It Can Go Higher

Do you remember what you were thinking during the depths of the market decline? On March 9, 2009, the Dow Jones Industrial Average closed at 6,547 – down nearly 54% from the all-time high of 14,164 on October 9, 2007. The S&P 500 also bottomed out on that day at 676 after falling nearly 57% from its all-time high of 1,565. We are now more than eight months into the market’s recovery from those lows, and oh what a recovery it’s been. The DJIA and S&P 500 are up 59% and 64%, respectively, since that dark day in March. Investor sentiment has turned from fear to greed in very swift fashion. The talking heads on the business channels have overwhelmingly embraced the notion that the recession has ended, recovery is at hand, and stocks offer strong return potential. Happy days are here again.

For my part, I find it interesting (to put it mildly) that such a dramatic reversal in sentiment has materialized while so many difficult issues remain unresolved. Consider the following:

The unemployment rate now stands at 10.2%, and the underemployment rate is at 17.5%;

The supply of and demand for credit remain woefully inadequate to support a robust economic recovery. Despite regulatory pressure, banks have tightened lending standards dramatically in response to surging loan losses and capital shortfalls. At the same time, consumers are borrowing less in an effort to repair their financial situation after the loss of over $11 trillion in net worth in the stock and housing markets. The return of free-flowing credit is a prerequisite for strong economic growth in the future;

The near-term fate of the housing market (in the absence of massive government intervention) remains very much in doubt;

The federal government continues to run up enormous deficits while some state governments are on the brink of financial collapse;

Uncertainties abound with regard to major federal government initiatives, including possible tax increases to support massive spending on stimulus and health care;

And perhaps most importantly, will the “recovery” be sustainable as the government takes off the training wheels (removes the stimulus)?

If you had been provided this backdrop in March, would you have believed the markets would be up well over 50%? Talk about climbing a wall of worry!

What makes this stock market rally troublesome is that it is being driven by factors other than fundamentals. While some degree of optimism is certainly warranted following a stabilization in the banking system earlier this year, it seems as though a significant portion of this rally is being driven by a government-induced liquidity binge. Let me explain. The Fed keeps telling us that the economic improvements to date are tenuous at best, which is exactly the point we make above. So in response to the continued job losses and weakness in demand across the economy, the Fed has reduced the Fed Funds rate to near zero (among a slew of other stimulus measures implemented over the past year) and continues to reiterate that an “exceptionally” low Fed Funds rate is warranted “for an extended period.”

Naturally, interest rates near 0% provide a strong incentive for investors to seek higher returns through other asset classes, including stocks. This is exactly what is happening. As the Fed continues to promise low interest rates well into the future, investors (read: professional investors like hedge funds and proprietary traders at Goldman Sachs, et al) are increasingly engaging in a strategy known as a “carry trade”. The carry trade simply means that investors are borrowing dollars cheaply to invest in risky assets across the world. Widespread implementation of this strategy exacerbates the fall in the dollar, which may have already been weakening in response to a deteriorating fiscal situation in the US. As I write, the dollar has now fallen over 15% from the highs of earlier this year against a basket of currencies. The more the dollar falls, the greater the demand for commodities, riskier bonds, and stocks across the world. This vicious cycle now seems to repeat itself each day as the markets climb higher and higher.

So what’s wrong with this formula? Seems to be working well so far, right? Unfortunately, running massive budget deficits to support a recovery and failure to enact policies supportive of a strong dollar can lead to unintended consequences. First and most importantly, it is imperative that foreign central banks maintain confidence in the dollar so that they continue to fund our massive budget deficits. If the Chinese or the Japanese decided to sharply curtail their Treasury purchases, this would lead to much higher interest rates in the US. Moreover, the need to fund such massive stimulus spending can eventually crowd out private investment, leading to higher interest rates for all. Secondly, this policy of easy money for an extended period of time is exactly what led to the bubble in housing, and we all know how that turned out. Some say we are already seeing signs of bubbles in areas like emerging market stocks and commodities. And speaking of commodities, how well would today’s economy digest a massive spike in oil and other commodity prices, resulting in part from a weak dollar? In my opinion, $147-a-barrel oil was the straw that broke the camel’s back a couple years ago. And finally, the spending required to “stimulate” the economy will have to be paid back at some point. The prospect of higher taxes is not a good thing for an economy trying to recover.

In one of our previous blasts we said we felt the economy and stock market had become dependent on government stimulus. At this point, we would add a falling dollar to the list of dependencies. Our strong preference would be to see a rebound in the economic fundamentals rather than a liquidity binge before we get too excited about this market rally.

As we’ve seen countless times in the past, irrational market moves can and do last longer than anybody expects. Alan Greenspan famously uttered the phrase “irrational exuberance” in a speech on December 5, 1996, when the Nasdaq closed at 1,300. Nevertheless, the index proceeded to climb upward in nearly straight-line fashion until a peak of 5,048 on March 10, 2000. We experienced similar euphoria in the commodities (particularly energy) and housing markets earlier this decade. The common denominator for all these “bubbles” was easy money. While we would not use the word bubble to characterize the US stock market right now, we do believe that conditions exist for speculation beyond the fundamentals. In this type of environment, we remain defensive by holding high-quality, blue chip companies with strong balance sheets and seasoned management teams. These types of companies have underperformed in this recent market surge, and they will hold up better in the event of renewed economic problems.

Hang in there,