Equity Proves Resilient; What a Shocker

In what is seemingly now a routine event, domestic equity markets once again erased intraday weakness and finished today’s session in a largely unchanged manner.  This was particularly interesting given the commentary out of the Federal Reserve that implied no change in their planned $600 billion purchase of Treasury securities.  Depending on just how bullish or bearish your outlook for the U.S. economy is, this news could have supported either case.  For bulls, an uninterrupted stream of monetary stimulus into the economy could ensure that the strength in asset values that’s been seen of late will continue.  However, bears likely look at this news and see yet another indication that the fundamentals of a U.S. economy have not yet recovered sufficiently for the Fed to remove its extraordinary monetary stimulus programs.  The sad thing is that both camps are correct.  But for now, as evidenced by the sharp rally in nearly all asset classes since September, the bulls are winning out.  The more relevant question at this point in the rally, in my opinion, is considering where the risks in the marketplace are concentrated.

It’s no secret that I’ve been skeptical of this equity rally for some time (about 120 S&P points in fact).  And while I have to admit that I’ve gotten the direction of the last few months completely wrong, I can’t shake many of the concerns that initially moved me into the bear camp.  Rising sovereign debt default prospects, Chinese/emerging market growth concerns, a continued need for monetary stimulus across the globe, and stubbornly high unemployment rates are still real pressing issues that the markets have simply ignored in this recent move higher.  However, the strength in corporate earnings over the past two quarters as well as many of the domestic economic indicators like initial jobless claims and the PMI index has been nothing short of impressive and appear on track for continued improvement.  Taken together, these developments suggest that the global economy has stabilized itself after the shock of 2008.  However, this stability should not be viewed as an indication that growth will be returning to long-term trend levels in short order.  To quote financial writer John Mauldin, we’re more likely to see a Muddle Through-type economic environment that is characterized largely by below-trend growth.  Why you ask?  Consider the following:

1.    The 3.5% - 4.5% GDP growth rate that was seen in the United States in the decade prior to the downturn of 2008 was highly reliant upon the growth in asset values (shares value expansion in the late 1990s and real estate values in the 2000s) and a significant increase in consumer spending that was facilitated by new forms of consumer credit.  Aside from the rally of late in the equity markets (remember that these markets are still significantly below their previous highs), real estate values remain constrained by significant inventory overhang that is being exacerbated by the stagnant job market.  Consumers, on the other hand, are currently paying down many of the debts they ran up during the boom years as evidenced by the movement in the savings rate from positive to negative.  So with these two growth engines largely stuck in neutral, it’s hard to see how they could end up supporting trend-line growth in coming quarters.  And even if they were to rebound somewhat, the absolute level of each indicator is such that the ultimate impact on the economy would be muted.

2.    For much of the 2000s, the unemployment rate hovered around 4.0%.  This was quite an impressive feat as many economists believed that the U.S. economy was structurally incapable of maintaining a rate below 5.0%.  However, during this time jobs were being created at a breakneck clip as strength in the technology and financial sectors necessitated larger headcounts.  This hiring boom not only kept the domestic workforce fully employed, but it also put upward pressure on wages which served to further stimulate already voracious consumer spending.  But with the onset of the financial crisis, not only has unemployment risen to nearly 10%, but wages have been largely stagnant as employers seek to streamline their operations and protect margins.  And while employment is likely to rebound at some point, I would argue that a return of the 4.0% unemployment rate is unlikely for some time, especially when you consider the number of Baby Boomers who are delaying retirement out of necessity, thereby forcing higher unemployment and underemployment upon younger workers.  And as these new entrants to the workforce are among the highest consuming individuals in an economy, sales and the resulting growth in GDP, once again, are likely to remain compressed and below previous rates.

3.    One of the defining characteristics of the past decade was the growth in the popularity of deregulation as a fundamental tenant of government policy.  By reducing the impediments (both taxation and regulatory) imposed upon corporations and individuals, the cost of doing business dropped, competition flourished, and more capital was put to use.  The primary beneficiary of this change proved to be the U.S. consumer.  But as the scandals ranging from Enron to Bernard Madoff have come to light and the disparity of income between the country’s wealthiest and poorest individuals has grown to historic levels, there is a clear desire from the American electorate for more regulatory oversight and higher tax rates, especially at the upper end of the scale.  Without delving into the political elements of this shift, it is clear that the benefits that accrued to the U.S. economy during the past decade as a result of deregulation and lower marginal tax rates will not materialize in coming quarters.  As such, this yet another drag on GDP growth that will have to be overcome.

Reading through this trio of issues, you might think that I’m quite bearish on the equity markets and believe that the S&P is headed back to the March 2009 lows.  This simply isn’t the case.  In fact, I believe that the chances of the domestic equity market moving back to its previous low is quite remote in light of all the monetary stimulus that’s been pumped into the global economy.  This doesn’t mean, though, that I believe that things are going to get back to ‘normal’ in an expeditious manner.  The fact is that the U.S. economy spent the better part of a decade sowing the seeds of the recent financial crisis.  And just like any illness a person has, it often takes more time to cure what’s wrong than it did to acquire the illness in the first place.  So too will this be the case in the U.S.  That is why I believe that the current market environment is largely fraught with danger on the downside.  At about 18 times trailing twelve month earnings, the S&P 500 is priced more akin to an underlying economic environment that mirrors the latter half of the 2000s rather than the paradigm of sluggish growth that now confronts us.  But just as the past decade has shown, this disconnect can last much longer than is seemingly rational.  That is why I prefer to view the marketplace in terms of risk concentration.  It’s a simple question:  Is the scale of the potential rally greater than that of the potential loss?  Considering the valuation of the market at these levels and the scale of the recent run, it’s near impossible for me to see how anyone could view the risks as skewed anywhere other than the downside.  Prudence, therefore, demands caution.  However, assuming no meaningful changes in the economic backdrop and earnings outlook, I will be looking to add equity exposure once the pullback I’m anticipating materializes.

Until tomorrow…..