Friday, March 13, 2009

Stock Vigilantes to the Rescue

During President Clinton's terms of office we had the Bond Vigilantes. They rode herd on the government by raising interest rates whenever spending plans threatened to get out of hand. Today, with interest rates on U.S. Treasuries near record lows, the Bond Vigilantes have been overwhelmed by a desperate flight to safety by millions of frightened investors. But a new vigilante group has arisen to take over, the Stock Vigilantes.

For several weeks, it seemed that every time President Obama opened his mouth to explain a new, far-reaching government program he was planning, the stock market would take another 100 to 200 point dive. On the off days, Pelosi or Reid would add their thoughts and stocks would dive again. Then a strange thing happened. President Obama's poll numbers started first to fall, and then to plummet.

What we now have is a President frightened by his popularity dropping and realizing that millions of Americans, and not a few foreigners, are blaming his policy pronouncements for each additional 2, 3 or 4% daily drop in their retirement plans. That is, the Stock Vigilantes have taken control from the Bond Vigilantes.

It's no coincidence that President Obama recently decided he needed to hedge somewhat on the implementation of "Cap and Trade" legislation. Every time he raised the issue, the Stock Vigilantes took another chunk out of our retirement plans. When word surfaced that he was becoming ambivalent about pushing the most far-reaching restructuring of the American economy since FDR's New Deal, we finally had the best market rally of the year.

This President wants to take America down a far-left socialist road. Of that there can now be little doubt given his policy pronouncements since Inauguration Day. And it's unlikely that a drop in the polls will stop him. But Congress has another election day scheduled in a year and a half, and campaigning will begin soon. The Stock Vigilantes don't have the power to turn President Obama into a moderate, but they do have the power to scare moderate Democrats, and probably even a few liberal ones, into reining in the president's more radical aspirations, each of which promises to drive the American economy further southward.

Economic Forecast

As I said on December 2, the economy would hit bottom by March and certain leading numbers including retail sales and durable goods orders would rebound first. Employment would lag by a month or two, but would be the number that ultimately convinces the markets that the economy is turning upward. So far, both January and February's retail sales figures have come out stronger than expected. Though January's figure failed to ignite any enthusiasm, when the February decline of .1 percent (versus an expected decline of .5 percent) was reported along with a significant upward revision to January on March 12th, the market added to the rally it began on Monday, March 10th.

Durable goods orders, on the other hand, were still plummeting as of the January number, reported on February 26th. The February number to be reported near the end of March should begin to show a turnaround, however. The employment number remains dreary, and will not show strength until the numbers for March are reported in early April, or possibly even a month later. Nonetheless, the economy appears now to me to be turning on schedule, as I wrote in early December. Interestingly enough, a poll at CNN on when the economy would recover offered no option for "soon" or "now" and only 22% of respondents even chose the "later this year" option. The other 78% are looking for the recession to last until the end of this year at least.

The Bond Market

Rates plunged to absurdly low levels after my December 2nd forecast with the 10-year note yield falling to nearly 2 percent from the 2.70% rate in early December. That rate was unsustainable and 10-year rate is now back up near 3%, fluctuating between 2.75% and 3% lately. The long bond dropped from the early-December number of 3.25% to a low of near 2.5% in late December and is now back up, trading between 3.5% and 3.75% for the past month or so. As the signs of a strengthening economy mount, long term government securities are going to be slaughtered, especially given the massive borrowing that is going to be required to finance recent spending bills. And this is before inflation becomes a major concern, a factor that will likely come into play later in the year depending on Federal Reserve actions over the next several months.

The Stock Market

My December forecast on the stock market failed to account for the willingness of President Obama to destroy wealth by jettisoning the capitalist system, or at least expressing his intentions to do so, at the first opportunity. Otherwise, it's likely the lows made last November, which were then tested in January, would have held. Instead, investors lost all hope that the economy would be managed for growth and the market plumbed new lows. Only in the last week, when President Obama expressed a sentiment, and only a sentiment, that perhaps some of his ideas might have to wait for the economy to recover, did the stock market put in a convincing rally. However, this president has shown a remarkable ability to be able to say one thing while doing the opposite but not getting called to account for doing so. It remains to be seen what he actually does next, but my money would be on further attempts at wealth destruction. As I said at the outset of this piece, only the Stock Vigilantes are likely to be able to bring this process under control, and then only by scaring moderate Democrats facing re-election in 2010.

We should have seen a significant stock market rally by this point, and maybe we still will. However, this president and this Congress are not the investor's friends. Forecasting a bull market, however much the fundamentals will justify one (and they will) is a fool's game with the present crew in charge. At least that's how I see it.

The Housing Market

Face it, housing has been beat up beyond most people's (though not my own) expectations. While it might have further to drop, and while inventories remain plentiful, it's probably time to start picking and choosing if one is looking to get into a house near the bottom. Housing markets are local, and some markets no doubt still have much farther to fall, but in general if a potential buyer puts in exceptionally low bids on several houses over the next few months, and ends up buying one, I suspect he will be satisfied with his purchase a couple of years later. This will be particularly true if the Fed lets the recent monetary burst remain in the system.

The Federal Reserve and Money Supply

The massive injection of funds into the banking system in September of last year resulted in over a 50% growth in demand deposits over the four months through December (from $300 bn in August to $465 bn in December.) That injection is now being wisely withdrawn and the February number came in at $397 bn. If monetary policy is not to generate a 25% or so increase in the general price level over the next few years, the Fed must draw down demand deposits to close to the $300 bn level over the next few months. If they do this over the summer, a historically weak period for the stock market, the process could be hard on stock prices. Nevertheless, it must be done if inflation is to be held at bay.

As I said in early December, the massive reflation by the Fed could "turn on a dime" and so it did. Within a month they had taken action that significantly contracted demand deposits. As a reminder, for a reader to fully understand this process, you must read and understand the seven "priority" posts on this site.

Another Note to Business Leaders

I asked in December if it would be useful to know that the economy would be turning up by the second quarter of this year. You now have a huge advantage over market participants. This is because you can see your own sales trends and how your customers are acting. If the economy is indeed picking up, you will see it in your sales (unless, again, you build houses.) The problem is that given all the gloom and doom talk, including that coming from the White House, you might not believe what you're seeing. Let me tell you this. If your customers are starting to show signs of perking up, it's real. The time to batten down the hatches has passed. Don't sail into an economic recovery with a shrunken sales force and with your manufacturing operations unprepared to ramp up production, or you'll be caught unprepared yet again. Trust what you're seeing in your own operations, not what you're being told by outside economists because they will miss the turn by several months.

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