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Posted: May 20, 2009

Bull market – real or an illusion?

A look at factors that could negatively affect the market

Wayne Farlow

Since March 9th, the S&P 500 has increased by almost 35 percent. In normal times, this increase would signal a major bull market rally. However, these are not “normal times.”

As an asset manager, I must continually consider whether I should be increasing, decreasing or holding my clients’ equity (stock market) allocations.  My decision has been to use the market rally to lower my clients’ equity positions.  While my crystal ball is no better than yours, here are a few of the factors that that I believe could negatively impact the market.

1) Valuation – Most economist are predicting that the S&P 500 will end 2009 with operating earning per share (before write-offs) of between $45 and $55. With the S&P 500 index at approximately 900, these earnings provide (pre-write off) P/E (price earnings) ratios of between 16 and 20. In a healthy, growing economy, those P/E values would signify a fully valued market. Can these P/Es be justified in our current environment?

2) Federal debt – Many ‘bulls” argue that low interest rates justify paying a higher P/E on equities. In normal times, they would be correct.  However, with the $700 billion stimulus package, a $1.8 trillion 2010 federal deficit and over $1 trillion dollars committed to federal bail outs, our federal debt will likely increase by well over $2 trillion in the next 18 months.  (Remember, a trillion is 1,000 billions.)

At some point, China, Japan and other “saving” countries will only buy our federal debt if it is offered at much higher interest rates. When interest rates increase, debt-oriented investments become more attractive and equity investments less so. Higher interest rates will also make corporate borrowing more costly, which could easily damage our economic recovery. 

3) Commercial real estate – The recent financial crisis, requiring $700 billion in TARP funds (not to mention TALF and PPIP), was mainly created by consumer debt. Defaults on mortgages, home equity lines and credit card debt created most of the current “toxic assets.”  However, the next “shoe to fall” is commercial real estate. Large commercial real estate bankruptcies are beginning to proliferate. As these failures continue, expect to see more toxic assets appear on our bank’s balance sheets.

4) Toxic assets – Many banks have balance sheets filled with toxic assets, with more likely to come. The Treasury has proposed the PPIP program to help banks remove these toxic assets to a “private/public partnership.” It seems unlikely that these assets are worth the value at which they are carried on the banks’ balance sheets. Assuming these toxic assets are purchased, much of any losses suffered, as reflected in the difference between their final value and the price paid under the PPIP program, will be assumed by the tax payers (you and me). These losses will increase our federal debt, putting even more pressure on interest rates.

5) International event – Shortly after the election, our new vice president predicted that the administration would be tested with an international crisis within its first six months. Most recent administrations have been tested during their early phases. Needless to say, there are many candidates to test our will and resolve. If such an incident occurs, the market will react negatively until the situation is resolved.

While “green shoots” may be appearing, along with signs that the recession may be slowing, our economy still faces many daunting problems. Until there are workable solutions to these problems, it will be difficult for the economy to have a significant recovery.

Considering the problems facing our economic recovery, it is hard to see significant stock market upside at current market prices. While it never pays to time the market, practicing “market intelligence” is always wise. If you are a long term investor, it may be prudent to stay at the low end of your investment policy’s equity allocation. In turbulent markets, investors should focus on asset preservation. The goal of asset preservation is to have the maximum assets available to invest when the economy truly begins to recover and grow.   

Click here, to see Wayne Farlow's recent interview with Channel 7 about 401(k)s.

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Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor firm.  He is a Certified Financial Planner (CFP®), focusing on Retirement Planning, Investment Management, Small Business Owner Planning and Sudden Wealth/Inheritance Planning.  His book, “Financial Abundance Guide,” is available free at www.farlowfinancial.com .  He can be reached at wayne@farlowfinancial.com or at 303-554-0309.

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