April 21, 2011
Dow Jones Average: 12,506
S & P 500 Index: 1,337
The Price of Recovery
For the past two and a half years the U.S. Government has taken unprecedented measures to bolster
asset prices. The thinking was that falling prices for assets such as stocks, bonds, real estate threatened
the economy and had to be reversed at all costs. The first rescue plan was the infamous TARP (troubled
asset relief program), followed by the stimulus package, quantitative easing (printing money to buy
bonds), and expanded tax cuts, then QE2, all accompanied by a zero interest rate policy. While the
economy is starting to show signs of life, there are side effects to the administration of so much
financial medicine.
Government leaders concluded in late 2008-early 2009 that the cost of rescuing the economy
would be less than the cost of letting severe recession run its course. In a severe, prolonged
recession total economic output declines as fewer people have jobs, personal and corporate
bankruptcies multiply, and government deficits soar as tax revenues fall while requests for government
assistance increase. Faced with this prospect the government decided that penalizing savers and
risking inflation was an acceptable price to pay.
The most visible beneficiaries of the government's financial rescue policy have been employees,
stockholders, and particularly the bondholders of the weakest companies. In late 2008 hundreds of companies were
teetering on the bankruptcy precipice. Most avoided default, with a few notable exceptions such as GM, Chrysler, and
Lehman Brothers. After being decimated in 2008-2009 the shares of many major banking institutions have partially
recovered. The bonds issued by distressed companies have come back to full value, a gain of one hundred percent from
two years ago. And the employees at the largest banks are once again being paid large bonuses.
Industrial companies such as Brunswick, the country’s largest manufacturer of recreational boats,
have experienced a similar revival. In early 2009 consumer demand for high priced, discretionary
products such as boats completely evaporated. Brunswick stock fell from the forties to one dollar per
share, as it appeared to face bankruptcy. The economic recovery came in the nick in time for Brunswick.
The stock price has since rebounded to twenty-three dollars per share and the employees still have jobs
making boats. There is little doubt that people, who own stock and bonds in public companies, are better
off now than they were two years ago. Government policy was designed to boost asset prices and it has
been largely successful.
The economic policy of the government has produced side effects that are negative for other
sectors of the population. The zero interest rate policy has hurt those who own the safest instruments
such as CD’s or treasury bills. Government efforts to boost asset prices and preserve jobs at distressed
companies provide little immediate benefit to a retiree dependent on interest from CD’s. In addition,
the Fed’s low interest rate and money printing policy has driven down the value of the U.S. Dollar. A
lower U.S. Dollar typically translates into high prices for commodities such as fuel and food. Higher
prices for basic necessities have a disproportionately negative impact on lower income people.
When the human body is afflicted by a virulent infection it is sometimes forced to diffuse the
bacterial or viral load by spreading it more widely to the skin or bloodstream. In an attempt to save
weakened corporations, particularly banks and insurance companies, the government mimicked the
human body, shifting the virus that was killing the financial sector to the public treasury and the
populace at large. While the financial firms are once again rolling in money, the public doesn’t feel
so well, as people face limited job prospects, diminished equity in their homes, no interest on savings,
and higher bills for food, fuel, and medical care. It will take all the persuasive powers of the current
administration to convince people that things could be worse, that the economy could have died
from its illness in 2008-2009, creating even greater economic hardship for the average American.
Current Strategy
The stock prices of most companies in the technology, industrial, and commodity sectors have
moved relentlessly higher since the market lows of early 2009. There have been a few notable, large
capitalization laggards in the medical and consumer areas, but in general most stocks have joined
the rally. It has been the largest, fastest recovery in stock prices in seventy-five years. The rise in
stock prices has been driven by a robust recovery in corporate profits. Companies have become more
efficient, producing more goods and services with fewer employees. In our opinion the positive profit
momentum is largely reflected in current stock prices, leaving few good deals on the table.
Both equity and bond markets could be at risk, because they have been so heavily influenced by
the Federal Reserve Board’s zero interest rate policy and its quantitative easing strategy. While there
is always an element of manipulation and artifice in any economic system that is subject to central
government planning, there is an air of artificiality in the current economy that goes beyond the norm.
The Fed’s latest asset support program, QE2, is supposed to end this June. If the Fed stops printing
and pumping money into the system asset prices may start to fall. On the other hand, if the Fed renews
its quantitative easing strategy, initiating a QE3 program, the U.S. Dollar will most likely continue
its decline and commodity prices their ascent. Americans who are already angry about four dollar
per gallon gasoline won’t be happy with gas at five per gallon. The Fed is now boxed in. They can
continue to artificially support asset prices or they can try to contain inflationary pressures, but they
can’t have it both ways. With asset prices (both stocks and bonds) at high levels, we think it is wise
to let the market respond to the Fed’s policy predicament, before making sizable new purchases.
