It’s time to look to Q4 . . . Using history as a guide, the high odds bet is that the market will be up and possibly by a large margin.

Q4 is the seasonally best time of the year.  In the post WWII history of the U.S., the market has been up 79% of the time in Q4.  It has been up a preponderance of the time whether Q3 earnings were up or not.  Since 1980, the market has been up in 80% the time in Q4.  It has been up in 80% of the quarters regardless if Q3 earnings were up or down. 

Add the fact that Q4 will be following a panic quarter and its seasonal strength – along with ample liquidity to fuel pent up demand for a big holiday season – and the outlook for Q4 is strong – possibly very strong.  If the economy is only in a slowdown – as I suspect – and NOT a recession, there could be a virtuous combination of rising estimates for 2012 along with encouraging, near real time news of holiday spending, along with potentially favorable fiscal and tax policy news out of Washington.  Jeb Terry, Sr. Aug 20, 2011

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The recent sharp drop in the stock market is a rare event. Drops of this type are usually followed by UP quarters.

Setting aside all valuation factors and fears that Europe will go into a black hole and take us all with them (doubtful), we can look at prior panic attacks in the market and see what happened next.  At the moment we are experiencing an emotional event more than a rational event.  Since 1970 there have been only 8 occasions (out of 167 data points) when the S&P 500 has dropped by 14% or more in a single quarter.  The S&P 500 is now down 14.9% for the current quarter. The average drop in these panic stricken quarters has been 19% so we may see some more downside if we are to reach the average.  That’s the bad news.  The good news is that the quarter following panics has been UP in 86% of the cases – that’s only 6 cases but 86% sounds cooler –eh?  It gets better.  Two quarters following a panic quarter – so 180 days after a panic quarter – the market has been up 100% of the time.  The average gain 180 days after the panic has been 15.3%. The average gain 4 quarters later has been 18.9%.  Remember, the average trailing 12 month gain for the S&P 500 since 1970 has been 8.0%.

 Consider for a moment the periods we are discussing here.  This analysis includes a 26% shellacking in Q3 1974 . . . back when Nixon resigned the Presidency and inflation was rising over 10% . . . the 23% crash in 1987 . . . the 1990 bear market decline, the 2001/2002 tech crash and of course, the panic of Q4 2008 – yikes! 

 So . . . except for a panic triggering event, 2011 has little in common with the prior periods of stock market panic – in all the prior episodes, the yield curve was flat or inverted, earnings were declining, etc.  Clearly we have some of the political theatre of the mid 70’s but today is tame in comparison – at least so far.  The bottom line:  sharp drops in the stock market are followed by above average gains.  Jeb Terry, Sr. Aug 20, 2011

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We are experiencing the widest spread in the S&P 500 earnings yield and the 10 year Treasury rate in modern market history.

 Panicked investors have bid up the price of Treasury bonds and sold down the price of equities to such a degree that the earnings yield on equities (the reciprocal of the P/E) is now 405% greater than the yield on the 10 year Treasury!  This is simply unprecedented in the lives of anyone active in the market today.  The earnings yield on the S&P 500 is now 8.4% compared to the yield on the 10 yr. Treasury of 2.08%.  Anyone who believes in regression to the mean should be wildly bullish.  The mean spread is 108%.  The implication is the Treasury rate must either go up to 7.8% or the earnings yield must fall to 2.2%.  An earnings yield of 2.2% would equal a P/E ratio of 45X.  Meeting in the middle suggests a P/E ratio close to 20X vs. today P/E ratio of 12.4X.  Either way – something has to give!  Jeb Terry, Sr. Aug 19, 2011

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Banks have too much cash and too few loans. It will be hard to have a recession when there aren’t a lot of loans to charge off.

Part of the cause and effect of a recession is the banking system has to contract its assets.  As business conditions heat up, loans grow too fast, interest rates begin to rise, the banks’ cost of funds starts to rise, their capacity to make loans becomes constrained and the growth in the money supply slows to a trickle.  We don’t have conditions anywhere near that scenario in the banking system today.  Last week saw news of Bank of New York Mellon charging large customers who choose to store cash at the bank . . . did you get that . . . customers will have negative interest on their deposits!  As I have shown before, the growth in deposits has ballooned in recent weeks as investors/consumers have hoarded cash.  In the meantime the absolute level of loans has contracted since 2008 and is only now showing modest signs of recovery.  These are not the conditions we see at the eve of a recession.  While, they do imply a severe level of risk aversion, they are foundational for a potential prolonged recovery in productive growth.  Jeb Terry, Sr. Aug 17, 2011

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There is a record $21.2 TRILLION in US retirement accounts, cash and bank accounts and retail money market funds.

While there is a record high amount of assets in the retirement complex, there is a low percentage invested in equities.  I have used the market value of the S&P 500 as a proxy for the equity portion of the retirement assets.  US investors are underinvested in stocks.  The S&P 500 is equal to only 50% of the value of all retirement assets today compared to 89% in 1999.  Not since 1994 (with brief exception on 2008 bear market) have stock values been equal to such a small percentage of retirement and liquid retail assets.  A recovery to the average ratio of equities to retirement assets of 66% since 1995 would imply an increase of the S&P 500 market value of over $3.3 trillion or 31% greater than today.  There is not a lack of funds to invest – there is a lack of confidence to invest. Jeb Terry, Sr. Aug 17, 2011

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Over $52 billion was stuffed into money market funds last week – the most since the panic of 2008/2009.

Not since the chaotic days of late 2008 and 2009 – when we had much greater uncertainty, illiquidity and systemic crisis than today – have we seen so much money flee risk and go into “money of zero maturity”, aka MZM.  MZM is now equal to 96% of the total market value of the S&P 500.  This kind of spike in the percentage of near cash relative to equities has only occurred very near market bottoms. Jeb Terry, Sr. Aug 17, 2011

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Disposable Personal Income (DPI) and Personal Consumption Expenditures (PCE) are both still on the rise.

Personal income and spending have both recovered fully from the Great Recession.  It is unlikely there will be a reversal of the trend albeit some slowing in growth.  Since the U.S. economy is centered on the US consumer vs. exports – the odds of a recession in Europe having a pronounced impact on the US economy are lessened. Jeb Terry, Sr. Aug 17, 2011

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There is over 10 months of personal consumption expenditures (PCE) sitting in cash and money market funds – this is the most in over 20 years.

We know that consumers and SMBs have hoarded cash but how does that relate to what is typically spent in a given month?  Since the Great Recession, U.S. consumers and businesses have put away more cash faster than any time in recent history.  There is now almost 10 ½ months of PCE parked in cash, savings deposits and money market funds earning practically zero percent.  The US consumer who has a job is in great financial shape compared to the last 20 years.  This condition is NOT consistent with the onset of a pronounced or prolonged economic slowdown or recession. Jeb Terry, Sr. Aug 17, 2011

Consumers are not in a state of financial distress as they were in 2008.  In addition to months of spending held in cash reserves, they have more disposable income to cover their reduced debt service.  The US consumer has sufficient income to cover their debt service by ~8.7X, a 20% improvement over 2008.  This is another indicator that any sentiment induced economic slowdown can be short lived and not severe.

 

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Despite the sentiment and cash hoarding there is still forward momentum in the economy as illustrated in industrial production.

The following chart (courtesy of Yardeni.com) does a good job of showing the state of the recovery in industrial production as of July.  Hopefully the slowdown I foresee due to the recent panic attack will only be a short term negative blip in this otherwise encouraging trend. Jeb Terry, Sr. Aug 17, 2011

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Retail sales show the consumer wasn’t panicking in July . . . so says Brian Wesbury at First Trust . . . While I can see the chart is pointing up, we must admit to the absolute collapse in consumer sentiment since the retail sales numbers were compiled.

The US consumer has plenty of funds to fuel retail sales.  My concern is the collapse in sentiment in recent weeks due to the fear mongering over the debt ceiling debate and fear of undefined and un-calibrated consequences of a default of Euro sovereign debt.  Jeb Terry, Sr. Aug 17, 2011

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