At Some Point

August 3, 2009

The market keeps charging ahead in spite of widespread criticism of government goings-on.  Nothing seems capable of stopping the upward move -- not rising unemployment, not growing deficits, not higher oil prices, not lingering global flu fears, not even the passing of the King of Pop. 

From the March low (hit just a few days after our last buy in our model portfolios), the market is up around 50% - among the greatest returns in a few months ever. Makes one wonder how much faster stocks could possibly go up in a short time period. What if the government did what everybody wanted it to do? Perhaps good and bad government policy is overrated as it pertains to stock prices.

In fact, all seems equally unimportant to the stock market, which appears to be trading largely on the growing sensation that the worst is behind us and while scary stories still exist, better to ignore negativity because deals on assets only exist when panic is still in the air. And the air is fast clearing.

With assets over the last 15 or so years in almost a state of perpetual overvaluation, the new normal because of the massive wealth globally chasing finite opportunities, there is truth to this theory: You can only safely buy during the brief periods when others do not.

It’s not just stocks. Home prices, which in many markets are still overpriced compared to historical comparisons to income and rents, are finding buyers and price stabilization. There have been stories of wealthy individuals buying up entire troubled Miami condo projects and (hopefully for their sake) pennies on the dollar. 

We’re a little suspicious these properties will ever be worth more than some amount of pennies on the dollar if you define the dollar as the peak price. South Florida condos may be fifty cents on the dollar, or $500,000 instead of $1,000,000 a couple of years ago. But by this logic the Nasdaq is trading at forty cents on the dollar, the dollar being the 5,000 level it hit in 2000. Don’t read this to mean we think tech stocks are a bad investment, we just would be happy to sell out at some point in the future at many sixty cents on the dollar.

Tech stocks have been particularly strong, with the Nasdaq just breaking through 2,000. Of course, this is a level first breached in 1998. As for the S&P 500, 1,000 has just been crossed, a big move from the high 600s hit during the depths of the panic earlier this year. Of course 1,000 was first hit in 1998 as well. The Dow is not far off from 10,000, a level first hit in 1999. (Dull Dow stocks lagged in the late 1990s)

Most remarkable is how quickly the market made its run to its current levels. We all remember the late 1990s being an era of great stock returns. The S&P 500 was in the 600s back in early 1996. What took over two years in the boom years just happened in a few months.

This action has drawn more investors into the party, which unfortunately will end the party at some point. Some investors are likely wise to this and don’t expect to own the stocks they are lapping up today forever. There is probably some level they all have in their heads where they will scale back, something they should have done with more gusto the last time stocks were elevated. 

Our biggest concern now is when “at some point” arrives. The problem with tops is similar to bottoms: They don’t seem obvious until much later. Making matters worse is the possibility that the government and investors are inflating assets once again.

The recent rise in stocks- although still down significantly from the market's peak - seems a bit strange, as the economy has, at best, merely stopped falling. Although “not getting worse” may sound like a good reason to pay more for stocks now than during the panic pricing of a few months ago, that's not a solid foundation for a long-term run in stocks. That is, unless something unusual is brewing in asset markets once again…

Everywhere you look, you see approximately 10-30% less business taking place then last year. Although it's possible this contraction is largely over, the economy won’t start growing at a fast pace for years to come. A cycle of layoffs can create a snowball effect, since reduced spending will result in more companies firing extra staff, and so on, and so on. So far, we seem to be avoiding such a death spiral.

The consensus is that if you artificially stimulate the economy, you'll get inflation and a falling currency. Many who think way, way out would also add that we're likely to see higher taxes (and reduced economic growth) in the future as the bills come due. Such are the things investors worry about when they are not worrying about a complete collapse of the financial services industry anymore.

But many investors don’t care about taxes and growth 5-10 years out. They're more worried about missing today's rally in case it cranks up another 25-50%. They believe inflation risk can be handled with investments in commodities, real estate, and higher risk assets, even stocks, and that currency risk can be managed with foreign investments.

The problem with this analysis is this: Prices on consumer goods aren't going up, but asset prices are. The price of music players doesn’t go up, but the price of music player stocks does. Rents don’t go up, but property prices do. The 1970's are over.

The "real" economy is smaller than it once was. The government is bending over backwards to stimulate it, but it's impacting asset prices more than the actual building and buying of stuff.

In other words, low rates won’t convince you to buy an extra TV or a car, but they may make you shift from safe, low-yielding assets to riskier assets so you can earn more money.  This is similar to the impact of ultra-low interest rates following the last recession. During the last recession, governments (globally) helped generate a massive asset bubble centered around real estate by using ultra low-interest rates to get people to buy stuff and grow their businesses. 

Instead, most of the borrowing was used to buy investments, and much of the business growth was based on providing homes to invest in or renovation items to increase the investment value of those homes. Although we saw major spending in the economy, it was more from borrowing against rising asset prices than from actual borrowing for the sake of borrowing. Most consumers may be too smart to borrow $3,000 to take a vacation, but they'll spend it if they can “earn” $100,000 on rising home values.

Governments may have no other choice. Although the world can handle a 5% or even 10% smaller economy, it can’t handle 50-75% smaller asset prices, not with trillions of dollars of debt backed by those assets. It’s possible the government is selling stimulus and bailouts to benefit the economy and individuals when in fact these measures are targeted squarely at re-inflating the asset bubble in the hope that participants will have learned their lesson this time around and therefore won’t take things too far the next time. A bigger question is this: can the government create economic growth and buy us out of a recession without most of the action hitting asset markets instead of real markets?

Can we get another speculative asset boom, only this time without the economy going along for the ride? Or can the economy boom again from the knock-on effect of rising asset prices? If asset prices rise, and the economy doesn’t join in the party, we’re just setting ourselves up for a boom built on even thinner fundamentals. We'd be like Wile E. Coyote when he runs off the cliff and realizes there's nothing but air underneath.

It’s a little early to be strategizing our gradual exit plan from overheated markets, since we only recently began planning our entry into stone-cold markets. But the way things have been going lately, we may be changing our plans sooner rather than later.

One reason for fear in the not-so-distant future is the government is surely aware that asset price “stabilization” is fast becoming asset price inflation. The Fed would probably love to start increasing interest rates from essentially zero to more realistic levels to nip the next bubble from forming, especially because commodities prices are taking off again. However, the central bank is probably scared such a move is going to mow down the so-called ‘green shoots’. 

If this upward trajectory keeps up, there will be no choice. Stock investors may not mind the higher rates initially because they will assume it means the economy is recovering. The problem is the economy probably won’t be able to handle higher rates. It could cause a second wave of problems.