Stocks Are Up – Everything Must Be Fine, Right?

Your stocks are up for the year, granted they are still well off the October 2007 peak. Many companies have reported better than expected earnings. The recession may finally be over. All these things are true. So we’re out of the woods, right? This is precisely what media spin doctors and government experts would have you believe. After all, they don’t want people scratching below the surface and actually finding something unsightly. That would ruin all the hard work that has been done aimed at getting investors to buy stocks and consumers to spend. They prefer to cultivate a superficial and semi-informed consumer/investor. The thinking man knows better. Look, it’s natural for people to WANT to believe that everything is fine. The fact is there is a deep chasm between current market sentiment and reality.

Strict technical definitions may suggest the U.S. is emerging from economic recession if we discontinue the pattern of two consecutive quarters of negative GDP growth. While this may happen, in the case of the U.S. economy this is akin to a cardiac patient having a couple of good days amongst many bad ones.

When Wall Street reports news that is marginally better than expected; people cheer. This is more indicative of the collective bar being set extremely low by analysts, and organizations operating with vastly reduced staff (translating into bolstered operating margins); rather than sound business growth and expansion.

This is perhaps the most troubling. A country’s currency (direction) is supposed to be a reflection of its economic strength. Therefore, when an economy is robust, the currency will gain in value, along with stocks. Since early this year, the U.S dollar has declined, yet stocks have risen. Why? Is it based on fundamental strength? The fact is the majority of the run-up in the major U.S. stock indices can be seen in the correlation between the U.S. dollar and foreign currencies, and the bond market. Simply put, a weak U.S. dollar means higher stock prices as global investors essentially buy U.S stocks at a discount. With their home currencies strong against the dollar, they have more purchasing power.

With bond yields extremely low - institutions, mutual funds, and pension funds across the world that are holding huge amounts of cash need to look elsewhere for a decent return. Much of this money has been pouring into U.S. equities.

All this demand has led to a resurgence in the stock market. What we are seeing is not so much a stock rally based on sound fundamentals as much as an adjustment to global prices. The majority of the increases in the major U.S. stock indices can be attributed to this.

When a country has huge deficit spending and its central bank is printing money as is the case in the U.S., this further de-values the currency and it becomes a less attractive investment, so investors go towards gold, other commodities, and other currencies as alternatives. This would account for the increase in the value of gold, which cannot be devalued like a paper currency by printing.

This phenomenon would be played out in reverse if and when the U.S. dollar ever regains strength relative to other currencies. Then, foreign currencies will weaken against the dollar and global investors’ purchasing power will be eroded. Bond yields (and interest rates) would increase. Foreign demand for U.S. equities will drop, while bond demand increases and these forces combine to cause a pullback in the stock market.

The problem is, there are indications that the U.S. dollar will continue its decline given massive U.S. deficit spending and proposed (‘reform’) programs that are completely unfunded. In short, our government is spending money it does not have and proposing programs it cannot possibly pay for without economy-crippling tax increases and selling ever increasing amounts of debt to foreign governments. If the current situation holds, you have to assume that foreign investors will at some point reach a saturation point (there are signs that this has already begun) with respect to U.S. equities (and treasury debt). They will look to diversify, take profits or cut losses, if for no other reasons than sheer common sense and capital preservation. Over the last three months, banks poured 63 percent of their new cash into other currencies – the Euro and the Yen – instead of the dollar. This is the complete opposite of what used to be the norm.

Here are some sobering facts:

• 98 U.S. banks have quietly failed so far this year.
• The President and many on Capitol Hill are calling for a $1 trillion+ healthcare bill — to be funded by additional borrowing and/or higher taxes on income and through some sort of value added tax scheme, - all of which will further slow economic growth.
• Federal government expenditures are growing much faster than the economy, and thus the government is becoming a larger and larger share of our nation’s GDP.
• Entitlement programs like Social Security, Medicare, and Medicaid all continue to grow faster than the economy. These will account for all federal tax revenue this year, requiring that other government spending programs, including defense and interest payments on the national debt be funded by selling even more treasury debt and by printing money.
• Our government cannot tax its way out of staggering deficits because increasing income tax rates on high wage earners will ultimately have a negative impact on jobs and GDP as less private sector money is available to invest in and grow businesses; and productivity decreases as the rich spend more of their time searching for ways to decrease their tax bill, and less time actually producing more revenue since more of it is now taxable.
• The Chinese and other holders of U.S. treasury debt are diversifying their holdings — many are buying large quantities of tradable commodities which are in part, a hedge against a plummeting U.S. dollar. Therefore, at the same time, the U.S. government needs to sell trillions of dollars of new bonds to compensate for the diversification. Our government is by its own actions driving away foreign bond buyers, which can only inevitably result in higher interest rates in the U.S., further slowing economic growth.

The life blood of our economy is the consumer and he’s not consuming. Credit still isn't widely available. Even if it were, people are very hesitant to borrow as they are in saving mode. The prospect of continued high unemployment will succeed in keeping wages down. Increasing taxes will slice further into budgets. So where is the disposable income supposed to come from that will revive our economy? The answer is that people will once again begin to open their wallets only after they have first saved to a level of some comfort; and when they have confidence in an economic policy and in leadership that places a much greater emphasis on fiscal restraint and in rebuilding an economy without instituting massive borrowing and promoting a continued debasement in the value of our currency.

The supply-side solutions are surprisingly simple:

• Cut taxes to create more available cash and stimulate business and consumer spending;
• The Federal Reserve must stop printing money and begin to remove excess cash from the money supply to begin to stop the bleeding;
• The Treasury should buy U.S. Dollars in the currency markets to begin to instill confidence in our currency;
• The Government must stop spending money it does not have and stop borrowing money it cannot repay;

Neither political party has put forth a viable plan for reversing the explosion of government (taxpayer) debt. Most Democrats are proposing accelerating spending, while most Republicans are doing nothing more than attempting to slow it down.

The U.S. economy and stock market cannot be artificially driven and sustained over the long term as Americans suffer in a jobless recovery, while our collective quality of life deteriorates relative to the rest of the world.