U.S. stocks rallied shortly after the open and held the gains to the close.  A rebound in commodity prices, helped by a lower dollar, overshadowed concerns that higher interest rates (India’s monetary tightening) and rising public-sector debt will derail the global recovery.

The rolling concern over European sovereign debt issues that was eminent in pre-market trading didn’t last long.  To be specific, the worries lasted exactly 30 minutes into the regular trading session as that’s how long it took for stocks to rebound into positive territory – and for the dollar to give up its early-session rally and turn lower.  As we’ve been talking about, the only thing the greenback has going for it right now is fear. 

Consumer discretionary, basic material and tech shares led the way.  Energy and utility stocks were the only losers out of the major 10 sectors.  The price of crude reversed an earlier decline, but the shares didn’t follow suit. 

It is interesting to watch consumer discretionary shares rally with oil over $80, pump prices inching closer to $3 (national avg. at $2.82), 10% unemployment and high household debt levels.  The index that tracks these shares has doubled over the past year and is just 18% below the all-time high hit in 2007 (for perspective the broad market remains 25% below its peak).    Something doesn’t exactly seem rational with this picture, if you ask me.  Either job growth is going to come back with a vengeance and justify this move, or…well you know where I’m going with this.

Market Activity for March 22, 2010

The Cost of Entitlements

So the health-care reform legislation will become law.  While it must still work its way through the reconciliation process (the House later amended the Senate’s bill that they passed Sunday night and those changes will be sent to the Senate, which will require just 51 votes for passage, after going to the White House to be signed), it seems a done deal.  Of course, there are several states, currently 11, lining up to sue as the huge expansion of Medicaid will crush their budgets – fiscal situations that are already ugly.  Further, one doesn’t even know if this whole thing passes constitutional muster. 

But assuming this is the new American model, which isn’t new at all as it merely moves us closer to the old European model, adding another entitlement onto the already budget-busting Social Security and Medicare programs will surely boost federal spending as a percentage of GDP to 25-30%; a level of 20-22% has proven to be the sweet spot that has allowed the private sector to flourish over the past 30 years.  If we are going to substantially increase government spending, then by definition we’ll need to sap more capital via taxation from the private sector.  Hence, one cannot count on our economy growing at its postwar average real annual rate of 3.4% based upon this dramatic government overreach. 

This has consequences for the stock market because if the economy grows at reduced rates then longer-term corporate profit growth will also be weaker, which means job growth and final consumer demand will be lackluster.  What the market will have to deal with is determining the appropriate multiple (P/E) at which stocks trade, in broad terms.  

The long-term average P/E on the market (S&P 500) is 15-16 times.  In a lower growth environment that multiple will also need to be lower – investors may no longer be willing to pay $15-16 for each dollar of earnings if profit growth is going to be lower or interest rates rise as a result of our growing budget deficits.  (I’ll note that interest rates are normally a function of Fed policy and inflation expectations, not the degree of the budget deficit.  However, current deficits have motored into unchartered postwar-era waters and thus one cannot be sure that budget shortfalls of this size won’t have an effect on interest rates over time – at these deficit levels I believe they must move higher, but economic headwinds may delay that move.)

We discuss the topic of market valuation and profit growth in a video soon to be released on our website.  I’ll let you know as we get closer to releasing that discussion. 

I’ll end this topic by stating:  While I’ve been negative on short-term economic growth prospects as both policy and the debt-driven recession will have lingering effects, I’ve held to the belief that we’ll reform our entitlement programs and engage in the correct fiscal and monetary policies that allow for the economy to flourish over the longer-term, once again.  However, adding on another colossal entitlement program certainly doesn’t help the long-term outlook.  Then again, this legislation sets up for a political sweep in November and that means gridlock, which the market almost always favors.  Problem this time is we have some serious structural issues that must be remedied, and gridlock fails to provide ameliorative action.

Chicago Fed National Activity Survey

We didn’t have a major economic release yesterday; we’ll get existing home sales and the Richmond manufacturing survey this morning.  Yesterday we did get a lesser-watched economic activity gauge from the Federal Reserve Bank of Chicago – this shouldn’t be confused with the Chicago Purchasing Managers Index, which strictly measures factory activity in the region.

The Chicago Fed’s economic activity reading is a bit difficult to explain, basically what it comes down to matching the index’s three-month average readings during certain stages of the business cycle.  The index, which draws on 85 economic indicators, fell to -0.64 for February from 0.04 in January as the production-related indicators made a negative contribution for the first time in eight months.  The three-month average on the overall index dropped to -0.39 from -0.13 in the previous month.  In all, 34 of the 85 individual indicators made a positive contribution (that’s down from 50 in January), while 51 were negative (up from 35 in the previous month).

So here are the parameters (the bold highlight the parameters that currently apply) :

 * A three-month average reading of less than -0.70 following a period of economic expansion signals there is an 

   increasing likelihood that recession has begun

 * Greater than 0.20 following a period of economic contraction signals there is a significant likelihood that a

   recession has ended (we have not yet seen a reading on the three-month average that’s above -0.13)

 * Greater than 0.70 more than two years into an expansion signals there is an increasing likelihood that a period

  of sustained accelerating inflation has begun 

Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900