Letter - April 2012





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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 investment bubble.

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


Tom Herzig


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