And So It Continues - part one - 9-16-2009

September 16, 2009 Edition, Volume III

Inside Signature Update

- The Market Should Always Ahead of Itself
- Recovery Patterns and Dynamics
- The Fed Balance Sheet and Money Supply


The Market Should Always Be Ahead of Itself

The DOW Industrials topped 9700 in early trading on Wednesday extending September’s gains and putting to rest most concerns over an early fall swoon in the equity markets. Fed Chairman Bernanke’s comments Tuesday reaffirming his position that the US recession has come to an end helped push the markets forward as investors began to bring money back from the sidelines. The level of money market deposits has now decreased from $3.8 Trillion to $3.56 Trillion as investors and traders have begun to back away from the overly risk averse posture that led to the March 2009 lows in the DOW and S&P 500. During most of the 1980’s through 2000’s the level of money market deposits hovered near the $ 2 Trillion mark; even at $3.56 trillion there is an impressive amount of cash on the sidelines waiting to enter the markets.

Some market pundits continue to suggest that the market is ahead of itself and that we are due for a correction, but in this case these people are ignoring the entire premise on which the markets are based: the equity markets reflect stock values based on corporate and economic activity 6-9 months in the future – they are always ahead of themselves! The real problem lies when the markets are more focused on what happened yesterday and ignore what is likely to happen next month or next year. The wild market swings of the fall of 2008 that led to the market’s decline into the spring of 2009 were driven more by fear than pragmatism. The early 20th century economist, John Maynard Keynes, labeled this type of activity ‘animal spirits’ and suggested it is the inconsistent factor of human behavior that is responsible for wide, or wild, swings in the markets and the economy as a whole.

I think we would all agree that the ‘animals’ have been very ‘spirited’ this last year, as we saw the pendulum swing from being overly optimistic to gut wrenchingly pessimistic in a period of months. One of the few benefits of such activity is the knowledge that calm will return and saner heads will prevail in due course. One of the more disconcerting realities is that we seem doomed to repeat this cycle every ten to twenty years as creative minds suggest that something is altogether different this time than it may have been in the past – rarely is this the case, but it certainly makes for an interesting ride!


Recovery Patterns and Dynamics

The more optimistic voices in the markets suggest that we are in the midst of a ‘V’ shaped recovery rather than a ‘v’, ‘u’, or ‘w’ shaped pattern. The differentiation of ‘V’ versus ‘v’ simply denotes the dynamic of how far we are likely to rise in recovery contrasted by how dramatically we fell in recession – it reflects a level of energy and optimism that may or may not be warranted. The ‘v’ versus ‘u’ description is intended to suggest that the market and economy will rise quickly from its lows rather than lingering near them before recovering, as is the case in a ‘u’, or returning to them, as is the case in a ‘w’. Each variation offers an acceptance that calamity has been avoided and growth will resume.

Seemingly inconsistent with evidence of economic growth and stock market rebound is an unemployment level near 9.7%, causing many to use the term ‘jobless recovery’. Closer examination reveals that the economic recovery in the midst of any period of high unemployment (anything in excess of 7%) begins with a continuation of an increase in jobless claims. In other words, virtually all substantial economic recoveries begin as jobless recoveries as we progress towards full employment.

The production/employment cycle in growth is counterintuitive to some. When an economy begins to recover, or expand, output (production) increases first by utilizing excess inventories built up during the recession, then by absorbing excess labor capacity and finally by adding employees to corporate payrolls. Only then does the employment picture show obvious improvement. A look at the patterns of recent months reflects this progression:

- Retail sales have improved modestly (up 1.1% ex autos last month) and inventories have leveled out (down 1.0% in August).

- Corporate productivity has improved and the rate of jobs lost has slowed.

- The velocity of money has sped up (more money changing hands more rapidly) and both producer and consumer prices have posted moderate gains (1.7% and .04% respectively).

- Industrial production has increased in spite of lower employment levels and an increase in GDP of as much as 3-4% for the 3rd and 4th quarters is becoming more of an expectation than a hope.


The Fed Balance Sheet and Money Supply

Concerns that the Fed will tighten the money supply and stall the recovery abound, but Bernanke and company appear to be walking this fine line better than most realize; not doing so would increase the possibility of the dreaded ‘double dip recession’ so many have warned about. The Fed expanded their balance sheet while also expanding the money supply over the last 12 months. The balance sheet changes aided in returning confidence and liquidity in the credit markets and the money supply increases (evidenced by a decrease in interest rates) have helped limit decreases in consumer spending and employment. Ultimately the Fed must return to a more normalized monetary policy to avoid overheating the economy and igniting inflation and that normalization process has certainly begun, but not at the cost of the money supply. The Fed has reduced its balance sheet from $2.2 trillion to $2.06 trillion over the last several months as those resources have no longer been as necessary to maintain stability in the credit markets, but the money supply remains relatively unaffected. The Fed’s balance sheet was at $800 billion before 2008’s credit and liquidity crisis.

At some point the Fed will have to reduce the money supply to avert inflationary pressures. Doing so now would not only stall the economy, but would unavoidably increase the unemployment rate and push us back into another recession. Again, the line here is thin, but it appears that the Fed is doing the right thing and doing it in a timely manner.





Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC