Examining current market forces

By Tim Suffish CFA, CPA Vice President, St. Germain Investments Where we stand Stock market investors throughout the world have suffered through a very tough first half of 2008. The headwinds facing the market are not entirely new, but the extent of their bluster is at a level that we have not seen in a long time. Both here in the USA and abroad, inflation concerns are joining the "credit crisis" and stubbornly high energy prices as reasons to pause. There's no glossing over the data from the first six months of the year, so let's get it right out there; Dow Jones Industrial Average down 14 percent; S&P 500 down 13 percent; Crude oil up 46 percent; Unemployment rate up to 5.5 percent; CPI up to 4.1 percent; Real GDP growth slowing to 1.0 percent; Case Shiller Home Index down over 15 percent (past 12 months); S&P Finance Sector down 30 percent. Each of these bullet points is worthy of in-depth discussion, but let's just take a look at a few of them to better understand where we are, and more importantly, where we may be going. The market Slowing growth and rising prices are not a good combination, and the markets have voiced their displeasure. Inflation rates have increased dramatically in many markets throughout the world. As one might expect, stock returns have been negatively correlated to the inflation rate; the higher the inflationary "shock," the lower the market. Inflation woes A silver lining for investors in the US market lies in the source of said inflation. While commodity prices have played a significant part in the inflation picture for all markets, wage pressures have tended to be problematic in the developing markets much more than in the developed markets. What does this mean? As commodity prices come down with a slowing global economy, the inflation situation should ease in the US as the underlying wage pressures do not exist; this will not be true (initially at least) in the developing market where wages will still be problematic. This backdrop should be a net positive for stocks as valuations (P/E ratios) should expand with lower inflation. The latter part of July has seen the price of oil come down over 10 percent; a step in the right direction. The oil situation Is oil in a bubble? While we're not brave enough to call a top in energy prices, historical perspective suggests that we are seeing price action similar to what has been seen in previous speculative manias. A comparison of the dramatic rise in oil can be plotted on a chart and compared to many "hot" markets that we've lived through in recent years; Japan in the late 1980s, the Nasdaq in the 1990s, and China in 2007. Let me emphasize that we're not looking at the "fundamentals" of the energy markets, we're not disputing "peak oil," and we're not doubting the growing demand from emerging markets. From a pure "technical" standpoint, the run in oil is very similar to these previous price spikes. If, and that's a big if, the price of oil comes down in a meaningful way, recent moves in the market suggest that the reaction from the stock market would be positive. The consumer You don't have to look far for evidence of the consumer slowdown. If fact, the media has even invented a new term; the "staycation," where consumers feeling pinched by energy prices can have vacation-like experiences while staying at home. Housing price declines, energy prices and credit conditions are weighing on the consumer mood, and are showing up in the consumer sentiment numbers. The most recent readings are the lowest we've seen since the early 1980s. With the continued softness in housing prices, the ability of the consumer to access home equity (for consumption) has declined over the past two years. Mortgage Equity Withdrawal (MEW) is a measure of this that ballooned during the housing boom years, enabling consumers to tap into housing "wealth" to fund consumption. Now that values are down and credit is tighter, access to this wealth is on the decline. For the short term this will serve as a headwind to consumer spending. In the long term this will lead to a healthier housing market, and a healthier consumer that doesn't count every last penny in housing equity like cash in their pocket. Sentiment is extreme and suggestive of a bounce Contrarian investing is a foreign concept to most investors and is difficult to implement in the real world. Buying weakness and selling strength at the extremes is usually a successful strategy. When we look at the state of the market, I believe we are approaching a point where many quantifiable measures are in our favor as investors. Sentiment, valuation, monetary policy, and fiscal policy have typically had a strong influence on the direction of the market. They are lining up in our favor. it's just a matter of time. Column provided to PRIME by: St. Germain Investment Management; 1500 Main Street, Springfield, MA; Phone is 413-733-5111 or 1-800443-7624; web site:www.dgstgermain.com