Has the Bubble Re-Inflated?

April 2010

 

 

Has the Bubble Re-inflated?

 

Over the past month or two, many conversations with our clients have turned to the thought that stocks may be getting overpriced. We don’t think so. Perhaps the best question to ask regarding that thought is: “What’s driving the increasing value of stocks in today’s market?” The most obvious two reasons are an abundance of cash, and a dearth of alternatives.

 

In fact, these two points are closely related. Over the last year, a large percentage of the cash resident in our economy has been provided by Uncle Sam. This large supply of money was not pulled out of an account at a bank and dispersed into the economy, but rather was created by our central bank through large purchases of financial instruments in the marketplace. These purchases were done on credit.  So the impact is simple – the FED created a trillion or so dollars in new money that was dispersed into the economy. The point of this exercise was to put cash into our economy to help cushion the impact of the impending recession. The net result of a large market purchase of bonds by the Government is the lowering of interest rates. This has been furthered by direct FED action to lower short term rates.

 

Which raises issue number two: a dearth of alternatives. As interest rates have come down to historic lows, bond and CD investors have seen the income on their portfolios fall dramatically, with no alternative investment to fill the income gap. Anyone considering a 5 year CD these days will find available rates in the 2 to 2.25% range. It wasn’t so long ago that 5 or 6% for the same certificate was the norm. Simply put, investors in this position are unwilling to invest for a 5 year period at such a low return. So this cash is in the system looking for income as well.

 

This quick look at the high level of liquidity in the system leads to the next point: as a result of the recession and our uneven recovery, investors and business have been wary of writing checks for illiquid investments. So a large chunk of the available cash has been drawn into the (liquid) financial markets. This has helped provide the impetus for a higher S&P over the course of the past year.

 

What’s the Next Step?

 

There is still upside left in stocks. There will likely be downside corrections, but we see 2010 as a good year for equities. When one considers a few statistics, it seems possible that the Market has quite a way to go.

 

Corporations have been spending the last year cleaning up their balance sheets. The cash has been provided, indirectly, by Uncle Sam through lots of cash and very low interest rates. Companies have been able to refinance or liquidate their debt at an unprecedented rate. Also, fear of a long recession has prompted a round of productivity improvements that will remain long after the recession is history.

 

Unfortunately, one casualty of the recession has been employment. As companies have downsized and recapitalized, they have shed employees. Currently with an unemployment rate of 9.75%, unemployment is going to be the last to recover. This is not unusual during an economic recovery, as business will be cautious about expanding into a wobbly environment. But it will happen, perhaps beginning in early 2011. Most likely, as employment begins to show improvement, the FED will begin to gently edge interest rates higher. This may lead to a flattening of corporate profits, which would be negative news for the stock market.

 

Some Government initiatives could stop stocks (and the recovery) in their tracks. For example, the Congress could decide to pass Cap and Trade legislation. Whatever the politics of carbon trading are, it has been estimated that this measure could cost our economy 2 to 3% of GDP. It is an invisible tax on everything and everybody. It’s hard to see how that would improve the economy in 2011. Another looming problem is the extraordinary increase in taxes on dividends that is likely to happen next year. Already taxed twice, the tax could approach 60%. It doesn’t seem likely to be well received by investors.

 

Of course, the elephant in the room is the scale of our public debt. Much higher than at any time other than World War II, we are watching for significant steps to reduce it. Failure to deal with this problem could be catastrophic, and so far there has been little movement. Inflation, currency problems and high interest rates are just the beginning. The Government’s thirst for cash could begin to crowd out individuals and business looking for financing. This scenario is one to be avoided. Thankfully, we are not there yet, and we do have some ability to read the markets for progress on the problem. Inflation seems to be under control for the moment, and the FED continues to favor (and telegraph) an expansionist policy.

 

Business has spent the last 2 or 3 quarters liquidating their inventories. This has helped to limit damage from the slowdown in the retail and supply sectors, but has put the manufacturers into a revenue and profit squeeze. We are beginning to see some good news, though. As the economy has slowly turned the corner, the manufacturers have begun to pick up, and their backlogs are starting to build. That will provide some opportunity for investors, as production picks up steam. It makes sense to emphasize investment in this area for the next few quarters, and we have done so.

 

Interest rates will stay low, perhaps into mid 2011. This will be good for business. It will help keep financing costs down, and help to bolster profit margins at a critical point in the recovery. This will keep our recommended allocation of fixed income securities a bit lower than normal and positioned in short term securities. That should give us the opportunity to take advantage of higher rates to come. In the meantime, we will rely a bit more on large cap, dividend paying stocks to help provide income and portfolio stability.

 

Spring 2011: A look in the Crystal Ball

 

A year down the road, it seems likely that we will have seen a move upward in interest rates. Employment should be starting to recover by that time – hopefully earlier – which should help growth in GDP. Business will have restructured their financial statements, thereby lowering their fixed costs. That may well lead to profit improvement, giving managers the opportunity to expand a bit and continued GDP growth.  The continued growth in the economy will prompt the FED to edge short term interest rates up a bit. If that comes to pass, our fixed income allocation will increase a bit to take advantage of higher rates.

 

Government actions and policies could change this scenario significantly.  The election in November and the news leading up to it will provide some clues to help with our 2011 strategy.

 

As always, thank you for your business!  We look forward to hearing your thoughts and comments.

 

Barrick Smart 

Disclaimer: All investment entails inherent risk. Smart Investments Advisory Inc. seeks to assist investors in determining when to buy and when to sell certain investments in an attempt to maximize profits or minimize losses. All final investment decisions are yours and as a result you could make or lose money. The statements made herein include information obtained from sources believed to be reliable, but no independent verification has been made. We are unable to guarantee its accuracy or completeness. The statements made herein contain general information and do not constitute an offer to buy or sell any security.