The market has rallied some 10% for a variety of reasons, not the least of which has been the prospect of a change in control of the House of Representatives this fall. Investors are hoping that Republican-backed initiatives, such as the extension of the Bush tax cuts across all income levels, will be supportive of stronger economic growth in the future. For our part, we agree that recent weak economic data have argued for a continuation of existing stimulus initiatives (at the very least). And we do not believe that letting the Bush tax cuts expire would be very stimulative for the economy. A change in control of the House would not only make it more likely that the Bush tax cuts are extended, but it would also make it less likely that any new taxes are instituted while our economy struggles to stand on its own two feet. The public is beginning to understand that the economic recovery remains very tenuous. Therefore, we do not believe that any new taxes, to include an increase in rates on the “rich”, would receive much popular support at this stage.
We still believe that deflation is an unlikely scenario, mainly because we have confidence that Bernanke will take aggressive action to avoid this outcome. However, we continue to believe that the economy faces a long period of consumer deleveraging as consumers struggle to rebuild their balance sheets after trillions in lost wealth in the housing and stock markets. We also have been warning that economic growth is likely to slow meaningfully if/when government stimulus initiatives are lifted. We are especially concerned about a second leg down in housing prices, and we see this outcome as inevitable at this point. On these issues, we have been correct. However, it seems that we may now be a point once again at which “bad news is good news.” Stocks rallied sharply on Monday despite weak manufacturing data out of China over the weekend. Recent data also suggest that manufacturing in the US is slowing while employment data remains very weak and consumer confidence has plummeted. Nevertheless, equities have managed to rally through all the bad data points (strong corporate earnings being the outlier). We believe this is because more and more investors are beginning to anticipate additional action from the Fed, which may come in the form of another large-scale quantitative easing.
Why might more quantitative easing (i.e., Fed purchasing of Treasury and mortgage securities) be in the cards? Because despite the Fed pumping over $2 trillion into the economy to date through these purchases, growth in the money supply has plummeted. The money supply is not growing because bank lending activity has declined precipitously, leading to a contraction in bank balance sheets at a time when balance sheets should be growing. We have covered the reasons that bank lending has declined in previous Market Commentaries: 1) bank capital shortages due to the surge in credit losses; 2) uncertainty surrounding future regulatory guidelines, including capital requirements; 3) a sharp decline in the demand for credit as consumers pay down debt in response to massive wealth loss in the housing and stock markets; 4) the failure of banks to cleanse their balance sheets of bad loans and securities. The basic problem in our economy right now is that everyone, including banks, consumers and businesses, is hoarding their money. Until this situation reverses, we are unlikely to have economic growth more typical of a recovery.
In summary, we remain cautious because we see systemic problems in the economy. However, we concede that the stock market could do very well if the Fed continues to pump massive amounts of money into the economy. Therefore, we think there is an element of downside protection in the near term which is providing investors with some comfort to get more aggressive with stocks. We will call it the “Bernanke put”. As with the “Greenspan put”, the Fed’s actions could be supportive of stock prices for a period of time. Longer term, however, we doubt the Fed has the prescription for what ails this economy – too much debt.
Despite our economic concerns, many high-quality, blue chips stocks look attractive at today’s valuations (especially when compared to bonds). Quality continues to lag in this market, and we see this reversing as investors begin to more fully appreciate the headwinds to the economy. And as always, we believe stocks will continue to be an important way for investors to achieve their long-term retirement, inheritance, and philanthropic goals.