Lynn Reaser: Significant Profit-Taking Ahead

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Includes: DIA, QQQ, SPY
by: Harlan Levy

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Lynn Reaser is chief economist at Point Loma Nazarene University in San Diego and is immediate past president of the National Association for Business Economics. Previously she was managing director and chief economist for the Investment Strategies Group at Bank of America.

Harlan Levy: Has the economy hit a wall?

Lynn Reaser: Actually, the economy appears to be showing better performance. We have seen manufacturing activity recently pick up. Job numbers improve in October and the first part of November, and retailers report a pick up in consumer spending.

H.L.: How will igt lok in 2011 and 2012?

The economy appears to remain on a recovery track. Growth is likely to be still moderate, as various headwinds, including the burden of foreclosed homes, the fiscal pressures on state and local governments, and the overhang of commercial Real estate weigh on the economy. The economy will probably gain momentum over the next couple of years, but we will see growth below the pace typically experienced following these downturns.

H.L.: So will 2012 be the year when things get robust?

L.R.: 2012 is unlikely still to be a year of robust growth because of the likely increase in interest rates that will be necessary at that time. The Federal Reserve will ultimately need to exit its very aggressive easing policies, and the federal government will need to address its debt burden.

H.L.: What effect do you see from the mid-term elections on solving any of our economic problems?

L.R.: Businesses will probably not see another major set of policy proposals such as we saw last year with healthcare and financial reform.

For instance, a major energy bill or effort to reverse global warming is unlikely in 2011. Unfortunately, the budget deficit is unlikely to be substantially tackled as gridlock may be the most likely outcome for the coming year. It’s good that there won’t be major uncertainty affecting business, but bad in the sense that we’re kicking the fiscal can regarding the deficit down the road.

H.L.: How bad do you think that will be?

L.R.: Ultimately, if we do not get a political solution to our budgetary problems we will have a market solution. That will be either higher interest rates, a much lower value for the dollar, or a combination of both.

Those factors could slow potential growth of the economy or could precipitate another period of financial turmoil, should the dollar come under massive attack.

H.L.: What do you think of the proposals that just came out of the deficit commission?

L.R.: Many of them have merit, but the more important question is do they have political traction, and at this point that is quite unlikely.

I think the overall objective to reform the tax structure is very positive, but the risk is that Congress will cherry-pick items off the set of proposals and not reach the kind of deficit reduction that will be ultimately required.

The most attractive options would be to delay the retirement age until 69, to end the ear-marking of various parts of the budget, and to end many of the exemptions in the overall tax code.

H.L.: Must taxes go up to pare down the deficit?

L.R.: In terms of the economic impact, reducing the share of government spending as opposed to raising the tax share from an economic point of view would be more positive for the economy and the stock market.

H.L.: How do you analyze the state of the stock market?

L.R.: The major problem with the market at this point remains the question about the effect of the Federal Reserve’s decision to buy Treasurys. Long term interest rates have increased. Because of fears about inflation and the pressures on China to curb rapid growth, inflationary pressures in that country have increased.

The markets are also concerned about the retaliation of various countries in trade because of the lower value of the dollar. The stock markets do not like the current situation and are very uncertain about the ultimate outcome.

We are looking at profit-taking to a significant degree at this point, but the market needs, one, a message that China is going to be able to slow its economy down without a major downturn, and two, evidence that inflation remains in check.

H.L.: You were in Washington on Friday meeting with the Federal Reserve on economic conditions in the country and various industries. You've talked about the economy. What sectors look good?

L.R.: I still think technology is favorable, as well as companies involved in infrastructure projects and companies involved in export and consumer discretionary.

Disclosure: No positions