Be Careful What You Wish For

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I often hear comments like “It would be nice to see the economy get going so the stock market will start to do better.” Or “the economy is doing better, so the stock market should do better, too.” I don’t know how to break the news to people who make these comments. The not-so-simple fact is that these comments seem to make sense, but they don’t really make money. The reality is centered on the completely counterintuitive fact that financial market performance and economic strength are not very highly correlated in the short term.

The investment process makes a lot of practical sense over extended periods of time. But there are also periods that seem entirely counterintuitive. After all, we understand the logical connection between a financial market that rises thousands of percent as a country spends a century revolutionizing the processes of industry, developing nearly unimaginable technologies, and doubling a person’s life expectancy. But we grapple with reconciling how a market can rise when unemployment is twice a historical average, a government is operating at ever growing deficits, and an economy is best described as a “plow horse”.

The truth is that investments tend to perform better when an economy is lackluster, not when things are booming. A good friend of mine, Dr. Steve Sjuggerud, is a well-respected analyst and very successful financial newsletter writer. In some of his recent work published in his Daily Wealth column last month he looked at U.S. stock prices versus the U.S. economy going back to 1800. What he discovered was pretty amazing.

Since 1800, when the economy has been doing really well (when “real GDP” has grown at 6% a year or more over the preceding 12 months), you would have lost money in stocks over the next 12 months. On the flip side, when the economy was contracting, you’d have made a nice return in stocks.

Since times are certainly different now than back in the 1800s, Steve also isolated the research to when quarterly data was first available in the U.S. in 1947. The results tell a similar story.

If an investor had put money into the S&P 500 in 1947 and left it alone to the present day, their investment would have earned a 7.3% compound annual gain. But, during the years in which the GDP was below 0% (which was 13% of the time), the 12 month return following that particular year was 18.5% on average. And when the GDP was above 6% (which was 14% of the time), that return was just 4.2%.

This precept is still at work. We all know the economy was shrinking in 2009. We also know stocks bottomed in early 2009 and then began to rise dramatically. Prior to that, the late 1990s were years of tremendous growth and high confidence. What followed was the reality that excessive optimism was paving the way to unsustainable asset prices.

This fact is that great conditions get “priced in” to the stock market. By the time people feel comfortable about investing, after things have felt good for a while, things are often too expensive. When things are shaky and the fabric of society seems to be coming undone, stocks tend to be cheap.

What I want to emphasize here today is that financial markets tend to perform their worst after the economy has had a great run of growth. At the present time, the economy isn’t exactly having a great run, but it is growing. For years I’ve likened it to a “plow horse”. From an investing perspective, the longer we spend time with this plow horse, the better.

So do be careful what you wish for if you are of the old view that a better economy means better investment returns. Sadly, the opposite is truer in history’s eyes.

The Federal Reserve’s Self-Chosen Conundrum

The Fed has built itself a very confusing box. They have publicly stated that they don’t anticipate raising interest rates again until the unemployment rate reaches 6.5%. As I said in the last issue of Worth Considering, I believe we have entered a new era in which unemployment will remain well above past historical averages as our workforce shifts to fit the new world of business. If this turns out to be the case, I would suspect unemployment will remain north of 6.5% for quite some time. This, in turn, would mean we’d have an exceedingly accommodative Federal Reserve for a length of time that would seem to end up being unhealthy.

During that period, stocks would almost certainly rise substantially. A lot of the super-cheap money being created would eventually land in the financial markets. Companies would likely also use these easy credit terms to stoke merger and acquisition fires. It seems to me that as the markets rise and the wealth effect shows up in the consumer world, the Fed would want to keep things somewhat in check with tighter policy, even if the unemployment rate is, say, 6.8%. To not do so would seem dangerous and would seem certain to usher in enormous asset bubbles that would continue the cycle of boom and bust pain our country has suffered in recent decades.

As investors, we need to accept the importance of the Fed’s actions, or lack thereof, regardless of how we might feel about them. As I said before, be careful what you wish for sometimes. A good deal of the current advance in the markets can be attributed to the Fed’s accommodative stance. If they were to start raising rates, as some might wish for, the market would likely lose one of its current lynchpins. I don’t believe the market would turn for the worse if rates were a bit higher. At the same time, I don’t expect the Fed to change their stance anytime soon. As a result, the market metric of cheap money will stay in place as a force for higher prices down the road.

At some point in the future, my hunch is the Fed will abandon the 6.5% unemployment rate bogey. I suspect they’ll need to take some gradual action prior to that date, which might be a very, very long way away. I believe the economy will likely hold up better than they think in a 7% “new normal” unemployment rate. If that’s the case, they can’t risk asset bubbles of epic proportions just for the benefit of clinging to a number that isn’t highly relative to economic output in the future.

Housing Continues to Recover

As I’ve suggested in prior issues, it just might be that the housing sector recovery turns out to be the saving force for the overall economy. Indeed, according to recent economic data reported by Washington, in this past year it has been the recovery in the housing sector that has been the brightest spot in the overall recovery. I expect the same again for 2013.

This recovery in the housing sector will bring with it a large number of jobs. It will serve to bring down the unemployment rate; just not to anything under 7% for a very long time.

Don’t believe that the housing recovery is over. The affordability of an average home is still well below historic averages. One really good sign is that banks are now working through their backlog of foreclosed properties. This is going to be a long and sometimes ugly process, but it is a productive necessity. People who have been cheating us, the taxpayers, by living in their homes and not making payments for years are finally being dealt with. The real estate divisions of banks are finally catching up with a workload that let these problems fester for far too long. As they do, the housing market gets a stronger pricing infrastructure. And with interest rates still at generational lows, those that have been diligent are hopefully taking advantage by getting into not only a good investment for their families, but are also bringing a sense of achievement and pride back into this element of our society.

The Sequester

To keep this simple, as reported by the Huffington Post, sequestration is the set of automatic spending cuts put into law by the Budget Control Act. Signed by President Obama in August 2011, that legislation raised the debt ceiling and sought to apply pressure on Congress to come up with a longer term plan for deficit reduction. Guess what. They couldn’t do it.

The idea was to buy time in 2011 thinking that surely over the next 18 months or so our elected officials would find a more proper plan than something cobbled together under the gun of a looming debt ceiling. Nope. Partisan politics prevailed and something that was initially seen as a last minute laughable place-holder is now law.

In total, there are $1.2 trillion in budget costs that are associated with the sequester. They are spread over nine years and are equally divided between domestic and defense-related spending. For the remainder of fiscal 2013, this means $85 billion of cuts will go into effect.

You might think this is a big, and potentially bad, development for the markets. It hasn’t been so far, and I don’t think it will become one. The investment world is starving for fiscal discipline. While this is a crude way of getting it done, it is getting done nevertheless. If discipline can’t be developed with sound judgment, it still needs to be developed somehow.

Warren Buffet was on CNBC this morning and he said something to the effect that sequestration is a stupid response to a very serious problem. I wholeheartedly agree. The only thing more stupid is to have no response at all. Therefore, Sequestration has a perverse beneficial effect in the investment world.

This is no way to run sound economic policy for our future. But as some analyst said on TV last week, the thought of economic disaster as a result of sequestration cuts is about as real as Manti Teo’s girlfriend. In a world where the Federal Reserve is buying some $45 billion of assets every month, budget cuts of $85 billion simply don’t stack up to much.

Tax Forms – expect amendments

A quick word on taxes and tax forms – due to all the uncertainly about tax law at the end of 2012, everything in the way of tax filings at the corporate level are behind their usual schedule. Individual companies and investment groups alike are having to rush to get information along to their shareholders.

Since the finer points of the classification of income payments wasn’t made clear to them until much later than usual this year, I think it is wise to expect an above average number of reclassifications; also meaning an above average number of amended 1099s. Don’t be upset with these companies or the brokerage firms, this blame isn’t fairly placed on them. They are going to reclassify taxable events in the ways that are most beneficial to their shareholders wherever possible. My advice is simply to hold off on finishing your tax returns until you receive amended 1099s near the end of March; and possibly into April.

I know this is a headache – believe me, I know! But I think headaches will be minimized by being as patient as possible with the process this year. Let’s hope 2012’s finale isn’t soon repeated by the folks on the Hill.

The Takeaways:

• I’ve been asked how it could be that the markets are nearly back to their highs while the economy is clearly well below its past peak. I hope the points I made in this piece help explain this counterintuitive relationship a bit.

• While it makes sense to remain relatively positive on the financial markets looking forward, I would still strongly suggest a balanced approach and not a pure stock driven portfolio. Markets are not cheap enough to warrant that type of speculation.

• Don’t believe that just because the real estate sector has been doing well lately that it can’t continue to be a key driving force in economic recovery. It will slow its pace of growth soon, but will still continue to grow.

• And don’t let Washington’s inability to reach agreements give you investment anxiety. This type of gridlock isn’t new and it actually tends to favor the financial markets. Sadly, it seems that the less Washington does, the more the markets like it. The clear fear is that anything they do will just be wrong.

Jeff Winn, Orlando Financial Advisor


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