Batten Down The Hatches

The author of this article believes there is something artificial about the Dow rally. The fiscal cliff seems to have been resolved but in a way that is certainly not positive to the economy, there were no spending cuts and the resolution consisted entirely of tax hikes.

Joe Calhoun
January 27th, 2013
Alhambra Partners

Back in November I wrote a weekly commentary that I called Looking For Silver Linings. The market had been taking a beating in the post election period and I wasn’t feeling particularly good about my forecasting skills. I had written a commentary just two weeks before arguing that the election really didn’t matter that much and my Republican friends were pointing at a 500 point selloff in the Dow as proof that yes indeed, elections had consequences. Well, as it turns out, Looking For Silver Linings was published right at the bottom of the market and Republicans have gotten quieter with every uptick of the Dow. My Democrat friends, in contrast, are crowing about how the market loves Obama and his policies. Stock market investors have indeed found some silver linings and we’re within hailing distance of the all time highs.

So why can’t I shake the feeling that something isn’t quite right about this rally? Why does it feel so….artificial? I think what makes me uncomfortable is the rapid manner of the change in sentiment. At the time I wrote Silver Linings, the pessimism about the global economy and US stocks was pervasive. The American Association of Individual Investors weekly sentiment poll had just less than 29% bulls and nearly 49% bears. The press was full of articles about the economy falling back into recession absent a resolution of the fiscal cliff stalemate. China was landing hard and Europe was still on the brink.

So here we are roughly two months later and the fiscal cliff has been resolved but in a way that is certainly not positive for the economy. As I predicted, there were no spending cuts and the resolution consisted entirely of tax hikes. Yes, the hikes were less than they would have been if we had gone over the cliff but the changes are not insignificant. Overall the fiscal cliff agreement amounts to about 1% of GDP and in an economy barely growing at 2% that is the very definition of significant. And that is a static analysis that does not take into account any changes in growth due to behavioral changes which may not be large but certainly do exist. Furthermore, the upcoming debate over the budget that encompasses the sequestration and the debt ceiling – yes it will be coming back – will involve even more tax hikes. President Obama has made it abundantly clear that he has no intention of cutting spending.

Since my Republican friends are mad at me and I always strive for balance around here, let me just comment here that there may be any number of reasons for the market to be up 12% since the post election sell off, but love of President Obama’s policies is likely not among them. If anything the market reaction is rooted in relief that as feeble as the Republican opposition has been, it was at least enough to prevent the President from getting everything he wanted. I guess that is a positive but this second term is just getting started and the President is feeling his progressive oats while offering no indication that he intends to even throw a bone to the roughly half the country that didn’t vote for him. And I guess he doesn’t have to but that doesn’t mean the economy has to cooperate.

And the fact is that the recent economic statistics have not been particularly robust. The housing market, which everyone seems to see as a tailwind for growth now, is showing signs of deceleration. Existing home sales were down a bit in December, constrained by a lack of inventory that is moving prices higher at a fairly rapid pace (median price up 11% year over year). Higher prices are not generally known as an inducement for more sales. Meanwhile, new home sales have been moving sideways for the last six months and even at this low pace of sales, homebuilders are running up against supply constraints. Many builders are reporting a lack of skilled labor and increased materials costs that are pushing building costs higher. Inflation may already be starting to have an effect even with elevated unemployment.

Consumption continues to grow but the rate of growth is relatively slow and with the hike in payroll taxes seems unlikely to improve in the short term. Manufacturing is almost impossible to judge right now. The regional Fed surveys have been fairly negative while the Markit national PMI has been more robust and the ISM positive, but not by much. I think the proper conclusion is that the manufacturing picture is mixed at best. The employment picture is also murky. Jobless claims have fallen to the lowest since the beginning of the recession but as Jeff Snider points out, the seasonal adjustments are hard to justify.

With one tax hike in the bag – and more likely in store – and an economy still struggling to find growth beyond the new normal as backdrop, the sentiment regarding stocks has done a complete about face. The AAII poll now shows bulls at 52%, bears at 24% and the balance neutral. Mutual funds are reporting inflows and a majority of investment advisers are now bullish. Everywhere I look I find complacency about the downside risks to the market. It is possible that the bullish sentiment can continue at these elevated levels without a significant correction but that is usually an early bull cycle phenomenon and at nearly four years this bull is getting long in the tooth.

The positive factors I talked about in Looking For Silver Linings were of a long term nature and they all still seem likely to contribute to growth in coming years. Over the longer term, housing will continue to recover due to population and household growth. Manufacturing seems likely to continue to return to the US as global costs equalize and the trend could accelerate if the politicians rationalize our awful corporate tax policy. The rest of the world also still seems to be stabilizing. I am worried about excessive credit growth in Asia in the longer term but for now growth there seems to be recovering from the China led slowdown of last year. Europe has seemingly stabilized – although I’m not alone in thinking that might be temporary – and banks are starting to pay back some of the LTRO loans. A return to growth will be long in coming but at least things seem to have stopped getting worse.

But these long term factors can easily be overwhelmed in the short term by the drag of higher taxes and the continued accumulation of debt. Growth can also be sidetracked by inflation and I suspect that will be a problem long before the Fed meets its unemployment target. Monetary policy today resembles more than anything the monetary policy of the 1970s and I don’t think the results will be much different. The inflation – in the form of a cheaper dollar – has already happened. We are just waiting for the effects now and when they come the Fed will have little choice but to respond.

The last factor I cited in Silver Linings was a more stable dollar and for now that also seems to be continuing. The Euro has recently climbed back to the mid 130s but the Yen is falling and the dollar index has been remarkably stable for the last two years. Gold has also continued to trade in a narrow range and the general commodity indexes are also quiescent although oil prices are once again approaching $100. The benefits of a stable dollar will not be immediately obvious though and it will take time for investors to recognize them.

My search for silver linings back in November was intended to show the long term positives to investors focused on the short term negatives. Today as everyone sails along under seemingly clear skies, we need to scan the horizon for clouds. There are plenty of them out there and they may not look like much right now, but a prudent sailor prepares for a storm before the winds start kicking up. I still think there are blue skies over the horizon but for now it is time to batten down the hatches.

(By the way, when I said a few months back that the election didn’t matter, what I was referring to was the only truly bipartisan thing in all of Washington, DC – bad economic policy. We’ve had bad policy under Republicans and bad policy under Democrats and good policy under both as well. Bad policy is bad policy and the party that puts it in place is irrelevant. And make no mistake, current policy is bad. Some of it was started by Bush and some by Obama but that is irrelevant; it needs to be changed. More on all this in a future essay.)

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