"The Market and Other Thoughts"

Sydney M. Williams

Thought of the Day

“The Market and Other Thoughts”

October 31, 2011

I pretend to no expertise as it pertains to calls regarding the market (nor to anything else, for that matter.) There are those in our office like Peter Zecca, Jeff Mondry and Steve Kroll who are students of the market and whose knowledge greatly exceeds mine. Unable to discern charts and made confused by myriad, conflicting opinions, it is my nature to try to look at markets over the longer term. That perspective suggests two conflicting conclusions. The first is that over the very long term, markets have generally risen, in the area of six or seven percent on an annual basis. The second is that our debt situation – and the culture that precipitated it – suggests that the historic long term positive bias to our market could be at risk.

As noted before in these pages, in my forty-four years on Wall Street, I have seen three broad markets: the markets decline (or flat-lining) from 1967 to 1982; a rise from 1982 to 2000 and the period in which we now find ourselves – a flat to declining market. Certainly, as Laszlo Birinyi has explained on numerous occasions, there are markets within markets. In his most recent issue of “Reminiscences”, Mr. Birinyi notes that we are in the 31st month of the seventh bull market over the past 35 years. But, for a broad sweep, I prefer my definition. In August 1982, the Averages were below where they had been fourteen years earlier. Over the next eighteen years those Averages rose sixteen fold. Today they are below where they had been eleven years ago. In each case, the results were a consequence of fiscal and political actions. President Johnson’s Vietnam policy and his “Great Society” program (“guns and butter”) in the mid and late 1960s proved unsustainable. The decision by President Nixon to exit the gold standard in 1972, followed by his observation “we are all Keynesians now” served as icing on the cake. In 1982, amidst a second recession and with soaring inflation, Fed Chairman Paul Volcker dramatically raised interest rates. A year earlier, President Reagan fired 11,345 air traffic controllers who refused an order to return to work – citing the Taft-Hartley Act that banned strikes by government unions. Reason and commonsense replaced the profligacy of Lyndon Johnson and the disgrace of Richard Nixon. Equity markets responded.

But too much of a good thing proved just that. “Irrational Exuberance” in markets was noted in December 1996 by Fed Chairman Alan Greenspan. March of 2000 marked the end of the tech-internet bubble that had sent those stocks to ridiculous multiples, lending veracity to the P.T. Barnum’s observation that “there’s a sucker born every minute.” Most stocks were selling at unsustainable multiples. President Bush’s decision to fight the War against Terror without making adequate plans to pay for it and the Fed’s decision to keep interest rates very low perpetuated the aura of speculation, transforming losses in equity markets to (momentary) gains in housing prices. Of course, a loss in equity prices had nowhere near the same impact on the broad populace as did declines in home prices. The first affected retirement plans – something American never seemed concerned about – the second their daily lives, as we are a nation of consumers, not savers. A bad situation was made worse. The ascendancy of Barack Obama did not help matters. He took Rahm Emanuel’s advice about a crisis to heart. With the country already entrenched with three entitlements we cannot afford, he decided to add a fourth – Obamacare. Additionally, he signed an $800 million stimulus bill which simply transferred federal tax obligations to state and local union workers, which served principally to stimulate his opposition. The result has been a dramatic rise in deficits, unemployment higher than it was when he took office and an economy that sputters along just above the break-even rate,

So, where does that lead us? In my opinion markets appear fairly valued, with some attractive dividend paying stocks. A lot depends on the outlook for corporate earnings in 2012. The strongest argument for stocks, in my opinion, is the richness of alternatives. The Ten-Year U.S. Treasury yields 150 basis points less than the current rate of inflation. Corporate bonds have been in a thirty-year bull market, with rates on corporate issues like Intel and Lockheed Martin yielding less than their common . Commodities have been in a ten-year bull market and incur a cost of carry. However, despite October looking to be the best month in a quarter of a century, we are only back to where we were in late June. In keeping interest rates at historic low levels, the Fed has benefited the borrowers of capital, notably government. The losers are creditors, be they elderly American savers or sovereign lenders. The situation is only exacerbated by creeping inflation. Keep in mind: Inflation benefits borrowers. The U.S. is the world’s largest borrower. The Federal Reserve (via interest rates) along with Congress and the President (by way of spending) are in the best position to affect inflation.

The risk to this otherwise somewhat tepid view of the market is if Washington maintains the trajectory they have been on for the past three years. Early in his recent book (a book which should be read by everyone who has a stake in our government and our capital markets) Keeping the Republic, Mitch Daniels lays out a scenario in which Americans awake on a Monday morning to cable television reports that the Chinese will no longer purchase U.S. Treasuries. Their decision is based on the unwillingness of Americans to confront the problem of trying to maintain a lifestyle, in terms of entitlements, they is no longer affordable. Governor Daniels lays out an ensuing scenario that will strike any unbiased reader as frightening in terms of potential consequences. (Let me make clear that this is not what the Governor expects will happen. He has faith in the American people to right what is wrong in Washington.) But this is his expectation if we persist on this path toward self destruction.

A study of history makes clear that one of democracies greatest hindrances is also its greatest preservative – a lack of efficiency. We have created a separate political class, in which too many seats are inherited or simply held too long. In the process, Washington seems no longer interested in the stewardship of government, but rather in enriching themselves and propagating their own careers. Just as the concept of the “Prudent Man” should be revived in the asset management business, the idea of the citizen politician should be returned to Washington and, in fact, to all our nation’s capitals. The only realistic way to do so is through term limits.

There are those who claim, perhaps reasonably, that the long term is nothing more than a series of short term periods strung together. That may well be, but the risk of error, when leverage is as high as it is and the inclination of government is to avoid making tough decisions, risk remains elevated.