In the context of market valuation, the U.S. stock market is overvalued. We are in a recovery phase that was artificially created via stimulus programs. For the global economy, the worst may be in the future.
In order for the broad U.S. stock market to achieve anything greater than moving sideways beyond the second quarter of 2010, real revenue growth is required, that is, growth not created via stimulus dollars, zero interest rate government loans to banks, and operational efficiencies. The level of consumer demand required to increase top line revenue is lacking, and I believe this trend will continue until the unemployment rate decreases.
Jobs must be created. Though some companies have started hiring, headcount increases won’t come close to pre-crisis employment levels. Companies are more efficient, performing required task with less staff; companies will continue to increase efficiencies, hence limiting headcount increases. The good news is that a large unemployment rate should keep inflation at bay in the short-term, the bad news is that more home foreclosures are on the horizon and real-estate values will remain under pressure. However, we will eventually get inflation when we get close to full employment (NAIRU: Non-accelerating inflation rate of unemployment, aka, the natural rate of unemployment).
With limited private sector employment growth, the government’s ability to respond is limited by the massive U.S. budget deficit, which is already high and likely to go higher. This means that even if the current administration wanted to keep the Bush tax cuts, America cannot afford it. Also, the U.S. government lacks the funds to increase tax incentives in an effort to entice small businesses to hire (approximately 50% of the U.S. working population are employed by small businesses). Such incentives, if provided, would erode quickly, as did “cash for clunkers.” So where will the new jobs come from?
Sovereign spreads, a measure of the risk of lending to a sovereign government, have increased in much part due to the same inherent risks that hurt the U.S. For much of the world, real-estate values are under pressure, banks have failed or were saved by the government, there is a lack of consumer demand, and there have been decreases in government revenue in the midst of increasing government expenditures.
While I hope the U.S. stock market continues the positive run its made since March, 2009, I’m realistic. Putting on my fundamentalist hat, I see the market as being overvalued based on an abundance of problems.
What I’m doing:
- I’m invested in U.S. domestic equities and emerging market ADRs and ETFs.
- I either have stop-loss orders on all of my long positions, or I own put protection, which I usually finance by selling call options, i.e. I’ve created low cost to zero cost collars, having both covered calls and protective put positions.
- Since I trade in the short-term with a portion of my capital, I sell short at times. To limit my margin fees, I’m rarely short for more than a few days, preferring to buy put options when volatility is low, rather than staying short for extended durations.
I hope I’m wrong. Good GDP numbers for the fourth quarter of 2009 and first quarter of 2010 might be realities (4-5% growth respectively). However, if U.S. unemployment has not gone below 9% by mid-year 2010, with a U6 number below 14% (i.e. discouraged workers, marginally attached workers, and part-time workers who want full-time work, but can’t find full-time employment), I would brace for the worst.