Halloween Sugar High?
Over the past year, stock markets worldwide have
experienced one of the all-time great rallies, gaining
more than 50% off their lows. One well-respected market
participant has referred to the rally as a sugar high.
Like a child overdosed on Halloween candy, easy money is
driving markets ahead, irrepressibly pushing valuations
steadily higher with barely a pause. Do the fundamentals
support such gains or will the market exhaust itself?
We wonder. It is not at all clear that the US economy
is out of the woods just yet. Things are still
deteriorating on a year-over-year basis, though at a
much diminished rate. Overseas, economies range from
great to not so great.
Here at home, consumer spending remains sluggish.
Walk down Madison Avenue or through the mall and the
stores are teeming with people (looking or buying?).
Merchandise is moving but at prices so low that
retailers are struggling to generate the revenue to
cover expenses and show a profit.
Hopes remain high that business investment will
rebound soon. Some believe that the recent release of
Microsoft’s Windows 7 operating system will unleash
pent-up demand driving a PC upgrade cycle. Maybe.
However, there remains a lot of spare capacity
particularly in the economies of the US and European
Union, which suggests that capital spending will remain
subdued. Of course what happens in the rest of the world
will have a big effect on investment spending and world
growth. Japan continues to struggle while China and
Brazil stun with their vigorous growth. Other developing
economies fall somewhere in between. On balance, it
looks like a mixed bag.
US Government spending is through the roof. The
budget deficit alone for the year just ended has
been estimated at $1.8 trillion, close to the amount the
government spent in total on its budget at the beginning
of the decade. Politicians promise a lower number for
next year. Given their track record, we doubt it.
Ambitious plans for health care in addition to the cost
of continuing fiscal stimulus in 2010 guarantee that
taxes will rise. Shifting funds from consumers to
government will hardly help beleaguered consumer demand.
Meanwhile, the stock market booms as the Federal
Reserve continues a regimen of low interest rates in
coordination with central banks around the world. We
have argued before that the Fed has pursued easy money
as a way to force investors away from hoarding cash and
into riskier assets thereby raising asset prices. Higher
asset prices help repair the balance sheets of consumers
and financial institutions. This strategy seems to be
working. We regularly receive calls from clients
frustrated with the negative real returns on cash
balances. (After adjusting for inflation, you lose money
by holding cash.) So, money has been moving into the
debt markets which are perceived to be relatively low
risk and, from there, into the stock market.
In addition to the cost of money, a major determinant
of a healthy stock market is the level of corporate
earnings. After falling off a cliff, earnings have
rebounded in excess of expectations in the second and,
it seems, the third quarter of 2009. In this recession,
companies cut costs with exceptional speed thereby
salvaging profitability. The stock market has taken
notice. However, we do not believe that cutting costs
can lead to long-term prosperity. For the US economy and
the stock market to prosper, there will need to be signs
that once again revenues are growing, something that
current quarterly financial reports seem to be missing.
We also do not believe that a country, any more than
an individual, can borrow its way to prosperity. The
enormous cost of Washington’s fiscal intervention and
proposed health care programs promise future budget
deficits for years to come. These deficits will be an
increasing drag on future US growth.
An easy money monetary policy raises concerns about
future inflation. Excess capacity in the economy has
held inflation in check for now, but financial markets
are signaling their concern. Gold has hit new all time
highs and the dollar remains under serious downward
pressure. China, our biggest investor (creditor), talks
openly of cutting back on purchases of US treasury
securities and diversifying away from the dollar. That
is not a vote of confidence.
At some point, the Fed will be forced to raise
interest rates. Further weakness in the dollar, rising
inflation and/or fear that easy money is creating
another bubble in financial assets are all good reasons
We do not intend to sound alarmist or unduly bearish.
The capitalist system is complex and subject to multiple
and unexpected adjustments that help it to adapt.
Muddling through is the norm even in the best of times.
Perhaps the dollar decline has gone too far; maybe
Congress will show signs of spending restraint. However,
in the stock market the easy money has likely been made
for now. Valuations no longer seem cheap so we spend our
days pondering whether to sell rather than rushing to
buy. With the trick or treaters gone and only a little
candy left in the bag, we wonder whether the sugar high
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about these letters and the securities they mention.