Charting A Course For Equity Markets And The Economy

| About: American International (AIG)

Where is this U.S. economy really headed? Recent reports and headlines are showing a truly contradictory picture.

An Improving Housing Market

As an example, last week RealtyTrac reported that foreclosure filings fell between June and July by 3%. Versus the prior year, filings fell almost 10%.

So, is the housing market really healthy? According to earnings reports from Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) housing is getting better. The two enterprises reported their best quarterly earnings since the housing boom era. Home prices have improved year-over-year, which helped reverse some losses in Fannie Mae's portfolio. Fannie Mae noted in its earnings report that "net income of $7.8 billion for first half 2012 demonstrates company's long-term earnings potential."

One can only imagine the equity value of a company that is able to earn $15.6 billion per year, which is consistent with the earnings displayed by Fannie Mae in the first and second quarters. In comparison, Exxon Mobil (NYSE:XOM) earns approximately $40 billion per year and has a market capitalization of over $400 billion. A similar valuation for Fannie Mae would make the company worth $156 billion.

To date, the companies have paid back about 25% of their total bailout of $188 billion by sending $46 billion back to the Treasury. The only thing that would unlock the true long-term earnings potential of these companies is a reduction in the senior preferred dividend, allowing them to build equity reserves, by keeping that cash. Then, the government could simply sell shares, as they are doing with AIG (NYSE:AIG).

Bill Gross' Cult of Inflation Trumps the Cult of Equity

Bill Gross of PIMCO recently said, "The cult of equity is dying." Gross was referring to his belief that the "real" long-term return on stocks being about 6.6% is unsustainable. This real return of stocks is adjusted for inflation. His argument was that an economy grows at 3.5% per year when doing well. If that is the case, he believes that stockholders must be taking that extra 3.1% return from others in the economy, concentrating wealth in the hands of stock holders and creating a massive disproportionate allocation of wealth to those who buy equities.

This does not negate the value of equity in the markets as a method to efficiently allocate capital. Stockholders are perfectly happy to risk capital to get outsized returns and this in itself drives economic growth and expansion of the economy as money flows to projects and investments that have the best return potentials. And eventually that wealth gets lost. One would be challenged to find a single family name that has enjoyed a consistent and steady investment appreciation without losing at least some of the wealth after a few generations. The U.S. economy is as downwardly mobile as it is upwardly mobile.

Gross' core belief appears to be that the concentration of wealth in the hands of the few has a long-term effect of diminishing growth for the market as a whole. Those who have a disproportionate amount of wealth don't allocate that wealth as efficiently as those who are in need. For instance, a billionaire could buy a dozen sports cars for multiple millions of dollars and simply lock them in a garage to look at on a rainy day. Yet, for the same amount of money, books could be bought to teach average students advanced math concepts and build a generation of engineers. If wealth is held in the hands of the few, the market becomes less efficient.

This is why Gross points to a deliberate and effective way of leveling the playing field using inflation. Inflation has the powerful effect of lowering the real value of debt while expanding the nominal value of investment portfolios and real assets. A struggling middle class with a heavy debt burden can gain economic wealth simply by doing nothing, when inflation lowers the real burden of their mortgage debt while pushing up the nominal value of a home. And in very real terms, things like home equity can be used to pay for investments like education.

Gross was not commenting on the stock market itself, but the propensity of governments to use inflation as a policy tool to support the economy. His comments appear to contradict good news the market is reporting on housing delinquencies and economic improvement, but perhaps this is not contradictory at all.

Quantitative Easing

Eric Rosengren, head of the Federal Reserve Bank of Boston, recently said, "We don't get to pick the timing of a global slowdown. If there's a slowdown and you have an independent central bank, the appropriate response is to act. I think that's exactly what we should do."

By calling for action, one can only assume that Rosengren is asking his Federal Reserve colleagues to vote for a third round of quantitative easing. This act of bond buying would put further downward pressure on interest rates, stimulate borrowing, and possibly create inflationary pressure.

Where Does This Put Stocks?

Some of the greatest investors of the past few decades have realized that the best hedge against inflation is investing in stocks. Companies with high debt to equity, or leverage, tend to do better in an environment where cash loses value, as the asset side of the balance sheet tends to expand, while liabilities remain frozen. This does seem ironic given Bill Gross' comments regarding the death of equity, but Gross wasn't telling us to dump our equity holdings. He was simply stating that it was time for market forces to be realigned.

Disclosure: I am long OTCQB:FNMA, OTCQB:FMCC.

Additional disclosure: Long GSE preferred stocks.