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Was that it? Is the great stock market correction of 2011 already over? Libya is in the throes of a revolution that threatens to spread to the more important parts of the oil producing world and the slippery stuff can’t hold above $100? All this geopolitical turmoil and gold can’t even make a new high? The dollar, meanwhile, has all the appeal of a Lebron James jersey in Cleveland and can’t even manage to rally against the Euro, home of the PIIGS, or the Yen, the land of the rising debt to GDP ratio. The stock market at its worst point last week was down a whopping 3.7% and by the close of the week the market had clocked in with a mere 1.7% loss, which barely qualifies as a bad day much less a full blown correction. It was a very confusing week.
Meanwhile, John Q. Investor can’t make up his mind what he believes. On the one hand, he’s ticked he sold at the bottom and embarrassed he missed most of the rally. On the other hand, he can’t find Libya on a map and has no idea what quantitative easing is but he knows his last fill up and grocery trip was painful. He doesn’t see the economy getting better because for him and his friends it isn’t. Wealth effect from the stock market? Well, you have to own the thing to feel it and he only turned bullish a couple of weeks ago. And just as soon as he did, the entire Middle East - not to mention our very own Midwest - blew up. Sometime early last week was about the time John Q. said, you know what? I’m outta here. Call me when the smoke clears.
For individual investors, the memory of the financial crisis is apparently still too fresh to weather even a minor storm. The AAII poll last week showed an equal number of bears and bulls when just two weeks ago the bulls were running like it was Pamplona and bears were doing what they always do in winter, namely hibernating. That standoff between bulls and bears is probably appropriate right now. I suspect we are moving into a period where the result will be a market that satisfies neither side. As the old saying goes, Mr. Market tends to act in ways that frustrate the maximum number of investors. Right now that would seem to encompass both the bull and bear camps.
Having said that, it seems to me that the risks are to the downside right now. The economy has been improving in fits and starts for almost two years but there are still significant risks. Fed policy is expansive and expectations for future inflation are rising as evidenced by the most recent consumer sentiment survey (see below). Ben Bernanke may not want to take responsibility for rising oil and food prices - while taking full credit for a rising stock market - but I have no doubt that fears about the future value of the dollar are driving investors to real assets. And those fears are well founded. Easy Fed policy is reinforced by a Treasury policy that explicitly advocates a lower value of the dollar. When Tim Geithner tells the world that the Chinese must let the Yuan rise it is no different than telling the world he wants a cheaper dollar. It seems obvious to this observer - but apparently not policymakers - that policies that raise the price of oil and other basic commodities will not aid the recovery.
In addition to the monetary policy risks, there is the elephant in America’s living room of fiscal policy. Our budget is out of control and deficits have to be reduced at the federal and state levels. If we do that strictly through spending cuts as some Republicans seem to want, there will be additional economic pain before the benefits kick in. If we do it only through tax hikes as Democrats seem to want the pain will be felt just the same. It is essential that fiscal policy be re-oriented to more pro growth policies in conjunction with any spending cut plans. The key to long term economic success is investment in productive assets and investors need to be given incentives to make them. Fiscal policy that is friendly to permanent investment will increase the demand for dollars and begin to bring capital flows back to the US. That increase in demand for dollars for investment will in turn make Bernanke’s job easier by raising the value of the dollar and reducing inflation expectations. If rising oil prices are a tax as so many have said, then raising the value of the dollar and reducing commodity prices is vital to future growth.
Monetary policy is probably set until QE runs out in early summer and the fiscal debate is really only beginning. Uncertainty is rising and during those times cash, even when it is paying next to nothing, is a good thing to have on hand. Stay cautious and don’t be in a hurry to buy this little dip.
It was a holiday shortened week and considering the economic data released last week we would have been better off it had been shortened even more. With the market focused on the Middle East, it didn’t get much attention but the economic news was generally negative.
Housing market data released last week showed that we are still a long way from a healthy market. The Case Shiller index continues to show price declines across the country. There are a few areas that have stopped falling but the only place prices are rising is the DC area which boasts the only area of the economy that is booming - government. The good news is that falling prices are exactly what we need to clear out the inventory and existing home sales responded, rising 2.7% month over month and 5.3% year over year. Median and average prices were both down over 5%. Supply at the current pace of sales is 7.6 months which is still too much but is coming down.
New home sales didn’t fare as well with sales falling 12.6%. Supply is 7.6 months but that is for this very depressed sales rate. A pick up in sales would make inventory look a lot leaner but that’s unlikely to happen before the inventory of foreclosures gets worked off more. Now if we could just get the Fed to understand that rising mortgage rates because of QE II are acting as a headwind, maybe we could finally put this unhappy housing market behind us.
The Goldman and Redbook retail sales reports were solid with same store metrics growing at about 2.5% year over year. Some of that was probably due to a short burst of warm weather up north but for whatever reason, American consumers continue to spend. The Consumer Confidence reports last week confirmed that individuals moods continue to improve but there was one area where they seem worried - inflation expectations. Expectations for the next year are now up to 5.6% and while these expectations are routinely higher than actual CPI, they do influence consumer behavior. If you think prices will rise next year it makes sense to buy more today.
Durable Goods orders rose last month (2.7%) but the headline was boosted by transportation orders distorted by a 4900% (that’s not a typo) increase in non defense aircraft orders. Obviously that isn’t sustainable and ex transportation orders were down 3.6%. That follows solid gains the last two months and one month obviously doesn’t make a trend so for now I’m not sure this means all that much. Of more concern was the drop in non defense capital goods orders ex transportation which dropped 6.9%. This measure of capital investment had been on an upswing but basically everything in the category fell last month. As investment is still the major factor missing in the recovery, this is incredibly important for future growth. Again, it comes after two strong months so I don’t want to get too negative but this bears keeping a close eye on.
One bit of good news was the jobless claims number which once again fell back below the 400k level. We’ll get more information on the jobs market this Friday with the non farm payrolls report which I expect to once again be less than encouraging. Claims need to get back to about 350k to see consistent job growth and we just aren’t there yet. The last report of the week was a revision of 4th quarter GDP down to 2.8%. It’s old news but still a bit discouraging.
The US economy is slowly - very slowly - improving but it is a long, long road to health. Rising prices for oil, food and basically every other commodity on the planet will not help and for that we can blame the Fed’s quantitative easing policy and squabbling politicians. QE raises fear of future inflation and the effect is seen in the falling dollar. One way to offset that expectation effect would be for the politicians to finally do something about the budget and tax reform. That would give global investors the confidence to hold dollars and make long term investments. Increased demand, even in the face of a rising supply of dollars, would raise the value and reduce inflation expectations. Oil and other commodity prices would come down and remove a major headwind to economic growth. Let’s hope the politicians figure that out before its too late.
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