As 2009 comes to an end, we’re left with a still-weak, but improving, economy, and a bull market in stocks, corporate bonds, and commodities. Will this continue in 2010? Or was it all just a mirage, a head fake, a sucker’s rally that is doomed to fail in the months ahead?
To answer these questions, I looked at the weight of the evidence in four areas: fundamentals, the Federal Reserve’s monetary policy, technical indicators, and investor sentiment. (Read Viewpoints: Four-Legged Bull for more insight on these topics.) I also looked at the “tail risks” and what the opportunities might be into 2011, 2012, and beyond.
What I found? More potential opportunity than risk over the intermediate term. Here’s why:
While some like to focus on lagging indicators such as unemployment, I prefer to look at leading indicators such as the cost of money, the shape of the yield curve, the direction of credit spreads, the inventory cycle, and monetary and fiscal policy. All of these indicators have continued to point to further improvement for the economy in 2010. In fact, we may well have an economy that surprises the economic consensus with its strength.
That’s not to say that there aren’t risks. A big concern is that the consumer is in no condition to return as the driver of our economy. After all, consumers no longer have the income or home equity to spend, and the banks aren’t lending. While that’s a valid concern, I think it’s one for 2011, not 2010. Why? Because the inventory cycle should have enough momentum to carry the economy for the next four quarters or so, perhaps to a growth rate as high as 5% or more.
Monetary policy is expected to remain highly stimulative in 2010 even if the economy recovers. The Fed has a dual mandate of full employment and price stability, and it’s clear that its main concern right now is unemployment and not inflation.
According to the Taylor Rule (one of the mathematical formulas used by the Fed to help determine at what level it should set its target interest rate), the federal funds rate should not be where it is now—0.13%—but at -5.83%, given a jobless rate of 10%. A negative rate isn’t possible, of course, which is why the Fed has injected a trillion dollars of reserves into the banking system. This is called quantitative easing (or printing money) and is designed to make up for the fact that the Fed’s “conventional” ammunition isn’t working (i.e., short-term interest rates).
So, the question to be asking in terms of monetary policy: What unemployment rate will lead the Fed to raise the funds rate? Using the San Francisco Federal Reserve version of the Taylor Rule, I used several different employment rates to calculate a Fed funds target rate: 9% unemployment got a -3.9% Fed fund rate, 8% got a -1.9% rate, 7% got a 0% rate. By this calculation, it would take a decline in the jobless rate from 10% to 6% to warrant any hike in interest rates. I think that’s a long ways off, which is why I think that it’s unlikely that the Fed will do any tightening in 2010.
The technicals are still OK. Not great, but not terrible, either. We still see a pattern of higher highs and higher lows in the major stock market indexes (which, after all is the definition of a bull market), but we do have some negative divergences from small caps, market breadth, and financials (i.e., they made a lower high while the S&P 500® Index made a higher high). Not the end of the world, but clearly a sign that the bull market is getting tired.
Sentiment is also still OK. Not great, but also not terrible. Sentiment surveys, such as the American Association of Individual Investors AAII Sentiment Survey, and Investor Company Institute (ICI) mutual fund sales continue to show a sentiment pendulum that has swung from a pessimistic extreme to the middle, but not (yet) all the way to an optimistic extreme.
What does this all mean?
All in all, the weight of the evidence from where I am sitting demonstrates that the economic recovery is progressing and may well turn out stronger than many investors expect, that the Fed will not risk an early exit from its policy, and that technically the bull market in stocks is intact but getting more and more mature. So, I see more opportunities than risk over the intermediate term.
Over the longer term, however, there are a number of questions that loom on the horizon.
For one, when will the Fed exit its unprecedented campaign of low interest rates and quantitative easing? If it doesn’t pull away too soon (which could trigger a deflationary relapse), will it end up pulling away too late or too slowly (triggering an inflationary spiral)? How is it going to remove all the excess reserves that it pumped into the banks? By paying interest on reserves? Will that be enough? Getting this right is like threading the eye of a needle, and that will be difficult given how high the stakes are.
Will Congress continue to run deficits, and what impact will that have on interest rates, the dollar, and the price of gold? In addition to $1.5 trillion of new debt, the Treasury also has to roll over $2 trillion of maturing debt. That’s a lot of debt. Who will buy it? China? The banks? The public? The Fed?
Has the U.S. consumer been so “scared straight” from its borrowing binge of the past decade that we are entering a prolonged period of more saving and less spending? With consumer spending comprising 70% of gross domestic product (GDP), that could have an enormous impact.
Will the combination of potential increased regulation and higher tax rates bring down productivity and dampen the country’s entrepreneurial spirit?
All profound questions, with no answers—at least not yet. For now I am focusing on the cyclical opportunities in 2010. But it’s not too early to start focusing on the longer-term unresolved issues that lie over the horizon.