Is the market is going lower? Of course!

As I walked down a cold Bay Street yesterday, the source of the stock market’s weakness finally dawned on me: it was too high for the times. That’s not to say that the market was mispriced when the Dow Jones 30 was at 14,000 — it’s just that the market is having a hard time catching up to the current state of the economy.

You know the old broker’s saw, “the market looks out 6 or 9 months”? Let’s accept for a moment that that’s true. Why is that only for rallies? Why doesn’t that axiom also work on the downside?

I think we’ve just found out how true that is in good times AND bad. 18 months ago I was being teased by some brokerage and portfolio manager friends for saying on BNN Television (see prior post “BNN interview on global credit crunch” August 9-07) that “the punters should hide” in this market. One PM (whose name starts with an “I”) sent me a particularly pointed and teasing note, and I wondered if I might have stepped outside my boundaries of expertise.

And then a portfolio CEO thought another prediction (that the Dow would fall from 10,000 to less than 8,000 last Fall – see prior post “Globe & Mail coverage on stock market turmoil” October 6-08) was so crazy that he bet me dinner that I was out to lunch. In a matter of days he tugged on his forelock as we broke through 8,000.

It is time that we all started listening to ourselves. Even what we are hearing isn’t stuff we like.

The one-two punch of recession and bank fears has pushed the Dow Jones Index from 14,000 to 12,000 to 10,000 to 8,000. Of course the TARP wouldn’t fix the stock market (see prior post “TARP passes, but brace yourself for the second shoe to drop” Oct 3-08). And the 90% of any government Stimulus Bill won’t be spent until at least 2010. No short term fix there.

Why was 7,000 impossible to break? We might hope that things will get better quickly, that any big market rallies are a sign of a “bottom” — but that isn’t possible. Investors know that it takes years to build wealth: from 1990 to 1995 the Dow rose from 2,700 to 4,150. Over the next five years it went up another 6,600 points to break 10.9k.

The speed with which the market has returned to 1997 levels should surprise no one, at least in hindsight: is the economy better off now that it was then? I don’t think so. Are our business powerhouses more solid than ’97? In many cases (U.K. banks, U.S. automotive {see prior post “Buckle up – the wheels have come off” August 13-07}, Canadian Forestry, etc.) “no way” is the only answer.

General Electric’s (GE:NYSE) dividend cut is the perfect forward-looking indication of what is going on in the global economy. There can only be three reasons why GE’s management and Board of Directors are not comfortable with maintaining the dividend: 1) forecast earnings won’t cover the quarterly dividend payments, 2) retain cash to bolster balance sheet and maintain credit rating, 3) bad optics given GE has accessed the FDIC’s Temporary Liquidity Guarantee Program.

In the first two cases, the GE team concluded that the economy wasn’t going to get better quickly. This undermines the positive noises we are hearing from Bank of Canada Governor Mark Carney and BMO Economist Doug Porter, unless you believe Canada can break out from the G-8 pack solo. The only recent silver lining is that BMO Bank of Montreal’s (BMO:TSX, NYSE) Board of Directors just declared the full 10.4% implied dividend this morning, even though some journalists were convinced it would be cut (see prior post “BMO insurance deal confirms dividend safety” January 13-09); one can be positive or negative about maintaining a 70 cent divi depending upon whether you focus on their $1.09 in adjusted cash earnings/share or the 39 cents/share/quarter net income.

Speak to any private equity or venture capital fund manager about their own portfolio: almost no one is hiring new employees, many are trimming, and ~85% of their portfolio companies missed their 2008 financial forecasts. Big companies are looking everywhere for inventive sources of capital: Rogers Communications (RCI.A:TSX) and brewer InBev (ABI:EBR) are telling their suppliers that they’ll pay invoices in 180 days. In essence, using them as 1,000s of mini banks, on an interest-free basis. “Micro-finance” has a whole new definition.

The sell-off yesterday might have been tied to the US$60 billion loss at AIG, but I think it went deeper. AIG’s announcement was just the latest evidence that the economy and the banking system are not as healthy as they were in the mid-90s, so why should the market be trading any higher than it was back then? I know that the global workforce is larger (maybe even more productive as well), and that U.S. GDP in 2007 was US$13.8B versus US$8.3B in 1997. But who believes that S&P 500 earnings will grow 21% in 2009, other than the equity research analysts (see prior post “U.S. Bank stock analysts still too rosy about 2009” February 26-09)? Fewer people than when that post was written, as we are off another 500 points since Thursday.

But from a sentiment standpoint, how does one trade the worst economic crisis in 75 years? You don’t. You hide. The major layoffs just started 12 weeks ago. Until they are over, the market can’t hope for a change in the economy and begin to “look out 6 or 9 months” for something sustainably positive.

Let the crazy mega portfolio managers trade Citibank (C:NYSE) all day long. That’s how they are getting their kicks right now: 1 billion shares traded again yesterday, or ~20% of Citibank’s market cap.

But that’s not a game for the rest of us. And don’t think for a moment that I’m patting myself on the back — I’ve largely stayed the course, and have made the mistake of ignoring my own gut.

MRM
(disclosure – I own BMO)