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Farr: I Should Be Warning You

The market has surged relentlessly higher (up over 22%) since late August, with only a minor 3-4% pullback during November.

Our contention continues to be that this has been a government-induced rally, and that the economy still cannot grow at an acceptable pace on a self-sustaining basis. If we look back to the action since the rally started (in late August), investors had begun to anticipate additional Fed action in the form of QE2 at that time. Additional Fed action was justified by the fact that economic indicators had started deteriorating again. Most notably, non-farm payrolls declined by 241,000 in the months of June and July after posting strong increases in the prior months. In addition, existing home sales fell off a cliff in the month of July as only 3.84 million units (annualized) were sold compared to figures above 5 million for the previous several months. This poor data provided the justification for further Fed action, and investors knew it.

Once the highly-anticipated announcement came about QE2 in early November, traders used the opportunity to "sell the news" following a roughly 15% increase in stocks over the previous two months. Stocks then drifted lower for most of November as traders began looking for the next catalyst to move the markets higher. And, as expected, they got it. By mid-December the House and Senate had passed a tax bill that not only extended the Bush-era tax cuts across all income levels, but also added a 2% cut in the payroll tax, a lower-than-expected estate tax rate, and tax incentives for businesses that buy new equipment. The anticipation of the tax cut extensions, in addition to the added surprises, kicked the market into high gear once again. The S&P 500 has risen nearly 9% since November 30.

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CNBC.com

The Fed and lawmakers on Capitol Hill have been on a deliberate path toward inflating asset prices, and in this endeavor they have enjoyed much success. The stock market is sharply higher, and housing prices have stabilized at much higher levels than they would have been absent any intervention. The government believes that higher stock prices and stabilizing home prices will lead to improved consumer confidence and spending. And greater confidence and spending will lead to more jobs, better corporate profits, and still higher stock prices. This is the virtuous cycle the government is trying to create through its aggressive actions.

But the government’s strategy of lowering borrowing and tax rates and boosting assets prices (housing, stocks) in an effort to drive economic activity is a risky one. Excessive debt and speculation is what caused the financial crisis, and more of the same seems unlikely to usher us into a new era of prosperity. We continue to believe that the consumer must reduce his debt load and save more, the government must reign in spending and address the long-term structural deficits, and the entire country must learn to live within its means. It seems obvious that our current course is unsustainable and that difficult choices lie ahead. For now, however, investors continue to loudly applaud the government’s aggressive actions.

Taking a snapshot of our current situation, recent economic data have been supportive of the thesis that the economy is recovering (albeit slowly). Employment data has improved, manufacturing is humming, confidence is up (off very low levels), holiday retail sales looked good, auto sales are up, and the economy is growing. Judging by these indicators, the federal government has succeeded in priming the economy's pump. For my part, I am not so sure. Unfortunately, along with the improvement in stock prices we have also seen a sharp rise in long-term interest rates and a spike in commodity prices like oil. How will the rise in mortgage rates affect a housing market that already appears to be headed for a double dip? How will $3.50-$4.00/gallon gasoline affect consumer confidence? Will lower home prices and higher commodity costs end the recent strength in consumer spending? Time will tell. However, it should be recognized that the government's actions do have negative side effects. At some point the government may run out of ammo.

So what else does the government have up its sleeve?

Under normal circumstances, we would certainly expect a pullback in the market following an almost uninterrupted 22% increase since late August. But if we judge by last year's market action, continued gains in stock prices are most likely to result from a deterioration in economic indicators followed by the promise of additional government stimulus. We are obviously very hopeful that this won't happen. But it begs the question, where will the fuel for the next leg up come from?

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.