Wednesday, March 17, 2010

The Fed and the Stock Market: Weak Economy Continues to Propel Stock Price Inflation

Every pro and many amateurs are aware of the correlation with the Fed funds rate and low volatility, and between that of low volatility and rising stock prices. Thus it is no surprise that the Fed's unsurprising reiteration of its prior policy track was followed by yet another late afternoon increase in stock prices. Gold was up all day, up a bit more later in the day, and is up a bit more overnight. The joys of cheap money!

Meanwhile, probably the best portent for job growth is yesterday's downbeat job projections out of the White House. They won't be caught on the overoptimistic side of predicting the economy if they can help it ever again.

Unfortunately, the health care "reform" fiasco is looking the end of Terminator. You can't kill it, but it keeps getting uglier. This plus the recent Nancy Pelosi pledge that Federalization of health care is just the start is definitely not helping the mood amongst small businessmen. One wonders if by some chance the majority party can't beg/borrow/steal just a few more votes from its own party members in the House to pass this bill the stock market will give a big cheer, just as it did when Bill Clinton lost control of the house in the 1994 elections. And one wonders if passing the bill would give a sense of finality (finally) and allow business to focus on business rather than the irritant of health insurance, which would also be good for the public mood. On the other hand, this bill imposes tax increases before the spending kicks in. So that might make it bad for the public mood and anti-Keynesian. So I'm ignoring this bill in discussing investment options.

Let us step back and with apologies to Barry Ritholtz and his blog, look at the big picture.

Money printing and various forms of credit extension into such things as the black hole of Fannie/Freddie and the new black hole of Ginnie Mae (FHA), plus population growth plus cyclical factors have "strengthened" the real economy-- whatever that really means. There will be growth in the spring. But much is rotten in the state of this country. The Federal government is not close to a true AAA credit any more. Multiple states are fiscally mismanaged. Many financial institutions that remain too big to fail would be insolvent today on a mark to market basis. Thus your money in the bank is not there. Gold is roughly trading at an historical average price relative to the (long-suffering) S&P 500 index.

Doubling back to the Fed-- if the economy remains so weak that cash must be trash and even the alleged security of 10-year Federal debt only pays $3.65 per $100, how are stock buyers so sure that the future is so bright as to pay such a large premium over tangible book value as they are today and to accept such a historically low rate of return on BBB-rated corporate debt?

Yet even more than the bond market to my eyes, the stock market has pockets of relative attraction. Discount retailers have surging stock prices but TJX and DLTR remain at quite ordinary P/E's. Everest Re is a totally boring reinsurer that trades far under tangible book value yet has a top-notch quality rating by S&P's stock advisory service. Chubb, a cream of the crop sort of insurer, trades marginally above tangible book, has a 3% dividend yield, has a very high free cash flow yield (as do the other names mentioned above), and could be a mega-company's takeover meal to boot. McDonald's is operationally outperforming its peers and has a stock chart that has already broken to new alltime highs in its 50 and 200 day moving averages. It yields almost that of the 10 year Treasury but in 10 years, if dividends rise 7% per year, it will be paying investors twice what the T-bond will pay out in year 10. What will the "stub" of the MCD equity be worth then? I dunno, but as a conservative income and inflation hedge, plus the strong chart pattern, I find it a worthwhile part of a diversified portfolio.

Every name mentioned above is "defensive". With ECRI sounding the tocsins about more frequent recessions ahead, but with many stocks pricing in a strong and/or prolonged economic expansion, yours truly finds this a stock market that only a pro should short but that most people should be leery of. As it should be of most of modern, debt-infested finance.

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