"The Market - Where Art Thou Headed?"

Sydney M. Williams

Thought of the Day

“The Market – Where Art Thou Headed?”

November 28, 2011

On Saturday, the Wall Street Journal noted that last week the Dow Jones posted its worst Thanksgiving week in the seventy years since Thanksgiving became a federal holiday on December 26, 1941. For the week, the S&P 500 was down 4.7% and is now down 7.9% year-to-date, a pretty poor showing for a third year in a Presidential cycle, typically the best year. But perhaps we should be thankful: The UK is down 13.6%; Australia, down 18.6%; Japan, down 19%; Canada, down 19.5%; Hong Kong, down 20.7%; Germany, down 24.2%; France, down 26%; Taiwan, down 26.3%; Russia, down 27.4%; China Small Cap, down 34.5%, and India, down 37.3%. Almost $10 trillion in global equities have evaporated so far this year.

U.S. investors are concerned; the decline has taken place despite the efforts of business leaders to rationalize their companies during a period of tough economic conditions. The decline has more to do with policy issues, than with bad fundamentals. It has been a failure of governments to recognize that spending on social programs may make good politics today, but at an unbearable cost to be borne by future generations. Prime Minister Margaret Thatcher saw the problem clearly when she condemned the path toward socialism Britain was on in the late 1970s: “The problem with socialism is that pretty soon you run out of other people’s money.” Today, our country has run out of our money.” Mrs. Thatcher was far from the first to recognize the problem of Socialism. Friedrich A. Hayek, in his book The Road to Serfdom published in 1944, warned of the unpleasant consequences of Socialism. He was, of course, referring to Germany and the Soviet Union. In November 1949, in response to a “pie-for-everybody” speech by President Truman in St. Paul, Minnesota, an unknown politician penned an “Ode to the Welfare State”. A foolish father is speaking to his sensible son. Two stanzas that resonate today:

“Don’t worry, bub, there’s not a hitch

In this here noble plan –

He simply soaks the filthy rich

And helps the common man

But, father, won’t there come a time

When they run out of cash,

And we have left them not a dime

When things will go to smash?”

The peculiar situation in today’s equity markets is that they have been riven by negative macro events (the Euro debt crisis and a failure in the U.S. to address our growing entitlements) and positive micro reports (positive corporate earnings and cash flow, along with substantial amounts of cash on corporate balance sheets and in investor’s portfolios.) Even the U.S. domestic economy is not in terrible shape. When a woman feels the need to pepper-spray her competitors as happened on Black Friday at a Wal-Mart in California, it is a strong indication that demand exceeds supply!

The macro challenges are obviously winning, and they are being helped by the manner in which stocks are increasingly traded. High frequency algorithmic trading programs have been capturing more of daily trading volume – an estimated 70% today. That factor, along with the continued growth and use of ETFs, indicates that the prices of individual stocks reflect less a company’s specific fundamentals and are more of an echo of market or industry psychology. A high frequency trader does not care about the underlying business of the stock he or she is trading. The security serves only as a vehicle, allowing him to make a penny or less on the direction it is trading. While an ETF investor has made an industry selection, he does not differentiate between good companies and bad ones. The wheel is spun and speculators put down their chips.

While the very cheapness of stocks, especially relative to alternatives such as Treasuries and Investment Grade Corporates, should bode well for stocks on a trading basis, a sustained rally depends on a fundamental change in policy. In the U.S., it will likely take a sense that a growth strategy – involving deficit reduction and tax reform – is more than just talk, that it will be legislated. “Going green” when we have excess gas reserves makes little sense. High paying jobs are out there, if environmental lobbyists would just lighten up. In Europe, it will take a public acknowledgement that the social welfare state cannot exist in its current form. Debt and demographics are forces too powerful to overcome. In neither continent is there enough money to do what our political leaders would like done. Both continents should adopt, as Mitch Daniels has written and spoken, “Change that Believes in You.”

It is easy for populist presidents to demonize Wall Street (and certainly many who labor in its vineyards are far from paragons of virtue.) The very name ‘Wall Street’ conjures up images of fat white men – the one percent – wearing suspenders, smoking cigars, ignorant and uncaring of the poverty that surrounds them – the ninety-nine percent. Demonizing Wall Streeters as “millionaires and billionaires” brings applause, the principal aphrodisiac to a politician. But there is risk in such blanket condemnation. First, Wall Street is well aware that, for example, entitlement reform will have to have a means test as a central tenet. Reasonably well off aging baby boomers collecting Social Security and Medicare have not helped income inequality. Second, our system thrives on capitalism. It is the source of all private sector job growth. (Public sector employees, it should never be forgotten, are funded by the private sector.) Roughly half the households in this country have some exposure to equities. What happens on Wall Street does affect Main Street.

The great irony is that as government has taken a bad situation and made it worse, the private sector has forged ahead. Fear of increased regulation and unknowns as to future tax rules have restrained corporate expansion plans, so they have run their businesses to produce and husband cash. Greater confidence in political leadership will encourage business leaders to start spending.

Forty-four years on Wall Street has not provided me the ability to predict markets. I recognize we have been down seven days in a row and that the market is now selling below both its fifty-day and two hundred-day moving averages. That probably suggests we are ready for a rally. (In fact, overseas’ markets and U.S. futures suggest a strong rally today.) Nevertheless, I suspect that the fuel is there for a sustained market rally. What is missing is the ignition – a spark. Washington, Berlin, Paris, Rome, Athens, are you listening?