The stock market has rebounded an incredible 78% since the March lows. Not since 1932 have we seen such a fevered upward rally. The rally has been strong but is tied to a weakening US economy, giving investors cause for concern. High unemployment and a growing federal deficit plague our economy, with these factors causing some investors to believe that the stock market might be in for some trouble, but it keeps rising, nevertheless. The continued rally is the result of increased business earnings (i.e. profits), because when earnings go up, so do stocks. That being said, strong headwinds are on the horizon, and we could be in for a bumpy ride. Cautious optimism should be the watchword for the savvy investor.
Current economic conditions are not favorable to a continued rally. The U.S. Department of Labor reports unemployment at 9.7%, meaning that there are 15 million people not bringing home a paycheck. This reduced income translates into less spending because people without jobs cannot afford to purchase anything beyond the necessities. This reduction in consumption is bad for our economy because it begets a cycle of less spending, requiring businesses to take creative measures to prop up their earnings, which often means layoffs. These layoffs translate into fewer consumers spending, creating an ugly cycle of slowing economic activity, leading to lower profits, followed by more layoffs. This is important because it has a direct relationship to the growing federal deficit.
Historically, federal revenues have been 19.5% of gross domestic product (NYSEMKT:GDP). If economic activity slows, then GDP shrinks and so do government revenues - leading to deficits (the shortfall between what the government brings in [taxes] versus what it spends) – now standing at $1.2 trillion. It is analogous to your household budget, which is determined by asking yourself how much is your paycheck, and what are your expenses? If expenses are greater than your paycheck, you have a problem. The accumulated deficits (i.e. national debt) have grown to a gargantuan $12.7 trillion and are rising. In 2009, the interest expense on this debt was a staggering $383 billion annually. This growing deficit and national debt are devaluing our currency, which means our dollars buy fewer goods and services. Unfortunately, this all leads back into the cycle discussed previously. If your dollar buys fewer goods and services, then you consume less, leading to more slowing in economic activity, begetting another slowing cycle. Americans consuming less means lower company earnings and that translates into lower stock prices and unhappy investors.
The earnings rally has relieved investors’ troubled minds because it has repaired some of the damage done to portfolios over the last two years. Companies have increased profitability by reducing their expenses (in large part by reducing their workforce) and refinancing their debt at lower rates to achieve improved profitability. This translated into higher profitability in the short term, but interest rates have almost no room to fall and companies will not be able to take further advantage of this environment. Perceptive investors can see that the foundation of the rally is built on shaky ground and will take defensive moves to protect their portfolios.
The stock market continues to rally despite worsening economic conditions. Unemployment is nearly 10%, the federal deficit is the highest it has ever been and things do not look like they will get better for some time. Why, with all of this seemingly dreadful news, does the stock market continue to rally? Earnings are king, profits are up, and stocks will continue to rise as long as businesses can make use of creative solutions to prop up income. No one can say how long this will last, but it’s obviously like erecting a building on a soft foundation.Currently, stocks are on the rise because earnings are improving, the market rallying an astounding 70% from the bottom. But the significant headwinds of growing unemployment and astonishing deficits to cautiously question the rally’s continued sustainability.
Disclosure: No positions