The Sleepwalkers' Rally

Although well off their all-time highs, American stocks are now marginally up for the current year. In the past two months, the markets have recovered over 30 percent from last year's lows.

But something just does not add up. In the first quarter of 2009, average U.S. corporate earnings were down over 30 percent. There is once again a serious disconnect between stock prices and economic reality. Perhaps these sleepwalking investors think that the 50 percent sell-off in 2008 was overdone and great bargains are now available. To believe this is to misunderstand the economic hurricane of last October, and the gaping holes in America's hull that it exposed.

In the last quarter of 2008, investors faced a meltdown of the banking system. World governments injected trillions of dollars into their economies and changed accounting rules to ensure that a systemic banking failure was averted. Though the system has stabilized, investors seem to forget that none of the fundamental problems have been solved. We may have survived the initial heart attack, but the system remains wrought with clots.

The epicenter of the global financial system is still found on Wall Street. Despite that immense responsibility, the American economy is failing to restructure and seems to be indulging its traditional vices of over-borrowing and over-spending. Wherever the private sector attempts to correct its behavior, a bloated federal government overrides its efforts.

By diverting trillions of borrowed citizens' dollars into keeping alive vegetative corporations such as AIG, Chrysler, Citi (C), Fannie Mae (FNM), Freddie Mac (FRE) and GM, the Administration is crowding out new, enterprising companies from access to vital labor and capital resources. Enshrining inefficiency in this manner bodes poorly for the U.S. corporate sector's future capacity to increase profitability. America needs fundamental restructuring in order to compete in an increasingly competitive marketplace.

Meanwhile, profitability in those countries that do the hard work of restructuring can be expected to rise disproportionately as the world economy revives.

In the meantime, U.S. banks will face an avalanche of loan defaults and derivative failures. Clearly, the Good Housekeeping Seal of Approval bestowed on many banks through the much-hyped "stress tests" were a politically cynical, confidence-boosting whitewash. Even so, most banks were deemed undercapitalized! This dark thought perhaps explains the Treasury's apparent unwillingness to accept early TARP repayments.

When U.S. corporate earnings fail to keep pace with the blistering ascent of stock prices, look for investors to reconsider their strategy. As they had in the second half of 2008, many investors will once again seek safety above all. But the safe havens of 2008, the U.S. dollar and U.S. government debt, are much more problematic in 2009. Alternatives will be found.

Despite severe downward recessionary forces, the apparent passing of a threatened financial meltdown and worldwide central bank manipulation, the price of gold continues to hold up. Clearly, many investors, including hedge funds, corporations, and even some governments, are taking refuge in history's oldest guardian of wealth.

Most notably, China, the world's largest gold producer, has recently double its central bank's gold reserve. China also floated a preliminary idea at the recent G-20 meetings to replace the U.S. dollar with a gold-linked international reserve currency. This idea may soon catch on among creditor nations who value real money but also want the flexibility to undervalue their paper currency for the benefit of exporters.

It appears that the world is moving quietly but steadily back to the future. The U.S. dollar became the world's reserve currency because, at the time, it was "as good as gold." Through political sleight of hand, the gold backing was withdrawn, leaving the world floating - and now sinking - along with the dollar.

This new standard, if implemented, will help rebalance current accounts, re-opening the path to growth for those economies that restructure. Riding on its sense of entitlement, the U.S. is not likely to be one of those economies. Instead, the world's largest debtor nation will suddenly confront the true weight of its obligations and be forced to significantly lower its standard of living.

As a result, the return of gold as a international reserve should not leave investors optimistic about a U.S. stock recovery. Those that are sleepwalking into this rally will have a rude awakening when they realize that the dollar has brought down the ship. Their more prudent neighbors will have already departed for the bedrock of real wealth: a healthy reserve of gold.

Comments

[Moon Kil Woong:]

"...Administration is crowding out new, enterprising companies from access to vital labor and capital resources. Enshrining inefficiency in this manner bodes poorly for the U.S. corporate sector's future capacity to increase profitability."

This is the best part of your article. Even though I tend to blame not this administration but the Fed and Treasury under both Bush and Obama for this calamity, I fully agree that government interventionism is styming both healthy companies and innovation as well as creating an unfair playing field for free market competition.

Everytime Fannie Mae and freddie Mac write another home loan on artificially low government backed paper it prevents mortgage reform and fair competition from springing up to compete with them. Everytime the Fed and Treasury extends low rates and bailouts to GMAC, GE's capital arm, and AIG the undermine other insurers, Ford, and more qualified companies.

Government has favored the big even though the big is what has failed the system. The simple fact is big government and big companies make much more natural allies than small, nimble, innovative companies that don't buy lobbyists or suck funds from the government through strange programs and quasi governmental organizations like the Federal Reserve that now plays God with the powers to buy private debt, manipulate interest rates, and print money which should rest with our elected officials through the powers vested in the Congress according to the Constitution.

I suggest people read the Constitution sometime and then ask themselves if, regardless of how the economy is currently, if this is really the direction you want America to go.

May 21 04:18 AM

[Alan von Al...:]

Moon, power to coin money exercised by Congress when it created the Federal Reserve, honored by 90 years of legislative oversight. No way you can read the U.S. Constitution any other way. The Supreme Court voided gold clause contracts and upheld paper money in the Legal Tender Cases over 100 years ago. Helvering v Davis gave FDR power to regulate every family farm and business in America in 1937. It's a done deal. We're screwed.

May 21 06:44 AM

[sunnsea:]

The banks are daytrading the TARP money. That's the only reason why the market is up. As soon as others come in, that will be next leg down in the bear market.

May 21 09:19 AM

[Carey Rowland:]

This newcomer thanks your for the very informative article.

As a teacher, I especially appreciate this connection between events long ago and what is happening now: "The U.S. dollar became the world's reserve currency because, at the time, it was "as good as gold." Through political sleight of hand, the gold backing was withdrawn, leaving the world floating - and now sinking - along with the dollar "
That explains a lot.

I also appreciate Mr. Woong's edifying comments above. And I'll address his concern by agreeing with his implication: No, this is not the direction I want America to go. Thank God for our Constitution. Let's make use of it.

As for Mr. Altendorf's declaration that "We are screwed," I must say that, while I understand his pessimism, it is unproductive. Life is not defined by what the Fed does, or what the Supreme Court does, or the Treasury, Fannie, Freddie or AIG.

Life is about how we respond to whatever challenges and opportunities are presented to us. We can act, individually and collectively, to protect and prosper our well-being and our families. We may be robbed, but we are not screwed.

And thank you, Sunnsea, for enlightening us about the banks' daytrading TARP $. It's a cover-up for sure. I was wondering where all the hot air was coming from.

May 21 09:00 PM

[Alan von Al...:]

On May 21 09:00 PM Carey Rowland wrote:
> Life is about how we respond to whatever challenges and opportunities
> are presented to us. We can act, individually and collectively, to
> protect and prosper our well-being and our families. We may be robbed,
> but we are not screwed.

Carey, you have a nice, level tone. You sound intelligent. I won't debate any further the merits of political activism. However, if you wish to protect and prosper your well-being and family, go with the flow and remain a government employee, vote the party line, support our troops, help your neighbor, love one another, etc. In the years ahead, you will be asked to support a great many charities at home and overseas. It will always be so, that America will be stronger and freer than the rest of the world. Our bank notes and IOUs will lose less value than other paper. It's a great time to buy a house.

Forget about the 19th century. Liberty is so-o-o like totally not tech.

May 21 09:42 PM