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Tug of War
New York: July 19, 2010
By John Stephenson

Lately, there's been plenty of warning flags, suggesting that the US economy may be faltering. And that has market watchers in a tizzy, as they hotly debate whether or not the US economy will dip back into recession. It wasn't so long ago that investors were prematurely musing about a strong v-shaped economic recovery from the depths the economy plumed during the 2008/09 financial crisis. But has the pendulum swung too far in the other direction?

The tug of war that's occurring in the stock market is between a solid second quarter of earnings announcements and economic indicators that are pointing toward weaker growth ahead. While US housing starts are up 25% from the basement levels they hit in April of 2009, they are still more than 70% below their pre-crash levels. And homebuilders aren't rushing to slap up any more new homes, despite inventory levels of new homes at their lowest levels since 1970, as they continue to be undercut by a torrent of distressed properties coming on the market.

With housing in retreat and with sluggish retail sales and slow job creation investors have been hitting the sell button, sending stock prices sliding of late. There can be little doubt that the mood has turned very negative lately, as the fiscal stimulus has begun to wane and jittery bondholders around the world have dissuaded politicians from promising more juice to try and jump-start the economy.

Governments are too indebted to keep pumping stimulus into the economy and the banks, fearful of a wave of defaults, aren't in a lending mood. Unemployment is high, so many people don't want to spend, leading many to wonder if America could be the next Japan—slipping into a deflationary spiral. With the bursting of the credit bubble in the US, the number and value of bank loans and other debts has been shrinking—slashing the amount of money available to power the American economy forward with purchases of such items as homes and new cars.

American banks have stashed some $2 trillion at the Federal Reserve, preferring to collect a meagre 0.25 percent interest rate that the Fed offers, rather than to invest their profits given the cloudy economic outlook. Making matters worse, a recent University of Michigan sentiment survey reported that only 39 percent of the respondents expected that their incomes would rise this year—the lowest recorded reading.

And in this decidedly sour time, talk has turned from worries about the impact of a general rise in consumer prices to talk of deflatio—na far more debilitating situation where businesses shun investing and hiring. Wary consumers are reluctant to spend during deflationary times, assuming that the price tomorrow will always be cheaper than the price today.

This is a sea change from a few short months ago, where the prevailing worry was that fiscal and monetary stimulus would cause inflation, or rising prices. Now that sentiment is on the back burner and investors are fretting that once the government stimulus runs dry, the US could end up in the same deflationary trap that has hobbled Japan 's economic prospects for much of the past two decades.

But to really usher in a deflationary period in the US , it would likely take a double-dip recession for consumer prices to tumble and unemployment to soar. If that happened, that would be enough to crush business and household confidence and usher in a protracted period of steadily falling prices. For my money though, that is a remote possibility.

The stock market, however, is unlikely to muster a sustained rally until expectations come more in line with the current economic realities. The market is pricing a roughly 35% increase in 2010 earnings from 2009 levels on the S&P 500 and a near 20% increase again in 2011. But, with economic indicators pointing towards a slowing, rather than a growing economy, it's highly unlikely that the recovery, if there is one, will be muscular enough to support these overly optimistic earnings expectations.

So what's a savvy investor to do? Play it safe. Avoid junk bonds, bank stocks and shares in companies that have heavy debts and instead look for companies with stable safe dividends, like those from the utility, telecom and drug sectors.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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