How High Can We Go?

The market continues its relentless climb higher. Since its closing low on March 9, 2009, the S&P 500 is up 29% and appears to be heading even higher today. The index is up 9.5% so far for the month of April – the best monthly performance since March, 2000. The latest round of buying was triggered by the news of a 2.2% annualized increase in consumer spending in the first quarter (despite a 6.1% annualized rate of decline in total GDP for the quarter), as well as comments from the Fed that the economic situation has improved on signs of stabilization in household spending. Acknowledging the continued risks, however, the Fed promised to keep interest rates low and to continue buying US Treasuries, agency debt, and mortgage-backed securities as necessary to keep up the momentum.

For my part, I remain concerned. I continue to worry that the risks to the economy are to the downside. I worry that the 2.2% increase in consumer spending for the first quarter, which was concentrated in the first two months of the quarter, was simply a bounce off extremely low levels for the fourth quarter of 2008. (In fact, the 0.2% decline in consumer spending for the month of March released this morning may confirm this view.) I worry that the huge supply of housing for sale and the “shadow” inventory of foreclosed properties on bank balance sheets may portend another leg down for housing. I worry that an estimated 20% of outstanding mortgages are underwater (borrower owes more than the house is worth), and that a huge amount of option-ARM and Alt-A mortgages are set to reprice over the 2010-2011 time frame. I worry that recent increases in Treasury yields, due to a huge supply of new debt needed to finance our deficits and despite Fed purchases of Treasuries, may continue and stop the recovery in its tracks. I worry that the rolls of the unemployment may climb to over 10%, eroding confidence and spending yet again. I worry what the results of the bank stress test, to be released next week, will mean for the financial systems and the banks’ willingness to make credit more available. I worry that the securitization market, which has become an integral part of our financial system, remains crippled. I worry that the process of deleveraging and balance sheet repair that the consumer must inevitably go through will hinder economic growth. And most of all, I worry where we would be in the absence of the enormous amount of government support that seems to have stabilized the situation, at least temporarily.

But it’s my job to worry. And I also know that the stock market often climbs a wall of worry. Some of the strongest and most enduring rallies in the stock market’s history have come in the face of very dour circumstances. Is now one of those times? Despite the sharp rally in stocks over the past several weeks, the S&P 500 remains down over 44% from its high on October 9, 2007. Are all my concerns already reflected in the price of stocks? Obviously this is the key question.

One thing we are not particularly worried about for the foreseeable future is run-away inflation? Economics 101 tells us that prices rise when there is too much demand for the available supply. Recent data suggest this is not the case. The 8.5% unemployment rates is the highest since the early 1980’s, meaning the supply of labor is abundant and wages should not grow. Moreover, capacity utilization is running at multi-decade lows. There is plenty of factory capacity to meet increasing demand (should it arise), which will keep a ceiling on prices.

Those economists worried about inflation point to the huge amount of liquidity being injected into the system through the government’s “quantitative easing” (purchase of assets). While at some point this could become troublesome, this new money is not currently translating to credit expansion. The problem is the sheer magnitude of debt already in the system in the form of securitization receivables (which fall outside the banking system and Fed control). Reduced lending means that the new supply of money is not turning over as fast as it has in the past (the velocity of money is shrinking). The velocity of money should continue to decline as we go through this process of deleveraging and re-regulation of the financial system.

In closing, I wanted to mention that Farr, Miller & Washington expects to be announcing some very exciting news in the near future. We are finalizing contracts on a large and very prestigious piece of business and will report further details as we get closer to deal consummation.