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Four reasons the market won't crash

We are concerned that the Federal Reserve is perpetuating an asset boom/bust cycle that began when Alan Greenspan was Fed chair. However, we don't think that the market is on the precipice of another Fed-induced asset-price collapse similar to the technology/Internet stock crash and the housing collapse. Here's why:

1) Asset prices, though inflated, are not really in bubble territory. Housing affordability has improved dramatically since the throes of the Great Recession due to the drop in housing prices and plummeting mortgage rates. The home-ownership rate is back to where it probably should be, and new household formation is finally picking up after years in which people chose to double up or live with their parents rather than buying or renting their own place.


As for stock prices, I remain troubled by near record-high corporate profit margins, which create the illusion of a market that is cheaper than it really is. As margins revert closer to the long-term average, stock prices may indeed need to come down more to reflect the slowdown in earnings growth. However, the S&P 500 has now retreated about 12 percent from its all-time high, with certain sectors like energy and materials getting hit harder. More importantly, the S&P 500 has now retraced about 17 percent of its rise from the March 2009 low to the peak early this year. This has not been a minor pullback.

Furthermore, alternative measures of stock valuation suggest that stocks could actually be cheap right now. The most compelling of these arguments is the fact that the yield on the S&P 500 is now in line with the yield on the 10-year Treasury note. During the financial crisis, the S&P 500 yield did surpass the 10-year note for a while, but the situation did not last for long.

2) The economy, though growing at only a 2 percent to 2.5 percent pace, does not appear headed for recession. I don't think that economic weakness outside the U.S. will pull us into recession territory. Yes, China is slowing with future growth rates coming in perhaps meaningfully slower than the government's target of 7 percent. However, U.S. trade with China is very small relative to GDP, and Europe appears to be pulling itself up by its bootstraps after following the Fed's playbook of monetary easing.


And, it's worth noting that consumer spending makes up almost 70 percent of GDP. So, while weak exports, flat government spending and subdued corporate investment certainly impact the pace of economic growth, the economy generally goes as the consumer goes.

3) The banking system in the U.S. has been recapitalized and remains heavily regulated compared to the years prior to the financial crisis. Banks are simply no longer allowed to rapidly grow their balance sheets by making risky bets with borrowed money — especially deposits. In addition, credit losses are running at generational lows, and U.S. banks have a ton of liquidity parked at the Fed and elsewhere, which can serve to both reduce the risk of a liquidity crisis and allow banks to take advantage of opportunities as they arise. In fact, the recapitalization of the banking system, in our view, is perhaps the single-best competitive advantage the U.S. economy has right now over some of the other developed markets (read: Europe).


4) The consumer, while still heavily indebted, has both reduced his debt and has refinanced other debt using lower fixed rates. This has led to a situation whereby the household debt-service ratio, tracked by the Fed, has fallen dramatically since the financial crisis. Don't get me wrong, I remain very uncomfortable with the Fed's encouragement of more debt in response to the problem of too much debt. There is also some evidence of credit bubbles in specific consumer-debt areas like student loans and auto loans. However, a good chunk of the consumer debt that existed prior to the financial crisis has either been charged off or effectively assumed by the federal government through increases in transfer payments. The reduction in the consumer's debt-service burden frees up money that can be spent elsewhere.

In addition to lower interest rates, the consumer is now and should continue to benefit from a plunge in energy/gas prices. The savings from lower gas prices don't seem to be triggering a noticeable increase in consumer spending just yet but they are giving the consumer the ability to pay down some debt and increase retirement savings. I have long believed that the relative lack of retirement savings is a huge intermediate-term problem for the U.S. economy. To the extent that consumers are able to clean up their balance sheets and save more through lower energy expenditures (and lower debt-service costs), this would be hugely beneficial to the long-term health of the consumer-centric economy.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.