallied from 429.4 to 449.3, which is a nice show of improvement. We're going to get the national ISM report this week. If it disappoints it could turn already defensive traders into downright bears.
Investors were also dissecting the latest reading on consumer spending. Economists were expecting consumer spending to rise 0.3%. After several months of gains consumer spending came in flat! You've heard it a million times. Consumer spending accounts for nearly 70% of the U.S. economy. Now a lot of that is essentials that people will always buy every month. It's everything above and beyond the essentials to live that get the economy going. If consumers aren't spending more where did the money go? It went into savings. The report said the U.S. savings rate surged back to 3.6%, which is the highest level since January. A rising savings rate should be bad news for the retailers.
This past week also had some new data on housing and some of it looked pretty good. Unfortunately, any gains in existing and new home sales is a temporary blip. The tax credit has expired and sales are going to fall. Analysts are already predicting that housing values will decline another 5% by year end. Readers of this column know that foreclosures have been rising at a record pace. Unfortunately banks aren't in a hurry to lend mortgages in the U.S. and the standards to get a mortgage these days remain tight. All the headlines about plunging mortgage rates are not going to help the housing market if no one can get financed.
We have a lot of economic data coming out this week. The national ISM report is on Tuesday. Wednesday is the ADP employment report, which is a precursor to the government's jobs report on Friday. The ADP report does not count government hiring so they're numbers are going to be a lot lower but analysts are expecting significant improvement. If the ADP number disappoints it would not bode well for Friday. Of course Friday's non-farm payrolls report is the big event. Estimates are running around +500,000 jobs for the month of May. About half of that (250K) are expected to be temporary census workers hired by the government. Last month's report was pretty solid. If May's jobs report can deliver a strong number it could really give this market a boost. If it fails to hit estimates the stock market could tank! In addition to the U.S. data this week the overseas markets will be digesting French PPI, Germany's unemployment, the EU unemployment number, German retail sales, and the EU GDP results.
You already know that I have been expecting the U.S. economy to roll over into the second half of a "W"-shaped (double-dip) recession some time in late 2010 or early 2011. Believe me, I don't want it to happen, but lately it seems the chances are rising. Europe is facing their own double-dip recession on top of a bad-debt contagion they can't contain and now the potential for a banking crisis. If Europe plunges into recession it's going to have an impact on our economy and the rest of the world, including China since the EU is a major trading party with China. The employment situation in the U.S. is not improving fast enough. Last month's jobs numbers were a big improvement but it could take several years before we finally create enough jobs for everyone who wants to work. We need something in the neighborhood of 125,000 to 150,000 new jobs every month just to stay even. With millions of Americans out of work it will take a long time for our economy to be considered "healthy" again. Our real estate market could also take a while to heal.
If the U.S. does face another double-dip recession what is the stock market going to do? I bet your first thought was "go down" and you'd be right. Now how do we take this bias, because it's still just an opinion for now, and apply it to our LEAPS trading? Not everything declines in a bear market but bullish positions are very, very challenging. Our strategy on LEAPS needs to be very conservative when it comes to position size. We need to be more conservative (tighter) with our stops and take profits sooner. I will be applying these changes to our trading in this newsletter.
However, I am not ready to give up just yet. Look at a long-term chart for the transports, semiconductors, the Russell 2000, defense stocks, even the retailers are all still in an up trend. Granted they will tend to follow the S&P 500 but the game isn't over yet. The S&P 500's bounce did fail near resistance at 1100 and its 200-dma this past week. That is short-term bearish. I wouldn't be surprised to see the S&P 500 bounce around the 1100-1050 zone the next few days. Given the shortened week and the jobs report on Friday stocks could just drift sideways and wait on Friday's announcement. If we're really lucky the rebound continues but the 1150 level will be new overhead resistance.
This is not a very friendly environment to be launching new long-term bullish positions - not with the S&P 500 looking so fragile. Trade carefully and preserve your capital. There is always another entry point if we wait for it.
Chart of the S&P 500 Index:
Chart of the Russell 2000 Index:
LONGER TERM OUTLOOK
Previous Comments on my Long-Term Outlook:
My long-term outlook has not changed. I still expect the economy to see a double-dip, "W"-shaped rebound with the second dip in late 2010 (some analysts are predicting it will not show up until 2011). Lousy consumer spending, rising foreclosures, and lagging job growth will be the main culprits. Several weeks ago there were some comments out of the U.S. Treasury concerning foreclosures. The Obama administration's HAMP loan modification program can only help a certain number of homeowners and one official said that even if the HAMP program was a total success we should still expect millions of new foreclosures.
Estimates were in the 3 to 5 million foreclosures over the next three years but a White House advisor was quoted with estimates in the six to ten million range over the next three years. This only reinforces my own belief that we will see another tidal wave of foreclosed homes in 2010 and 2011. What is that going to do to consumer confidence and consumer spending? It's not going to help! You can review my long-term outlook here. It's the second half our my "Two Months Left" commentary.
~ James Brown