"It's the economy, stupid!"
It has been two decades now since presidential politics first introduced this now famous phrase into the popular vernacular. But while it likely sums up the main focus of today's 2012 presidential campaign as well, the economy is not the force at all that is driving the stock market today. Instead, it's all about monetary stimulus.
The stock market has been on a roll for several weeks now. After trending lower during the first half of December, the stock market swiftly shifted higher on December 19. And the subsequent melt up has occurred virtually uninterrupted in the four weeks since.
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In the last 21 trading days since the December 19 bottom, the stock market as measured by the S&P 500 Index has risen in 17 trading days, or 81% of the time. And in a market that has been characterized by extreme volatility over the last several years, the daily gains have been quietly consistent and generally subdued, with 13 of these 17 daily advances at less than 1%. This is remarkable consistency for a stock market that continues to face the daunting threat of another potential financial crisis breaking out on any given day.
The positive sentiment of many investors has fallen squarely in line behind this market. I was traveling in the car one day this past week and had the opportunity to listen to roughly six hours of analyst discussion and commentary on the radio. I used this opportunity to keep a tally of the sentiment of the guests on two separate stations covering financial markets. Two particular facts were notable by the end of the trip.
First, nearly all of the guests were bullish on the market outlook. And those that were not fully bullish were at least neutral. Not a single analyst in my tally that day was definitively bearish. This supports recent data from the American Association of Individual Investors (AAII) indicating that heading into the week only 17% of investors were bearish on the stock market versus 49% that were bullish, both of which represent differences that are more than one standard deviation removed from their respective historical averages.
Second, the overwhelming majority of analysts cited the improving economy as the primary reason for the recent market advance as well as expectations for further stock market gains. I found this fact particularly notable, and is a conclusion with which I strongly disagree.
We have recently seen signs of modest improvement in the economy. And this is certainly good news. But before drawing the conclusion that we are now on the cusp of some sort of sustained economic recovery, it idea must undergo greater scrutiny.
My background is that of an economist and a statistician. So my initial inclination is to delve into the granularity of the numbers to refute this notion that any style of economic recovery is behind the recent market advance. But upon further review, a simple walk through some fundamental qualitative topics more effectively tells the story. I present these topics below in a series of questions.
If we were on the brink of a healthy and sustained economic recovery, would the U.S. Federal Reserve be engaged in launching a new monetary stimulus program on an almost monthly basis since the middle of 2011? And would they be floating to the press on a regular basis that they stand ready to implement another round of large scale asset purchases in QE3 at a moments notice? The answer: NO
If we were on the brink of a healthy and sustained economic recovery, would long-term U.S. Treasury yields continue to linger below 2% on the 10-year and 3% on the 30-year? In a normal environment with a economic recovery getting underway, would investors be satisfied with capital left in instruments offering such low yields and potential downside price risk? The answer: NO
Is the fiscal austerity that many global governments are now undertaking that involves reduced government spending and higher taxes supportive of accelerating economic growth? The answer: NO. Instead, it represents a meaningful drag on growth.
Is a decline in the unemployment rate that is being driven just as much by a decline in the labor force as it is new job creation an indication that the economy is sustainably improving? The answer: NO, at least not as much as the drop in the headline unemployment rate might imply. And at 8.5% with monthly new job creation still well below +300,000, the employment situation remains far to sluggish to get excited about at this point.
Can the eurozone really effectively solve the crisis that has been overhanging the region for the last several years now? The answer: NO. If they could fix it, they would have a long time ago by now.
Is the U.S. economy decoupled from the eurozone economy? The answer: NO. See late 2008 and early 2009 for the most recent example that we all live in a highly integrated global economy. A banker sneezes in Europe and the ripple effects are felt around the world including here in the U.S.
Would an eventual Greek default be necessarily contained as an isolated event ? The answer: NO. To see how unexpected consequences can result from a destabilizing event such as a financial default, once again see late 2008 and early 2009 for the most recent example. And if Greece were to default, can we be confident that another at risk sovereign might not soon follow in its footsteps? Once again, the answer: NO.
Has household debt as a percentage of GDP declined to levels that imply a consumer with lean balance sheets that are eager to go out and spend again? While some progress has been made, the answer is still: NO, not yet. And unfortunately, much of the progress in reducing consumer leverage has not been an elimination of debt but instead a transfer of this indebtedness to other parts of the system including the public sector.
Does a fiscal stimulus program such as accelerated depreciation that brings purchases forward into 2011 imply that this demand will not only continue but also grow further in 2012? The answer: NO. To the contrary, the bringing forward of demand into 2011 is likely to serve as a drag on growth in 2012.
Would China be launching new stimulus programs of their own if their economic outlook was healthy and strong? The answer: NO.
Is the scope to grow earnings favorable even in a strong economy given the fact that corporate profit margins are already at historical peaks at over two standard deviations above the historical average? The answer: NO.
So while we have seen some positive signs for the economy recently, a litany of questions remain that any one of which could easily undermine this growth going forward. And even if this growth is maintained, it is likely to be sluggish at best for many of the challenges cited above.
If not the economy, what then is driving the stock market higher in recent weeks? Just like it has since the beginning of the financial crisis, it is monetary stimulus. Stocks are not rising behind the momentum of an accelerating economy. Instead, they are once again drunk on the latest serving of money printing from global central banks.
It was QE1 along with aggressive fiscal stimulus that resuscitated the financial system in early 2009. It was QE2 that prevented stocks from cascading lower in the summer of 2010. And it has been a parade of monetary stimulus programs rolled out since August 2011 that has kept the market from declining sharply in recent months.
Every time the market appears ready to break lower over the last few years, monetary stimulus is there to turn the market around. But here's the problem. The global economy is not healing, and the problems underlying the system remain unaddressed in many respects. The longer these issues go unresolved, and the higher the stock market is induced to float behind the intoxication of monetary stimulus, the more profound the pain will ultimately be in the end.
Of course, given that markets are still receiving these doses of monetary stimulus, it is worthwhile to position portfolios to capitalize in the meantime. This includes maintaining allocations to the stock market that are proportional to other asset classes in order to hedge risk. Focusing this stock exposure on more defensive names that can rise along with the broader market during upswings but also typically outperform during sharp pullbacks is also beneficial. Representative names under this theme include Family Dollar (FDO), JM Smuckers (SJM) and WGL Holdings (WGL). Adding positions to McDonald's (MCD) on any pullbacks is also worth consideration. Attractive opportunities also exist outside of the stock market, particularly in the precious metals space, as both Gold (GLD) and Silver (SLV) stand to benefit directly from further aggressive monetary stimulus. Both metals appear particularly attractive relative to stocks at present, as Gold and Silver have underperformed stocks during their recent advance. Allocations to TIPS (TIP) is also beneficial given their dual status as a safe haven Treasury and a protector against inflation induced by aggressive global money printing.
We are not at a 1982 moment today. Nor are we at a 1946 moment. We are not on the cusp of a sustainably strong economic recovery or the beginning of a new secular bull market. Instead, we are still mired in the corrective process and still have more work ahead of us. We are now 12 years into the current secular bear market. And secular bear markets have historically lasted 16 years on average. A great deal of progress has been made over the last decade to cleanse the financial system of the excesses accumulated during both the previous secular bull market from 1982 to 2000 as well as in the years since the current secular bear market began at the turn of the millennium. But before we finally arrive at the dawn of the next secular bull market, we must still endure the final cleansing process. And the inclination of global policy makers to continually inject monetary stimulus into the system only serves to prolong the process.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.