The correction I’ve been expecting is now in full swing. Stocks have retreated nearly 7% from the recent high, commodity prices have fallen a similar magnitude and the dollar is attempting to stabilize. We have entered a transition phase for the economy and the market that will likely take several months to play out but could ultimately prove to be very beneficial - if the politicians and Fed officials can hold back the urge to “do something”. It isn’t encouraging that we’re starting to hear renewed calls for more “stimulus” from the DC crowd but I suspect the only form of stimulus that can emerge from that swamp in the age of austerity will be of the variety displayed so recently and graphically by Rep. Anthony Weiner (D, NY).
Mr. Weiner, in case you missed it, is in trouble for sending out photos of his inflated…um….ego to women who aren’t his wife, via Twitter. Mr. Weiner spent last week strictly adhering to the well established script for disgraced public officials by holding a tear filled press conference, professing his love for his wife and dramatically redefining the phrase “public service”. He also announced that he would be entering rehab although it is unclear whether a facility had been found with expertise in turning misogynist louts into productive citizens. Rep. Weiner may have single handedly - no pun intended - done more for the US economy than all the stimulus to date by launching two new industries in one week - rehab facilities for powerful male chauvinist pigs with impulse control issues and package delivery via Twitter. He will probably have to pay royalties to Dominique Strauss Kahn.
Weinergate also serves to remind us that dynamic economies are always undergoing what Schumpeter called “creative destruction”, something sadly missing from the US economy of the last few years. The impulse of government officials to be seen as “doing something” about the economy is a large reason why we find ourselves with a 9.1% unemployment rate and barely discernible growth nearly two years after the end of the recession. Government efforts to prop up the existing structure of the economy rather than allowing a new one to emerge naturally have impeded progress. Quite possibly the only positive to come out of the huge deficits of recent years is that the size of the public debt now precludes more such efforts.
The transition I spoke of above, before I descended into double entendre and innuendo, is one the Fed has been trying to avoid with QE II and probably would have happened last year if someone had managed to kidnap Bernanke prior to his speech at Jackson Hole. In that speech, Bernanke spoke of the portfolio rebalance effect that would result and for which he is now denying culpability. As the Fed bought Treasuries and drove real interest rates negative, Bernanke anticipated an investor shift to riskier assets, particularly stocks. He believed that a wealth effect would then spur economic growth. Unfortunately for Mr. Bernanke, no one told investors they weren’t supposed to buy oil and other dollar sensitive commodities. The rise in oil prices alone has offset any potential positives from QE II and probably the payroll tax cut too.
Now that QE II is coming to an end, the dollar is stabilizing and commodity prices are coming down. Yes, stocks are falling too but at some point, investors should start to realize that lower commodity prices aren’t a sign of impending doom but rather a nice tail wind for growth. For the last few years, investors have come to see a falling dollar as a positive for risk assets and a rising dollar as negative, the so called risk on/risk off trade. If we can make it through a period where the dollar stabilizes - or even better strengthens somewhat - and the economy proves more resilient than feared, that mindset should start to fade. The fact is that a stronger, stable dollar is what the US - and the world - economy needs right now.
A stronger dollar would give foreign and domestic investors confidence that their US returns would not be eroded by an ever devaluing dollar. We’ve heard a lot of talk over the last few years about uncertainty impeding investment but it has mostly been confined to the uncertainty of fiscal and regulatory policy. The uncertainty over our commitment to a stable dollar (or more accurately, the certainty of our commitment to a weak one) is one that has been with us much longer, dating back to the early days of the Bush administration, and in my opinion is at least as much a factor in our ongoing investment drought. Ending quantitative easing and addressing the budget will start to relieve those concerns.
The naysayers will protest that “austerity” will reduce GDP and they may be right in the short term. Government spending is part of the GDP equation and any reduction in spending will certainly have an effect but the other variables in the GDP equation are not static. A rise in investment could easily offset a fall in government spending especially if it is aided by permanent fiscal policies that encourage it. Investments, however, do not happen overnight and so the current “soft patch” may persist for a while. If we can get through that period without the Fed panicking into QE III or the politicians enacting another round of “temporary” stimulus, a real, more robust recovery could evolve sooner than anyone currently believes. If it does, stocks will respond positively and likely before it becomes obvious in the economic statistics.
For now, we are maintaining our large cash reserve as we observe the evolution to a stronger dollar. There is certainly no guarantee that the Fed and the politicians will be able to resist the temptation to “do something” and further delay the recovery. In fact, history suggests that especially in an election year, they won’t. So we will remain patient and use this time to evaluate potential future investments. I suggest you do the same.
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[...] Stocks were down most everywhere last week and as noted above sentiment is eroding. I think we might be near a bounce in the averages but until the economic statistics start to show improvement, any bounce is likely to be short lived. The transition to a stronger dollar will take time and investors will have to adjust to the idea that a stronger dollar isn’t bad news. For more on that, read my other weekly commentary here. [...]
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