Market on Steroids
Since the bottom in March 2009, the S&P 500 has just
about doubled, putting it not too far from its 2007
high. Bonds have had a big bull run too. Meanwhile,
corporations have muscled up balance sheets and
earnings. Investors feel a whole lot better. Many
consumers feel better too. Higher stock and bond prices
make them more secure, more willing to spend. This has
helped the economy rebound. More people are working. The
hope is that the economy is entering a virtuous cycle of
growth. What is the wonder drug the Federal Reserve has
prescribed? Low interest rates, cheap money!
How is the Fedís low interest rate strategy working?
The results are mixed. While growth has improved, it
remains sluggish by historical standards. Corporations
are flush with cash but have been issuing bonds at a
rapid rate in order to lock in historically low rates.
Yet, so far, they donít seem to be ready to invest the
cash aggressively in plant, equipment or labor. Rather
they are returning some of the money to investors by
buying back their own shares and/or raising dividends.
Housing prices seem to want to stabilize, but sales
remain weak. A clear loser is the fixed income investor
who seeks investment income with low risk and protection
from inflation. Witness T-bills, money market funds and
bank CDs, which adjusted for inflation yield 0% or less.
As athletes know, there is a dark side to steroid
use. Many economists tell us that extensive use of
artificially low interest rates is risky business. In
theory, a free market sets the level of interest rates
that will result in an optimal and efficient allocation
of capital. By suppressing interest rates to
artificially low levels, the Fed runs the risk of
supporting the misallocation of capital. This could
result in sub-par GDP growth and lead to another
The bond market is a likely example of a market in
bubble mode. For 30 years, it has been in a bull market
as interest rates have fallen persistently and prices
have risen. With the Fed buying longer dated issues
pushing prices artificially higher, there is little room
for further advances. Bond investors find themselves
boxed in a corner. If the Fed is successful in driving
up GDP growth, interest rates will have to rise, pushing
down bond prices. If and when inflation begins to rise,
the market itself will force rates up. (Remember we have
a $15 trillion Federal debt and the Fed has been
pursuing an inflationary strategy.) For these reasons,
we find bonds unattractive.
As confidence returned after the 2009 market
blow-out, investors with the Fedís encouragement have
been migrating to riskier assets in order to generate an
inflation adjusted, positive return. By pursuing an easy
money strategy, the Fed has encouraged the demand for
stocks, resulting in higher prices.
The Fed has indicated that it might well keep
interest rates low for another two years. As long as it
keeps supplying cheap money to the economy, the stock
market should continue to lumber higher. ďDonít fight
the Fed,Ē goes the old Wall Street maxim. So we remain
positive on stocks though, as usual, we expect periodic
corrections and volatility.
While the outlook for the stock market is positive,
we donít want clients to lose focus on the many risks to
the world economy. Problems in the Eurozone remain. It
is not clear that European economies will be able to
dodge a severe recession. The risk of social unrest
remains front and center. Growth in emerging markets is
slowing as they attempt to mitigate some of the
imbalances created by years of stellar growth. Everyone
is looking over their shoulder for that bogeyman,
inflation. And finally, armed confrontation with Iran
would be a show-stopper, at least temporarily.
Human beings have a remarkable ability to muddle
through in the face of seemingly intractable problems.
Perhaps it is an evolutionary key to survival. So, as we
continue to muddle through, expect the stock market to
continue to climb the ďwall of worry.Ē
Please read our important notice
about these letters and the securities they mention.