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Farr: Is This Rally or This Economic Recovery Real?

A tour bus passes the Wall Street bull in the financial district January 22, 2007 in New York City.
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A tour bus passes the Wall Street bull in the financial district January 22, 2007 in New York City.

Do you believe the economic recovery is real and sustainable?

Those are really two questions, and we suppose someone will want to parse our definition of “real.” The S&P 500is up 10% over the past twelve months and 24.7% since September 30, 2011 . The recent rally is filling Wall Street with feel-good breezes that are lifting all moods. The higher it goes, the higher portfolio values go, and folks begin to feel whole and maybe even a little bit rich again.

The seductive siren song is wafting from Federal Reserve speakers and furtherance of Greek life-support has driven share prices higher. Investors are increasingly more sanguine despite historically high profit margins (which are mean reverting) and still-tepid demand growth. According to a generally positive report from the Wells Fargo Economics Group, “The weak underbelly of the recovery continues to be sluggish income growth and the massive destruction of household wealth from lower home prices and the 2008 financial crisis. Household wealth remains $8.4 trillion lower, with financial assets $3 trillion lower, and the value of real estate holdings $6.7 trillion below their respective pre-crisis levels.”

In our view, the strength of the economic recovery will likely be capped due to a few very important factors. First, baby boomers are ill-prepared for retirementfollowing trillions in lost home equity, years of irresponsible spending (on credit), and a decade or more of very weak inflation-adjusted income growth. The need to increase savings rates will likely be a drag on economic growth for years into the future.

Second, the unwinding of very aggressive monetary policy is likely to result in higher interest rates at some point. As we all know, low interest rates have been the life blood of this recovery, and higher rates could have a dramatic effect on economic growth and asset prices.

Third, we have yet to know the ultimate effects of trillions in central bank monetary easing across the world. Our own analysis shows a very clear link between the Fed’s monetary easing and the prices of commodities, especially oil. Will central banks across the world be able to reverse course in time to avoid a surge in inflation? Has Fed policy led to some irrational exuberance in asset prices such as stocks?

And finally and perhaps most importantly, investors are beginning to hear the ticking of the election clock, dwindling toward November. Regardless of winners and losers, Congress will be forced to address our structural deficits some time in the near future. If the Republicans gain control, we expect federal government spending will be scaled back. If the Democrats gain control, we would expect a greater focus on tax revenue. Either approach will likely be a drag on economic growth in the near term.

Europe and China are on the down-slope of economic cycles, and the US, once again, seems to believe in “decoupling.” We seem to feel that the rest of the world may experience trouble, but it really won’t bother us on our happy island. These feelings have proved inaccurate in the not distant past. The interwovenness of the global economic fabric is intense.

With these issues in mind, we continue to believe that a climb from profound labyrinth-like depths will take time and at points become quite difficult. We find ourselves neither despairing nor rejoicing, but rather we feel resigned to the advent of a more sober time which will not be without profitable areas. Our portfolios are positioned to tap growth as it occurs around the world, but should also benefit from balance sheet strength if the tides begin to turn.

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.