"Stock Market Descent - Is the End Nigh?"

Sydney M. Williams

Thought of the Day

“Stock Market Descent – Is the End Nigh?”

August 4, 2011

The sharp decline in the U.S. equity markets, in the aftermath of the signing of the bill to raise the debt ceiling, is a sharp rebuke to the President’s failed economic plan and, in my opinion, to the concept of demand-side economics. As I wrote a few days ago, the debt ceiling is nothing more than an arbitrary number arrived at by politicians whose attention are more focused on the next election than on what’s good for the economy. The important issue is reinvigorating the economy.

Over eight days, the U.S. equity markets gave up more than a trillion dollars (6.6% of their value,) more than the stimulus that did not stimulate! This decline marked the longest continuous daily drop since October 2008. On Tuesday, the S&P 500 closed down 2.6%, the largest daily decline since August 11, 2010. Yesterday the S&P 500 rallied five basis points. This morning futures are down seven basis points.

Stock indices act as a barometer, warning of changing economic conditions – and the message they are sending is not good. An extended period of low interest rates, a falling dollar and $800 billion in stimulus spending have not brought the economy out of its slump. Whisperings, including those from PIMCO’s Bill Gross, that Fed Chairman Ben Bernanke will announce QE 3 from Jackson Hole later this month would aggravate an already bad situation. Should those rumors be true, it would be an indication that the Fed has not learned the lessons of QE 2 – a decline in the rate of economic growth and a rise in the rate of inflation is not the way to get the country on track to economic recovery.

Is there a way out of this enigma? There is, and it is a growing economy – a growth agenda. The exit was pointed out by Erskine Bowles and Alan Simpson in their report to the President last December – a combination of tax reform and debt reduction, including addressing that third rail of politics – entitlements. The problem for stock investors is two fold. (I am sure there are others, but there are at least these two.) The first is that 75% of the volume on the NYSE is estimated to come from high frequency traders, or other quantitative programs which ignore the fundamentals of individual securities. Their trading tends to accentuate existing trends; so that if a stock is sold, for example, because of an earnings miss, that fundamental selling begets program selling, extending what might be a correction into a rout. The second problem is the most important, a lack of confidence – a condition difficult to measure, except in its absence.

However, the building blocks for recovery are present. In general, corporations have managed the fiscal crisis pretty well, rationalizing their operations and building their cash reserves, both at home and abroad. But the cash has not been put to work, or at least not aggressively. Reserves overseas can only be returned to the States in exchange for a large tax, so it is more likely that they will be deployed in the country in which the money was earned, thereby helping that economy, but not necessarily ours. Cash at home could be invested here, but managements are uncomfortable as to changes in the tax code and cost/restrictions of the Administration’s fiscal policies, especially the cost of yet another entitlement – the Affordable Health Care Act of 2011.

Consumers are in better shape than they were four years ago. After declining for twenty years, the savings rate has risen, according to the Federal Reserve Bank of St. Louis, to 5.3 percent. Nevertheless, the savings rate remains substantially below where it was at the start of the 1980s, but at least the trend is up. Again, confidence among consumers is low. Doubts about housing persist, there is uncertainty as to whether we face inflation or deflation, and questions regarding taxes remain unanswered. Are we looking toward tax reform (a positive,) or higher taxes (a negative?)

On the positive side of the ledger, stocks are reasonably priced and earnings have generally surprised positively. Companies have managed their businesses well through the slowdown. Low interest rates mean low borrowing costs, and low interest rates suggest that stock multiples are attractive on a discounted cash flow basis.

While Mr. Obama’s instincts lean toward more government rather than less, it is interesting that, in signing the deficit bill, he acceded to demands of Republicans in terms of no tax increases and reductions in spending that four months ago he was obdurately against. It could be that this time, should the twelve legislators come back with proposals similar to those put forth by the Bowles-Simpson commission as seems likely, he will be more willing to accept tax and entitlement reform – both essential ingredients for economic growth. In doing so, he may feel the heat from his left, but as the 2012 election approaches he may have no other choice. Should Mr. Obama aggressively pursue a pro-growth agenda, by co-opting many of the points Republicans have made, he will win re-election handily. However, whether he allows pragmatism to overcome ideology remains to be seen.

Many of my friends on the right will find such a prospect unlikely and unattractive, and perhaps it is. But if it leads to a better economy and better markets, and the price we have to pay is four more years of Mr. Obama, so be it.

The hard left has not retreated though, as was evident in an op-ed by Lawrence Summers in yesterday’s Financial Times. In his conclusions, he writes: “First, the single largest and easiest method of deficit reduction is the non-extension of the Bush high-income tax cuts…modest entitlement reform [and] it is essential the payroll tax be extended.” That model calls for big government and is anti-growth. It would assuredly extend the economic downturn and expand the deficit. There is no question that Mr. Summers is a brilliant man, but he, like so many east and west coast liberals who suffer from what I call Rudyard Kipling Syndrome – a variation of Mr. Kipling’s “White Man’s Burden.” These people see themselves as smarter, better educated and more knowledgeable than the rest of us; it is, therefore it is their destiny and obligation to take care of us, make decisions regarding our social, health and retirement needs. It recalls to me the wisdom of William Buckley’s comment that he would rather be governed by the first 2000 names in the Boston phone book than the 2000 members of Harvard’s faculty.

If the whisperings about Mr. Bernanke and QE 3 are true, and if Mr. Summers and his ilk continue to hold sway over the White House, I believe we are doomed to continue on the road toward West European Socialism – sluggish growth, higher taxes and ever bigger deficits. However, should we find that Mr. Obama’s signing of the deficit ceiling bill, with no tax increase, was the signal event of the last few weeks – that it was a prelude to the acceptance by him of the tax and entitlement reform package that is likely to emerge from the new group of twelve this fall – that would indicate a path out of the morass that has enveloped us, and stocks should do well, (though they look sharply lower this morning!)