Market To Economy: Heads I Win, Tails You Lose

 |  Includes: EFA, SPY
by: Alan Hartley, CFA

Despite a lackluster economy, an uncertain political environment, and the potential for ample downside, U.S. equity markets and the iShares S&P 500 SPY continue to post solid, positive returns. Considering its unprecedented amount of monetary support, the Federal Reserve has had a weak effect on unemployment levels and aggregate demand. However, it has been undeniably successful at creating a "heads I win, tails you lose" mentality for investors. If the economic recovery falters, it is perceived that the Fed will ride to the rescue (with the implication of success). If, on the other hand, the economic recovery continues apace, it is believed the market's ascent should too.

Economic data for the month of July remained mixed. Employment figures are a good example of the variation across reported figures. The establishment survey showed that the private sector added 172,000 positions in the month of July, while the household survey had employment declining 195,000 jobs and the unemployment rate rising to 8.3%. Hours worked and weekly earnings rose in the month, but so too did unemployment claims, which have bounced off their lowest level in four years in the first week of July. Manufacturing surveys, including the ISM report, signaled contraction in the sector for the second straight month. Industrial production, reported by the Fed, grew. Earnings growth has slowed to a crawl, expected to rise just 3.1% year-over-year to September 2012. Earnings growth would have to reaccelerate to nearly 13.0% to reach analysts' lofty 2013 projections--the basis of most "cheap" market valuation claims.

At 1,413.49, the S&P 500 is trading near four-year highs and 15.9x trailing profits, earnings that are the largest ever and flow from near-record profit margins. While many say the stock market is cheap, we beg to differ. On more normalized metrics, the market is expensive and its valuation rivals prior market peaks, excluding both the technology and the housing bubbles.

Politically, the landscape is just as disjointed. Congress seems too inept and too partisan to serve its purposes and the people. Each day we get a little closer to the fiscal cliff of 2013 and the tax increases and automatic spending cuts associated with it. A significant downturn is to be expected if Congress fails to act. Overseas, there is no additional clarity for investors.

China's economy, the supposed steam engine of world growth, has been cooling rapidly and thus far those in command of its economy have failed to announce any simulative measures. Europe remains a mess, though markets there, including the iShares EAFE Index EFA, have been buoyed recently by a couple of sentences uttered by the ECB's president, Mario Draghi: "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough."

Time will tell if the ECB will really do whatever it takes to protect the eurozone from collapse. It is obviously in the best interests of the world that they take action and not just mere short-term appeasement, but something big. Though the political environment there is much more complicated than in the states.

At this time, we expect the Federal Reserve to release additional monetary support at the sign of economic deterioration, Congress to delay most of the forthcoming tightening measures for one more year, and the U.S. economy to continue to grow at a disappointingly slow pace. This environment should suit our high-quality, undervalued approach well.

Disclosure: I am long EFA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.