Economic News & Analysis - March 15, 2012
A central bank overshoot?
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist; John Manley, CFA, Chief Equity Strategist

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John Manley photo


  • At the risk of sounding stodgy, the recent rally in response to the Fed’s mostly positive “stress test” of U.S. banks seems like the right thing at the wrong time.
  • We suspect that new challenges will emerge as the year progresses.
  • Despite the challenges, we still remain optimistic—though not exuberant.
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On Tuesday, the Fed gave us a glimmer of hope on the economy and mentioned that “only” four banks had failed its latest stress test—and quite a stress test it was, as it assumed a scenario in which the economy would tank worse than it did in the 2008 financial crisis. However, the mostly positive results were enough to change more than a few minds about the direction the economy is taking. Most major U.S. equity market indexes climbed nearly 2% and closed at levels not seen in four years. For the technology-heavy NASDAQ Composite Index, it was the highest close of the century (or millennium, if you want to get technical). The S&P 500 Index went through the top end of our projected trading band (1,250–1,375) with great enthusiasm.

While we had written last month in “Swan flu” that equities were being constrained mainly by investors’ fixation on the possibility of negative “surprises,” we clearly did not expect this kind of surge—though we will welcome it, as we have consistently been recommending an overweight to equities relative to fixed income.

Better does not mean good

At the risk of sounding stodgy, the recent rally seems like the right thing at the wrong time. While we are aware of the systemic problems that have dogged equities for years, we are also cognizant of the market’s acceptance of healthier future earnings growth, the apparently real sustainability of progress in domestic employment, improvements in the European debt situation, and the easing of emerging markets monetary policy that has been made in recent months. However, despite these positives, market expectations seem modest and skepticism rife.

Things are getting better (as in less bad), but they are far from being better (as in healed or fixed). In the interim, the world’s central banks seem willing to backstop economies and markets as needed. Given Federal Reserve Chairman Ben Bernanke’s long-held desire to make investors take on more risk, I suspect that he slept quite soundly on Tuesday night. I am happy for him; he, along with central bankers around the world, is the market’s best friend these days.

We began 2012 with the notion that it was simply too early for the markets to go up or down significantly and stay there. We expected this to be a year that would set us up for good equity markets on the horizon. In our opinion, the consensus outlook was that the excesses of the past 25 years would eventually come home to roost. Until we were disabused of that notion, we felt that all moves in the equity market would simply be a function of timing. We knew all about the issues but argued over when they would diminish us. We envisioned a scenario like the one that occurred in 1980–1981 in which stocks bounced along the bottom, with investors fully knowing the problems but unable to see a clear and present solution.

We believed that the risk would be limited by the low expectations and high level of skepticism already priced into equities, with the countervailing tendency of policymakers to push acute problems down the road until they could be properly and permanently addressed. This thesis has not been challenged this year, and we still believe it to be true.

We thought that the upside limit would remain in place until there was at least a roadmap—or shadows of a roadmap—to solving our structural problems. While that still seems a reasonable hypothesis, a combination of improving global fundamentals and the perception of central bank vigilance against any potential calamity has beguiled the equity market to (and slightly above) the level that we thought would be the upper end of its trading range. Another tenet of our trading range narrative was that we could see a move higher, to 1,450 on the S&P 500 Index, during those market moments when the sun was shining and all seemed all right in the world.

Challenges still on the horizon

We suspect that challenges will emerge as the year progresses. Questions about earnings may arise as first-quarter pre-reporting begins. Questions about continued U.S. economic growth may arise as the effects of a warm winter are better known (seasonally adjusted data are not adjusted for unseasonably warm weather). Questions about Europe may arise as the Europeans have to deal with themselves and the results of their fiscal restraint. While any of this would occur against a background of low expectations, it could prove unsettling to a market that now appears to see problems only on the distant horizon.

What to do? Two slogans of the distant past spring to mind: “Don’t fight the Fed” and “Don’t fight the Tape.” We believe that the long-term direction of stocks is up, and we will rely on this in the face of near-term uncertainty.

We would reiterate our positive stance on large-capitalization information technology (IT) stocks. Those that sell to corporations have cash-rich clients who are keenly aware of the benefits that IT investments have brought them. The sector itself is at a multi-year low in relative price/earnings and is only now emerging from the excesses of 12 years ago. We suspect that its recent strength is far from over.

Despite the challenges, we still remain optimistic—though not exuberant

The clean bill of health the Federal Reserve’s stress tests gave to big financials and the European Central Bank’s (ECB) long-term refinancing operations suggest that banks—at least in the U.S.—could get more liberal with credit creation. Although the Fed was loose with monetary policy over the past few years, regulators and Congress seemed to be hamstringing the creation of credit through various provisions of the Credit Card Accountability, Responsibility, and Disclosure Act and the Dodd-Frank financial reform act. While the policies themselves may or may not be good, they were, at best, the right policies at the wrong time. At worst, they were the wrong policies at the wrong time. Effectively, the Fed eased monetary policy while Congress tightened monetary policy. Regardless, the stress tests and the ECB backstop of the European banks should be a positive going forward.

Another factor helping the market outlook is the sign of less balkanization in the House and Senate. Although we think the Jumpstart Our Business Startups Act will likely create few—if any—jobs, the bipartisan support of the act suggests that there may be a way to avoid the tax wall facing the economy at the end of the year, regardless of who wins the White House. Under current law—not current policy—dividend tax rates are set to go from 15% to 39.6%, with an additional 3.8% surtax for high-income individuals. Capital gains tax rates are set to go from 15% to 20%. Income tax rates are scheduled to go up across the board to pre-2001 levels. The two-percentage-point reduction in payroll taxes is set to expire. High-income individuals are set to get hit by the Medicare health insurance tax of 0.9% on earned income. The alternative minimum tax is set to capture more people in its net. We could go on, but we are already getting depressed with the possibility of these increases in the face of one of the most sluggish economic recoveries of the past few decades. These tax increases seem like an error worth avoiding. Maybe, just maybe, this tax wall can be avoided.

There is a growing possibility that the high price of oil we see today may become a distant memory. Sadly, the price may go higher before lower, though. The reason is that it seems to us that there is a growing likelihood of a diplomatic solution to problems with Iran. Iran’s truculent president, Mahmoud Ahmadi-Nejad, is coming under domestic criticism, being accused of disloyalty and mismanagement, while the Ayatollah Khamenei—the supreme leader of Iran—has given at least the appearance of being opposed to the further development of Iran’s controversial nuclear program. If Ahmadi-Nejad loses domestic support, which seems more likely than not, then oil prices could move lower as the risk-premium associated with a conflict shrinks.

In the near term, high oil prices still threaten to make analysts question their near-term profit estimates of companies. A move higher in oil could force analysts into cutting estimates, which could push stocks lower. We’d view that as a buying opportunity, since we think oil prices will eventually go lower and improved financial conditions could provide a nice support and then a lift for the market. In short, we think the market is still in a trading range. We originally said it was 1,150 to 1,350 for the early part of the year. We then upped that to 1,250 to 1,375 for the near term. For the balance of the year, we expect a range of 1,250 to 1,450. Notice that we did not raise the lower end of the trading range, which reflects some of these very real and looming challenges.

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