NOVEMBER NEWSLETTER

It’s mid-November and the stock market is hitting new, recent highs. The bulls argue that retail buyers are back, productivity is soaring and there are still huge piles of cash on the sidelines waiting to be invested. All is good – or is it?

The current market euphoria aside, the numbers underlying the stock prices and the economy as a whole don’t seem to add up. Here are some facts that should give investors doubts about the ability of the stock market to sustain its recent rally, and especially the likelihood of the market going even higher.

Price/ Earnings ratios: With the most recent rally the average P/E of the S&P 500 stands at about 19, well above its long term average of 16*. While some may argue that corporate earnings have shown rapid improvement, the reality is that a major part of higher earnings is due to cost cutting, not from increasing business activity. As demand for their products falls, businesses quite rationally close their least efficient plants first and as a result overall productivity increases. Unfortunately (or maybe fortunately) this process can only go so far until the business closes all its plants and goes out of business. The earnings gains produced from cost cutting are limited and are largely behind us so eventually improved earnings will have to come from growth in demand.

Unemployment: With over 10% national unemployment it’s easy to see why consumers are deciding to spend less. The consumer led recovery from earlier this decade is not likely to be repeated now. While the stock bulls point to improving unemployment data as a sign the tide has turned, the fact is unemployment is still increasing, just at a lower rate. People who aren’t making money can’t spend money, especially when the ability to borrow is very limited.

Household Debt: The buying binge of a few years ago has left consumers with a mountain of debt. Household debt as a percentage of disposable income (the money available to be spent on nonessential items) is now 122%*, roughly double that of 25 years ago. Given the fact that this is only an average and that higher income folks tend to have less debt, this paints a picture of a badly over-levered Middle America that has little room to consume, except for basic needs.

Interest Rates: The Federal Reserve continues to maintain interest rates at near zero levels. While low interest rates tend to encourage borrowing and consumption, we’re already benefiting from that effect and with no room to further lower rates the current level of business activity may be as good as it gets for quite a while. Worse still, if the economy begins to slip from here, the Fed’s first line of defense in reviving the economy – lowering interest rates – won’t be an available option.

The General Business Climate: Not only are over-levered consumers spending less but we are also in an environment where higher taxes, more regulation and most likely higher inflation are headed our way. None of these factors are good for business so further gains in earnings are going to be hard to come by after the easy cost cutting gains are done. Business activity itself may not get worse because of this, but it’s unlikely to make things better either.

All this leads us back to the main point of this newsletter, stocks are very arguably overvalued right now. I’m certainly not advocating investors abandon their carefully thought out investment plans, but rather I’m throwing up a note of caution to those who are chasing the market and/or have plans to invest large amounts of cash near-term. Take the time to think through your investment plans carefully before you jump in because, as the saying goes, "buy in haste and repent at leisure".

Randy Gridley

November, 2009

* Wall Street Journal, November 9, 2009, Pg. C1