Good Luck, Goldilocks

It has been over two months since my last market update and the stock market is just roaring ahead, repairing all the damage from last year’s financial collapse and indicating that the recovery is in full swing. Or is it? In fact, I feel like a backseat driver in the movie, “Thelma and Louise,” careening towards the cliff with the top down on my vintage convertible. The financial reality is that we are facing some of the greatest uncertainty seen in generations which is starkly exhibited in the markets today.

The stock market change since my last market update is a up 3.6%, not a robust return for anyone who jumped into the market this past September. Gold has beaten the living snot out of the market, up 19.5% and even TIPs are up by 3.8% (TIPs are the Treasury-Inflation Protected Securities, a safe haven that also indexes to inflation). But here is the paradox – there is no inflation and no one is predicting for strong inflation anytime soon, even though Gold and TIPs are traditionally used to hedge against inflation. The only other time there is a flight to these securities is during times of severe financial risk.

Yet the stock market shows no such signs of financial risk. In fact, the main volatility indicator for the stock market, the VIX, touched a low of 20.05 last month, the lowest point we have seen since August of 2008, well before the collapse of Lehman. In a nutshell, the stock market is plunking along as if all is fine in the world while traditional safe havens are seeing enormous inflows of cash. Where is this split view coming from, and what does it mean for the next few months and years?

These stark numbers were reported by Bloomberg last week. In November, the rate on 3-month treasuries went to zero (it even went negative for a brief moment) while the equity indicators are showing minimal risks after a 25% gain this year. This has happened once before in modern financial history. It was 1938: the stock market had gained 25% that year and short-term Treasuries were yielding 0.05% (read: 5/100 of one percent). For the next three years starting in 1939, the stock market lost one-third of its value. Is this where we are headed next? Maybe – it all depends on whether policy makers can get it right this time.

Economy

The biggest battle that the financial markets will face is the improvement of the economy. Almost 70% of our Gross Domestic Product depends on the consumer – their ability to spend money on everything from gel toothpaste to plasma TVs. This consumption has been driven by two factors, disposable income from earnings and the ability to borrow. A key impetus to spurring consumption was home growth – the purchase of a new, larger home and all the items needed to fill that home. Yet today, in every aspect of this dynamic, we are hurting.

The housing market is in the toilet for a while longer. Prices have increased for the past few months, but have done nothing to repair the enormous loss of home value and home equity. As reported last week by the Wall Street Journal, one-in-four homes are underwater (worth less than their combined mortgages) and 5.3 million homeowners are more than 20% underwater. While this collapse has headlined the news for two years now, the reality is that we have many more years before the residential real estate market again becomes an impetus for growth.

Credit is declining commensurate with these events. Credit card reform legislation takes effect in February, and already banks are increasing rates and limiting lines to “buffer” themselves against the changes (in fact, this is an egregious abuse of their banking privileges to be discussed in another article). Combined with the current job market and mortgage delinquencies, it will be years before the consumer credit market again extends credit to consumers to fuel consumption. In fact, expect to see major lenders from Bank of America to Capital One suffer enormous credit losses in the coming year, well beyond their current projections.

Jobs are scarce, and growing scarcer. The “official” unemployment rate has passed 10% this year, months earlier than expected. And while layoffs continue at a clip of over 500,000 per week, the creation of new jobs is stagnant. The reality is that employers are finding ways to do more with fewer employees, and this trend shows signs of continuing. At the current trajectory, we will soon hit an employment level of 57%. That is, roughly 1-in-2 working age Americans are working. That compares to 2-in-3 during a robust economy. The last time we saw these levels was in the 1970s, when far fewer women viewed career as a viable option. For the first time ever, more women than men now have jobs.

(As side note from December 4: this morning’s unemployment figures show an improvement for November. While this could be an encouraging sign, I suspect there is a distortion in the figures that would be revised in January. I don’t believe this marks a sudden change in the employment scene.)

Policy Makers

Simply put, the Great Recession is here and the damage will be felt for years to come. In my view, it will be a decade before we see a return to “normal.” America needs to find a new source of growth. The consumer is not in a position to be the growth driver this time around. They are overextended on credit, underwater on their home, underemployed as a family, and wondering what happened to their 401k plan. In short, things are tough.

For the interim, the government has filled this void. With spending measured in the hundreds of billions of future tax dollars, cheap capital is flowing into the markets. This may in part explain the run-up in equities earlier this year, and the current bubble in gold and other assets. But it also explains the dramatic losses in the value of the dollar as a currency and the rush to inflation-hedging securities. Fiscal stimulus can be a zero-sum gain if not managed well, with future generations holding the “tax bag.”

Back to our parallel crisis in the late 1930s: In response to the situation, the government tightened monetary policy for fear of inflation, with the hopes of stemming it before inflation dramatically eroded the dollar. Turns out that was a bad move – leading to a double-dip economy as inflation never materialized. They may have succeeded in one aspect, but killing off the economy was not the intention.

Ironically, Bernanke did his graduate work on the Depression making him one of the best candidates to take us through this economy. He has repeatedly asserted that monetary policy will remain loose for the next six months, if not longer, allowing for the economy to mend. Many of the current policy makers have also attested to the fact that they can remove the stimulus and tighten policy before inflation roars back – sort of like Goldilocks and her “not too hot, not too cold” foray into culinary arts. The other prospect is that Congress now wants a hand in this process – if that comes to fruition then it might be time to pack you bags.

In the end, it comes down to human judgment. If the Fed gets it right, all is ok. But if they get it wrong, we face two detrimental scenarios – either a stagnant economy or hyper-inflation. Remember these are some of the same folks who thought it would be ok to let Lehman fail (in case you missed it, that was an “oops”). While they will be employing some of the best minds at solving this conundrum, we think it prudent to assume that they won’t get it quite right.

Regards,

David B. Matias, CPA