Corporate earnings reports have been overwhelmingly positive thus far for the third quarter reporting season. We are encouraged. However, as our attached quarterly newsletter points out, we have become somewhat concerned that the economic recovery has become highly dependent on a series of government stimulus initiatives.
The removal of any or all of these initiatives, which have cost the Treasury and future generations of Americans dearly, could have negative implications for a stock market that has risen over 60% since the March lows.
The program at least risk, in our opinion, is the $8,000 tax credit for first-time home buyers.
Congress is expected to not only extend this program through mid-2010, but they are also mulling its expansion to include all home buyers (not just first-timers).
While this program and others like it will undoubtedly continue to lend support to a consumer struggling with job losses, stagnant incomes and housing price declines, we fear there must come a day of reckoning as the budget deficits roars through the stratosphere.
Until then, however, the bulls take us higher.
On September 30, 1929, the Dow Jones Industrial Average traded at 381. Two months later, at the end of November, it traded 198. By the end of April, 1930, it had regained considerable ground, almost 50%, to trade at 294, and from there things got ugly yet again. The 1929 stock market crash was just the beginning. Following the April, 1930 recovery, the DJIA followed a one-step-forward, two-steps-back pattern until it bottomed in July 1932 at 41. The years 1932-1937 were very good to investors, and then share prices moved lower until the beginning of World War II. The Federal Reserve misjudged the 1932-37 recovery and removed stimulus before sustainable end demand materialized.
Following the initial years of the Great Depression, the country went through the feel-better stimulus period similar to the one which we are enjoying now. However, the Federal Reserve’s Open Market Committee (FOMC) removed the training wheels before the toddler economy was secure, and the economic contraction was renewed. Chairman Bernanke is a great student of the 1929 Market Crash and Great Depression. He knows the downside of stepping back too early, and Central Bankers the world over know the inflationary ramifications of keeping stimulus around too long. There is not a lot of room for error. Stock investors seem to expect that the FOMC will get this timing just right. We certainly hope they do, but we’re worried…and skeptical.
Federal Reserve Vice Chairman Donald Cohn said, in the first week of October, "we must begin to withdraw accommodation well before aggregate spending threatens to press against potential supply, and well before inflation as well as inflation expectations rise above levels consistent with price stability." So, they’re reminding us that they appreciate the precarious balance. My favorite line came from Chairman Bernanke himself last week when he said, "Accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road." Well, that certainly clears things up. Later, Bernanke said that the Fed would look to remove stimulus when, “the time was right.” Wow, again!
Here and Now
This market is a classic example of when and why not to fight the tape. Benjamin Graham said it best 60 years ago, "markets can remain irrational longer than you can stay liquid." Market timing does not work as a long term strategy, so stay invested, but pay close attention to what you own. Solid balance sheets, free cash flow, earnings growth and management matter more now (in a relatively high market) than ever.
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.