Outlook for Equities: Curb Your Enthusiasm?

by: Balance Junkie

I don’t think the market discounts anything anymore. I think it is purely a day trader’s market that’s trading off the Fed, trading off the headlines. One day it’s manic. The next day it’s depressive. I think we can’t really draw any conclusions.

~David Stockman

We’ve been looking at some solid investing guidelines from an experienced Balance Junkie reader over the past couple of days. Some of you were probably wondering whether I was going to start cheering on the market after drinking a pint of bullish Kool-Aid. While I do intend to point out some different investment options, my fundamental caution on the market hasn’t changed.

There are profits to be made in stocks. The gains from the 2009 bottom are phenomenal, although we still haven’t recouped all of the losses sustained in 2008. Those profits are real. But let’s not pretend that the gains have resulted from anything other than the unprecedented monetary and fiscal intervention undertaken globally over the past couple of years. The real effects of that intervention have yet to be felt, and they may not be so positive.

It’s also important to remember that similar loose money policies contributed heavily to the crisis in the first place, and that sovereign and bank balance sheets read like a fairy tale written by the Brothers Grimm rather than an honest, meticulous accounting of assets and liabilities. I thought the U.S. housing market was an accident waiting to happen in 2005, but it didn’t really implode until 2007. When it did, it was much worse than I thought due to the snowball effect of derivatives. Still, there were tremendous investing profits to be had between 2005 and 2007.

My caution on equities has nothing to do with a belief that they are a bad asset class to invest in. It’s more a concern that the markets are currently distorted by interference from central banks and governments pursuing policies that are unprecedented and dangerous. All of this may catch up with the markets again soon, or, as in 2005, it could take a few more years. I really don’t know.

In light of the recent melt-up in equities, I thought I might provide some Food for Thought from two sources I respect. As you might expect, their views are not rosy. Both, however, raise some noteworthy ideas and I invite you to use them in a manner that fits your risk tolerance and investment approach.

State of the Markets: Danielle Park

I link to and quote Ms. Park fairly often here because I find that I often agree with her analysis, because she says things you won’t hear a lot of professional money managers say, and because she’s right a lot. She appeared on BNN back on November 22, offering her updated view on the state of the markets.

I highly recommend the video, but I’ll hit the key points for you here in case you don’t have time to watch the whole thing:

  • Valuations Are Stretched: We’ve had about 3 -4 years’ worth of gains in 14 months. The pop since August was based on the market’s anticipation of QE2 and the resulting weak dollar trades.
  • QE2: This policy is good for assets, banks and markets, but not for the real economy. It hurts consumers through higher prices for gasoline, groceries and other commodity-based staples.
  • Bailouts Are a Bad Idea: They should have made banks write down their bad debts rather than artificially inflating things.
  • Japanese Tendencies: The accounting rules set aside by FASB in the United States in March 2009 have rendered balance sheets a farce. It didn’t work for Japan, and it won’t work here.
  • You Can Time the Market: Their firm stepped out of the market during the recession and re-entered in 2009. There’s nothing wrong with stepping aside or taking some risk off the table.
  • Rational Savers Are Being Penalized: Low interest rates discourage responsible saving and encourage speculation.
  • Housing Market: The US housing market is closer to a bottom, but Canada’s market was artificially reinflated by the easy money policies used to combat the financial crisis.
  • Gold: Rising prices show a lack of confidence in “places to put money.”
  • Be Defensive: Pare back on stocks and commodities. Passive holders will “get their head handed to them again.” Her firm has exposure to the US dollar, but zero stocks. Treasuries will do well again if we see a repeat of 2008, which she sees as a real possibility.

Not a Real Recovery: David Stockman

David Stockman, former director of the Office of Management and Budget under Ronald Reagan, recently analyzed the latest US nonfarm payrolls report on CNBC. (His part comes in around the 3 minute mark.) Next, he discusses the broader economy and the stock market. (He comes in around minute 4 here.) Again, I’ll hit some of the highlights for you here:

  • Sluggish Recovery: US has only gained back 2% of jobs lost and many are part-time, low-paying jobs. This will not lead to increased incomes or spending.
  • Structural Job Losses: Many of the jobs lost were in the construction industry and were symbolic of the massive over-building of the boom years. Those jobs are not likely to come back.
  • Government Job Losses: Many state governments are broke. The federal balance sheet doesn’t look too good either. Government jobs are some of the highest paying jobs, and they are being cut as well.
  • Fed Interference Is Causing Dislocations: “When the Fed takes its big fat POMO bid out of the bond market . . . who’s going to buy the $100 billion a month of bonds we’re putting out there?”
  • Investment Ideas: cash and gold. The idea is to preserve capital.
  • Biggest Issue for the US: Solvency. Consumers, governments, and banks need to repair their balance sheets. We can’t really move forward until they do.

Mr. Stockman goes on to list what he calls the 4 Unsustainables:

  1. No Middle Class Jobs in 10 Years: We’re not creating jobs, which are the basis for real sustainable growth.
  2. Massive Current Account Deficit: The US consumes too much in imports and doesn’t produce and export enough. This hurts the standard of living.
  3. Monetary Policy Bordering on Lunacy: Those were the words he used. Monetizing the debt at these rates is completely unprecedented.
  4. Fiscal Calamity: The US government is extending the spending rather than opting for any type of fiscal restraint. He described plans to extend tax cuts, unemployment benefits and other measures as a “big Christmas tree bill” that the government will push through this month. None of these programs, while they may be worthwhile, are paid for.

Does This Mean Stocks Will Go Down?

Truthfully, I have no idea whether any of these factors will cause equities to fall next month, or next year. I just wanted to point out a few reasons to be a little careful if all of the exuberance in the mass media about the market rally has you itching to jump in with both feet. On the other hand, all of these issues have been with us since March of 2009 and that didn’t stop the market from taking off.

Maybe things can continue like this for a few more years. Who knows? Either way, it’s always wise to understand the potential risks as well as the possible rewards of any position.