A year ago, when we were all collectively peering into the abyss, I predicted a 20-25% rally starting in late January or February. Seemed like a bold call at the time. I got the rally right but wildly underestimated the magnitude, which is now over 50%. My prediction was predicated on the sheer amount of cash that was being accumulated, with one the largest chunks coming in January in the form of hedge fund redemptions. I figured some of it was bound to start trickling back into an oversold market, and it did. But there were other factors that really juiced this rally.
First, of course, the government has turned on the monetary spigot like no time in history. No one wants to risk deflation, so there's nothing subtle about this. Official rates have been lowered to near zero. The government is also artificially lowering rates in private credit markets through its TALF program (in which Belstar participates). And of course, those printing presses are humming.
Second, the government has passed the largest fiscal stimulus bill in our history. The effect of this is debatable because very little of the money has actually been spent, but it's possible it was a short-term psychological prop to the market. (Note: the use of proceeds in these measures is highly dubious. More on this below.)
And then there's politics. It may seem like I've been dwelling on this a lot lately, and it may also seem like I have "taken sides." But markets are affected by politics, so you can't very well have an opinion on one without having an opinion on the other. Market commentators who studiously try to avoid saying anything political ignore the elephant in the room. Or the donkey.
The new laws being contemplated in Washington today such as cap and trade and healthcare will have a profound influence on the American economy, and more specifically on corporate profits. They are game changers. If you try to analyze what's going on in markets without considering the political landscape, your views are meaningless. Ah, for the days when all we had to worry about were P/E ratios. So, agree with me or not, you will get my honest opinion.
So, let's take a look at the market this year, viewed through a political lens:
Here's my take. When Obama was elected, there also came large gains for Democrats in Congress. This was something the implications of which many didn't fully ponder, at least not until November 5th, 2008. The market traded off initially, rallied somewhat in December, but then tanked hard through early March. It was during this period that the full scope and ambition of the Obama agenda crystallized for many. With a strong Democrat majority and a completely cowed Republican minority, it appeared there were no limits on Mr. Obama's power. This very clearly had negative implications for industries such energy, insurance, utilities, drugs, healthcare, agriculture, and others. Is it any surprise the market tanked? The S&P was down 29% by March 9th.
Then something interesting happened. In early March it became apparent that "cap and trade," which amounted to an enormous tax on energy (cum a serious dose of social engineering), was not a slam dunk. Democrat House members from energy and agriculture states got an earful from their constituents and balked, and while the measure passed, it was by a mere 7 votes, and passage in the Senate suddenly appeared unlikely. This was a surprise to many, and the first falter of the legislative juggernaut. The rally's inception coincides almost perfectly with the appearance of the first meaningful opposition to the president's agenda.
Next, in middle/late March, another key initiative faltered, the so-called "card check" bill, which was a sop to big labor, and decidedly anti-business. The market gathered momentum.
Then, just as the rally appeared to be waning in mid-summer, the town hall meetings started, the ones where droves materialized to vent their opposition to Obamacare. Again, no one saw this coming. Republican lawmakers - too busy rummaging around for their spines - had been ready to roll over, and passage seemed likely. But as the reality changed, the market once again picked up steam.
Below you can see the Intrade.com odds of healthcare legislation passing this year. Note that the odds peaked in mid July, just about when the town hall protests started, and just about when the market began its latest surge. Coincidence? Hmm.
Which brings us to today. The political aspect of the rally is somewhat perverse: the market rallies because something bad is less likely to happen rather than something good will happen. Corporate profits won't stink as bad as we thought, huzzah!
Moving beyond politics, the liquidity argument has been stretched a bit thin. Obviously a lot of that cash has been spent. Although cash levels are still reasonably high, I would argue that they will stay high relative to pre-meltdown history.
Monetary stimulus has definitely helped, but it runs the risk of going too far and causing hyper-inflation, as I've discussed in previous letters. Also, the TALF program will expire next year. Will credit spreads blow out when not artificially constrained by the Fed? Very possible.
As for fiscal stimulus, all this does is borrow from the future to ease our pain today. It is the policy equivalent of being a 12-year old. The amount of debt we are accumulating is unconscionable. The one area where I might have been sympathetic to fiscal stimulus is with national infrastructure, roads, bridges, electrical grids, etc. The fact is, much of this needs repair or modernization, so what better time than now when people need work? Also, this money shouldn't be considered spending, per se, but rather investment. Economies need infrastructure, so there's a return on that investment. Sadly, the stimulus bills we have passed have little to do with this. Mostly, they give money away to pet projects and special interests. My personal fave is $150 million for "volcano research." That'll get the wheels of commerce rolling!
We are left with a rally that seems mostly artificial. The fact is that we are still deleveraging, so consumer and corporate spending will remain low. Tax rates are rising fast, particularly at state and local levels (although the Feds will catch up soon). Housing and autos have been briefly propped up by still more government programs, but "cash for clunkers" is over and housing tax credits will have to end as well. The sheer growth of government guarantees the future misallocation of resources coupled with a higher level of economic uncertainty hence higher risk and higher volatility We have taken about five shots of whiskey for a quick buzz, but the hangover awaits. It's difficult to imagine any other scenario.
Many, including I, have noted that the stock market rallied 48% in 1930, post crash, and went on to new lows. I wonder if this is an analog for today. Personally, I don't think new lows are in store, but we could be at the high end of a trading range that lasts years.
I should say, by the way, that I am by nature an optimist, so all this negativity doesn't come naturally. (It makes me feel sophisticated, though - have you ever noticed how pessimists are held in higher intellectual esteem, even though they are wrong most of the time?) I should, however, throw out two or three bright spots. First, emerging markets are quite healthy, and consumer-led demand from the newly minted global bourgeoisie will help our own economy, particularly the export sector. Second, the next great game-changing technology is just around the corner. Don't know what it is, but since technological progress is speeding up, it will be here soon. Will it be enough? Don't know that either. Third, the fact that I, a preternatural bull, am bearish is a very bullish sign!