I’ve gotta say—I was a bit surprised by the opening life of Evan Simonoff’s column in the October Financial Advisor magazine. He said “Who among us (referring to the financial advisor community) really takes this 60% rally in equity prices seriously.” He then goes on to say its “remarkable” how many observers are convinced this rebound is for real. Evan’s column, The Long View, which I read most months, usually provides careful analysis to its arguments. However, this month I was a bit disappointed. Simonoff cites Liz Ann Sonders throughout the article who, it turns out, is actually pretty optimistic about the big market bounce. I didn’t find much if any of the solid data I would expect from an article which looks to support an overall bearish sentiment amongst advisors. Based on what I’ve been hearing at recent financial advisor conferences around New York City, the sentiment is anything but bearish. So let’s take a look at why some advisors might actually take this rally in equity prices seriously.
Good news has outweighed bad news hand over fist since the March lows in the market. It has become increasingly evident that the big market declines from February to March were fueled by panic. Along those lines, I find the case for a W recovery (over a V recovery) minimal at best. The last W recovery was in the 1980’s during the stagflation era. The Fed ran a bonkers monetary policy, raising the Fed Funds rate from 7% to 17% in the late 70’s to halt inflation. It worked, but it caused a recession. The Fed then lowered rates back to down to 9% to stabilize the markets but then raised them back to 19% in 1981, causing the infamous “W” shape. If you chart out the Fed Funds rate against the Dow Jones for that period the parallels become quite clear. Most people view the Fed’s current monetary policy as accommodative whereas back then it was more ‘combative.’ Recent Fed policy decisions indicate deflation is still more of a short-term concern than inflation which I find interesting since so many traders and investors have already jumped all over the inflation plays. I suppose future inflation prospects are hard to ignore given the government’s massive spending agenda.
I look next to the ‘fear spread’ which often builds in the bond market when a double-dip scenario may be looming. But when I look at a broad range of bond market indexes I can’t help but notice dramatically narrower spreads now than we had at the beginning of the year when unprecedented default rates and depression were being priced in. The bond market has essentially priced out the possibility of a double-dip recession. Investors have jumped back into bonds—especially lower grade bonds—at such a rapid clip that many bond indexes stand to outperform the S&P 500 in 2009, an odd victory in a year where equity prices could be up 20%+. As an advisor, I’m hoping for some hint of a rate hike in the near future so bond pricing cracks and I can buy some high quality issues anywhere near par.
On the spending front, we can’t ignore the retail sales numbers which came in earlier this month. September showed a second consecutive month of ex-auto improvement. The weak dollar has done its part by bouncing exports and buoying commodity prices significantly. The housing stats have clearly been improving although one can’t help but point to the housing tax incentive for artificially floating the market. I think the program was a smart idea to help consumers and banks but I think it’s almost time to cut the plug. It all adds up to higher taxes for the wealthy in the future which I believe is an incorrect but nearly given solution at this point.
In terms of unemployment, the pace of job loss has decelerated sharply from those awful numbers earlier this year. With inventories at low levels, rebounding consumer spending, and corporate earnings strong as we’re seeing in the 3rd quarter (especially in the red-hot tech sector,) job growth should be on the horizon. On another note, I’ve heard some pretty out-of-the-box opinions lately regarding unemployment and its potential effects on the economy. Some believe we’re entering an era of naturally higher unemployment (6%+). There are various explanations for this ranging from technological innovation leading to improved efficiency, globalization, business-unfriendly tax policies, etc. The point is that many economists believe not only that the economy can sustain a healthy pace of growth with a slightly smaller but more efficient workforce but also that equity prices can and have traditionally performed just fine immediately following periods of historically high unemployment.
Now, let’s talk about the elephant in the room: government spending is out of control. We could approach this from various angles ranging from TARP to overly-accommodating tax incentives to ballooning entitlement spending, the new healthcare proposals, etc. The government certainly has the power to screw the improving economy they helped to create. At this point I think it’s a given that marginal tax rates will jump next year at the rate government is growing. Obama couldn’t raise taxes in the middle of the recession—history already taught him why that would have been disastrous. But once economic growth is back on track those individuals and small business owners earning over $250K should gear up for 40% or higher on the federal tax brackets. If you’re a guy like me, living in New York City, my effective tax rate after federal, state, city, social security and Medicare is already somewhere around 50%. Let’s hope those Jimmy Carter brackets aren’t on their way back into style. If you look at the data, the private sector always spends money more efficiently in the long-term. Unemployment generally rises in periods when the governments spending share of GDP rises. Let’s hope Washington is smart enough to avoid these dismal scenarios that market bears love to draw conclusions about.
My bottom line is that we could move higher from here. I believe pre-Lehman equity pricing (S&P 1200) is a fair target and I believe, pending more positive economic data, that we can get back there by the end of Q1, 2010. As always, feel free to e-mail me with any questions or comments.
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