Letter - November 2009





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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 to act.

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 can last.

Tom Herzig


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