By Stephen W. Mack, CFP®
Pictures speak louder than words. That’s a saying that has gained acceptance among those with a bent towards photography. For others, shooting pictures is not as meaningful as shooting off a few words that speak louder than a picture. To those of us who listened to the past vice-chairman of the Federal Reserve, Alan Blinder, it was quite clear: “We’re not stuffing this crazy aunt back in the closet that quickly.”
Now we ask those who look at this as an insult to their favorite aunt to look at the enormous implications of Mr. Blinder’s words. No picture could ever speak louder. Of course, this was not meant as an offense to Mr. Blinder’s mother’s sister. It was to describe the inevitable conclusion that the Fed could never have ceased its unprecedented operation of buying securities with the economy continuing to cry uncle.
Since the Fed announced its plan to exit its rescue maneuvers back in March, the economy has shown weakness, forcing it to resume its purchases of securities. Since March, interest rates on 10-year US Treasuries have slid from an already low 3.6% to a now low (though not as crazy low as March 2009) 2.47%.
Is this good? It depends on what you are, a saver or a borrower. Borrowers are enjoying the ability to finance at low rates, that is if they have jobs, while savers marvel at the idea of lending borrowers money for 10 years at 2.47%.
Yet, that is exactly what is happening. At a record rate, investors are pouring cash into bonds, lending to the US, corporations and individuals at what appear to be historically low rates. Since the beginning of the year, according to the Investment Company Institute, bond mutual funds attracted a record (data since 1984) $185 billion through July. At the same time, investors in US stock mutual funds redeemed $33 billion.
Could the bond investors have it right? Lend money at 2 to 3% for 10 to 20 years (higher rates for higher risk? They hope so. As investors learned in the late ’70s, rates can rise and when they do, bond values decline, sometimes precipitously.
What could cause interest rates to rise? A number of events have the ability to influence rates, most of all the tremendous amount of money being pushed into the system by the Fed. While it seems an unpopular view today, the economy could actually strengthen. Of course, that would be good for stocks. And, as investors look to re-enter stock markets, bonds would attract less money. And for mom and pop (and crazy aunts), the resulting losses in bonds could come as a shock.
Still, before that can happen, the stocks have to become more of the choice, something many are saying cannot happen. Indeed, with stocks down in May, June and August, some are now calling for a crash in September or October. Based on history (back to 1900), this may not be far-fetched. In the past 109 years, September leads all months with an average loss of 1.1%. And, the month sees gains only 42% of the time (next worst month is June, advancing only 50% of the time). OK: to end the suspense, December has the best gains, up 72% of the time with an average of 1.5%.
So, with stocks on their backs, should investors wait until the “coast is clear” is sounded? While we are cautious (actually outright pessimistic) longer-term, we see several positive events that could mean higher markets by the end of the year.
Earnings: Before-tax corporate earnings have risen, compared to one year ago, at their fastest clip (+39%) in at least 27 years.
State Taxes: While state like Illinois (-7%) and California (-0.9%) continue to see losses in tax revenue, average state taxes in 47 states were up 2.2% in the second quarter, the 2nd straight quarterly gain. Florida (up 14% and Arizona, up 3.9%) are recovering some of their lost revenue from their plunge in ’08-’09.
Sentiment: Multiple measures of investor skepticism are pointing to, at least, moderate gains over the next six months. One indicator of individual fear is the American Association of Individual Investors, which reports only 21% of its members as bullish (see stocks rising). That’s the lowest number since March, 2009, (18.94%) just before markets embarked on a one year 80% gain from their lows. This was a relatively high 48% back in April, just before the rapid decline tied to Europe’s sovereign debt problems recognized in May and the May 6 1000-point “Flash Crash.”
Europe: After suffering through the debt fears of May, growth estimates are now being raised for 2010 (from 1% to 1.5%). While minimal, it shows progress and could help support stocks.
Remember, the idea is to try to buy stocks when risk is low (normally when few in the market want to buy and prices are depressed). The time to sell is when prices have recovered and a majority is bullish and comfortable.
As the US approaches elections, it is likely markets will begin to reflect an expected change in Congress. With all House seats up, a turnover to the Republicans is being anticipated. What will this mean? Gridlock – and a slowdown in the growth of government programs. This does not mean Blinder’s crazy aunt won.
While we see a chance for strength into 2011, we also see enormous risks that have been raised by artificially supporting the economy. Look for markets to resume their secular bear market in the next 1 to 2 years.
Stephen W. Mack, president of Glenview-based Mack Investment Securities, publishes a monthly newsletter called Mack Tracks, which provides a current overview of the markets, economy and monetary and fiscal policy. You can subscribe to the newsletter for free by calling 847/657-6600.
