Time to take profits in equities and reset shorts

Amost nothing in life is certain. But, the high for this bear market rally has most likely been reached or very soon will be. The outlook is for a renewed trend decline in equities beginning in coming weeks to at least retest their March 9 lows, and possibly even establish new index lows. That equity market price retreat will reawaken the safe-harbor attraction of US Treasuries, producing lower Treasury bond yields. And that will further reduce bond yields on medium through high-grade corporate credits. Indeed, that process of improvement in corporate bond prices has been underway, even while Treasury yields were rising, reflecting the improved corporate access to market funds and the lightening in percieved underlying default risk.

There are many reasons for the equity market's likely coming change of direction from rally to decline. These include a lessening in the unwarranted "green shoots" euphoria that the recession is already ending and that the economy is actually on the mend. There is an increasing recognition that the recession will persist, even if the rate of decline is not quite as headlong.

The earnings season is coming to an end. And the results suggest that at current price levels the equity markets are overbought. The per share earnings for the S&P 500 at just over $10 for the first quarter, suggests some $45 or less for the year. That equates with a relatively rich 20-times earnings price level, well above the 15 times price-earnings ratio long-term average and the far lower p-e ratio levels amidst past long wave p-e ratio cyclical declines.

While the Federal government assessment of the bank stress test reports were less worrisome than had been feared, there is an increasing realization that to a considerable extent the banks were given a free ride. The economic stress that was built into the bank loss picture is by no means extreme and the presumed loss under the supposed worst case scenario is far smaller than a worst case scenario would actually create.

The upsurge in new equity offerings is bolstering the financial position of the companies involved, but it is also watering down the equity position of current stockholders. The latter is a clearly percieved market negative.

The same mixed message for the markets can be discerned from the Federal governments intrusion in corporate affairs. While the prevention of a domino chain of simultaneous failures is certainly welcome, the unintended consequences are adverse for those firms that did not benefit from the Federal governments largesse. For example, small and medium sized banks have had their FDIC insurance premiums so sizably raised to help pay for the bailout of the larger banks that there will be little or no net earnings benefits from the low cost of their deposit funds. Similarly, Ford, which received no Federal assistance, will bear the competitive cost of the bailout of GM that keeps them in business despite GM's past inefficiencies. Perhaps even more onerous from the equity markets point of view is the degree of control of corporate affairs that is being implied by recent comments by Federal officials. These include references to limitations on corporate pay and bonuses, performance related pay schemes, replacement of boards of directors and CEOs and especially efforts to limit profits for health related firms and others. Even though some of these changes may be long overdue, the upshot is a percieved encroachment on capitalism that is anathema to equity markets.

Recent inflation reports keep the prospect of a quick resumption of inflation at bay. There is outright deflation in the CPI year over year, even with the overstated so called "imputed rent" component. The huge excess capacity of production and labor in the US and globally precludes any meaningful step-up of inflation literally for years. The massive expansion in the money supply means nothing so long as credit is not expanding. And it is not. A massive deleveraging of the past credit expansion of business and the consumer is still required. The point of this is that there will be little or no pricing power in the hands of corporations sufficient to significantly boost earnings for years to come.

The conclusion to be drawn from the forgoing is that there are far more near term risks than are generally recognized in investing in equities at this juncture and more opportunity than is widely percieved in investing in investment-grade corporate bonds.

Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

Email address:philipbraverman@Gmail.com

This and prior reports can be accessed by going to internet explorer and typing in the following internet address: philipbraverman.blogspot.com