It seems the stock market has reached a crossroad between an improving economic backdrop and increasing nervousness about the direction of long term policy under the Obama administration. The economic outlook has gone from bleak and getting bleaker to bleak but not getting bleaker over the last two months and that was enough to get us a nice rally in stocks, but a further improvement in stock prices will require that things actually start to get better. Last week served to remind everyone that the improvement is not yet at hand.

President Obama said early last week that the present deficit spending is unsustainable and spent the rest of the week talking up health care reform as a cure. Increasing the demand for healthcare by offering low cost insurance to all and doing nothing to increase the supply of those services while simultaneously cutting expenditures would qualify as an economic miracle unless the legislative agenda includes a repeal of the laws of supply and demand. Paying for this adventure in economic alchemy is the source of increasing doubts about the long term growth potential of the economy. President Obama has proposed raising individual and capital gains taxes on the wealthy (definition of which seems to be a moving target), raising the effective tax rate on corporations and enacting a cap and trade program to limit carbon emissions (which is just a tax in disguise) and yet still projects large deficits for as far as the eye can see. If today’s deficits are truly unsustainable it is hard to see that gap being closed by anything other than even higher taxes. I know of no country in history that has taxed its way to a high growth rate, but President Obama seems determined to give it a try. I’m guessing he didn’t spend a lot of time down in the economics department during his stay at the University of Chicago.

Last week’s stock market correction left the S&P 500 at a critical juncture on the charts:

Technical analysis is not exact stuff, but most short term traders do pay attention to it, so it is a bit of a self fulfilling prophecy. It seems clear that a break below the 875 level would be important for the chartist crowd, opening the way for a deeper correction down to the 825-850 area. To me, charts are useful because they give a visual representation of how the market is reacting to the underlying fundamental data. Last week’s correction was a logical response to the economic data.

The market rallied sharply over the last two months because the economic data and sentiment changed for the better. The economic data improved over that time frame by merely getting worse at a slower rate. The rate of decline slowed and investors responded by bidding stocks higher in anticipation of the end of the recession. Sentiment improved as we moved away from the precipice of economic collapse. Bread lines didn’t form, “Brother can you spare a dime” didn’t become a surprise comeback hit and life, while lived a bit more frugally, went on.

A slowing in the rate of decline for the economy is certainly a prerequisite for the end of the recession, but it can only carry the stock market so far. Stock prices are driven in the long run by earnings and interest rates. Earnings for the first quarter were better than expected, but are still down signficantly from last year’s first quarter. The recent rally was merely a repricing based on actual earnings versus the previously too pessimistic expectations. Interest rates, at  least in the Treasury market, have been rising since the beginning of the year. Falling earnings and rising interest rates are not the traditional recipe for a bull market.

For stock prices to resume their rise, we will need to see a further improvement in earnings expectations that is large enough to overcome the rise in interest rates. And that will only come from an actual improvement in the economy rather than a mere slowing of the rate of decline. Last week’s economic reports, while not terrible, did not move us closer to that goal. In fact, one could argue that, to put it in football terms, the economy took a sack last week. Retail sales and industrial production fell. Jobless claims rose, breaking a string of improving reports. Inflation, while not worrisome (yet), was higher than expected. Consumer confidence did rise again, but that wasn’t enough to offset the negatives.

Last week saw a mini revival of risk aversion. Treasuries and gold rose while stocks, commodities and REITs fell.

IShares 7-10 Year Treasury

IShares Gold

IShares GSCI (commodities)

IShares Real Estate

This short term trend was not confined to the US markets as stocks in all the major regions of the world fell last week. There were some exceptions in individual markets such as Chile which continues to outperform, but basically the correction was worldwide.

Whether the correction continues next week will depend to a large degree on the news flow, but I tend to think there is more downside risk in the short term. Next week brings readings on Housing Starts and the Philly Fed Survey along with the weekly jobless claims. Housing starts are trying to form a bottom, but the March data was disappointing after the surge in February and there are still significant inventories of houses for sale. The Philly Fed Survey will probably be similar to the Empire State index released last week which still showed contraction, but at a slower pace. In other words, I don’t expect anything next week to surprise on the upside. The wild card is jobless claims. Last week’s numbers spiked because of layoffs at Chrysler so many dismissed it, but the GM bankruptcy is coming up fast and they will be laying off as well. Both are closing large numbers of dealerships and that doesn’t bode well for future jobless claims.

The economic data will continue to improve over the balance of the year because of what the Fed is doing, but it isn’t going to be a straight line from here to growth. We are in an economic transition period now that will take at least a few months and I think the best we can hope for during that time is a base building process in stocks.

While I’m not that bullish on US stocks in the short term, I am more optimistic about foreign markets and commodities. Asian and Latin American markets exhibit better technical characteristics and underlying economic fundamentals than the US. Asia is where the money is and I have thought for some time that they would emerge from recession first. They have the capital to support economic stimulus and while they still depend on the US for export growth, they also have growing middle classes that will increasingly support domestic demand. Latin America is basically the raw material supplier and their growth is increasingly dependent more on Asian than US growth.

Selected Asian Markets

Taiwan

South Korea

China

Regional Index Pacific ex Japan

Latin America Regional Index

Two other commodity based economies that I expect to benefit from Asian recovery are Australia and Canada:

To sum up:

• Stocks mark time - at best - as we transition to better economic data.
• The long term outlook for the US economy is coming into focus and it includes higher taxes.
• Asian and Latin American markets are more attractive than the US.