Anyone looking for thrills these days should forget roller coasters and
skydiving. Instead, simply buy a few shares of US stock. The past year has
reminded us how truly stomach-churning the financial ride can be. And after a
white-knuckled drop in 2008, investors who held on are now enjoying a dizzying
ascent.
In the past five months alone, the S&P has risen by 22% and the NASDAQ by
33%. Emerging markets are back almost to their pre-recession levels. Even
individual American stocks have performed in a stellar manner. Apple, Cisco and
Oracle have all risen by over 200%. Ford, an aging relic once given up for
dead, has risen by 268%!
But what we have seen is more than just a lesson in physics. Stocks are not
going up only because they previously went down. We are witnessing a return of
hope. While the change is
heartening, it is sadly based on the flimsiest of evidence.
The current rally has been sparked by some modestly good news about the United
States economy - the Purchasing Managers' Index is up, gross domestic product
has retracted by only 1%, and the fall in home values appears to be leveling
off. Taken together, the appearance of these "green shoots" has many, such as
the director of the President Barack Obama's National Economic Council, Larry
Summers, and Treasury Secretary Tim Geithner, convinced that the recession is
over.
Somewhat more guarded, Federal Reserve chairman Ben Bernanke testified to
Congress that he foresaw a "jobless recovery". One is left to wonder how an
economy burdened with double-digit unemployment can recover without new jobs.
In recent decades, there have been some jobless recoveries from mild
recessions, but they were built upon asset booms. Today, we face a very deep
recession. The asset boom has collapsed. A jobless recovery in an economy based
on 72% consumer spending is an oxymoron.
Unless our economy can go through a needed and painful reorganization, in which
the industrial sector is revitalized, recovery from this recession will have to
be based upon consumer demand. With unemployment increasing at over 500,000
workers a month, wages dropping, and hours worked declining, it is hard to see
consumer demand rising convincingly enough to provide the engine for a rebound.
Meanwhile, US Treasury debt is exploding, the US dollar is falling, and
unemployment is rising. In such circumstances, how can the stock market rise be
trusted? What is the reality?
Added to this conundrum, credit remains tight, despite the injection into the
banks of vast amounts of Fed funds at zero percent. And, for the first time,
banks are being paid interest on the reserves required to be held at the Fed.
Paradoxically, this hidden taxpayer boost to banks' earnings is one of the
prime reasons for tight credit. What bank would lend to corporations or
individuals, incurring risk, when it can lend to the Fed - at considerable
profit - without risk?
With the consumer still in shock and denied credit, why do some indicators
appear positive?
The short answer for this is massive deficit and stimulus spending by the
federal government. More than US$3 trillion alone this year. That's nearly
$10,000 for every citizen in the country. Little wonder that some consumers
have "handout" money to spend. And it's no surprise that after a massive
sell-off, certain retailers are refilling their inventories, causing the
Purchasing Managers' Index to rise. Likewise, now the threat of a banking
collapse has passed, albeit temporarily, the rate of job cuts can be expected
to fall.
Looking ahead, there is a $3.4 trillion commercial mortgage problem due to face
the banks in September. This most sobering prospect, combined with the various
pressures on consumers, would appear to indicate that the American economy is
in the eye of an economic hurricane. When jobs fail to materialize and credit
remains frozen, look for corporate earnings to remain depressed. This reality
can only be ignored for so long.
Any investor in US stocks and bonds should be extremely wary, particularly as
autumn may well herald a rise in interest rates and, as a result, another round
of collapses. The ride up may have been fun. But remember last year before you
dare to hold on for more.
John Browne is senior market strategist, Euro Pacific Capital.
(Euro Pacific Capital commentary and market news is available at
http://www.europac.net. It has a free online investment newsletter.)
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