The economic adjustment process we discussed in our previous report is somewhat underway. President Obama tried to avoid it, for reasons that aren't clear. (He didn't follow the customary path in his first term, either.) But Congress forced through the sequester. It also restored Social Security taxes. While the federal deficit remains elevated, it's coming down.
The stock market rallied on the move. But new risks have been introduced to the equation. And several systematic threats remain. Confidence in the future exists but it still is shaky. Investors know stock prices are being supported artificially by the Government. And while they would like to think the stimulus will lift the economy sufficiently to make those bets pay off, there's a nagging worry it won't. If the support is withdrawn before the fundamentals catch up a sell-off could result.
A similar situation existed in Ronald Reagan's second term. Speculation was rampant. Every morning the Financial News Network (as CNBC was called in those days) identified another potential takeover target. Mike Milkin and Ivan Boeske and Carl Icahn and a slew of lesser lights tapped Drexel Burnham and the rest of the junk bond market to finance those deals. As soon as a raider said he was, "Very confident of arranging financing" the bidding wars began. Stock brokers looked for the next takeover target, the same way they looked for the next Internet stock with rising click volume in 1999. The rest of the market was strong. If earnings slowed you'd get bought out.
The excitement level peaked in 1987. At the same time the U.S. and world economy began to slow after the explosive gains registered during President Reagan's first term. China hardly existed from an economic standpoint in those days. But the rest of the world began fighting for jobs and market share, using their currencies. Trade deficits rose dramatically in the United States. The Japanese bought Pebble Beach and Rockefeller Center and a lot of Americans began wondering what was next.
On October 15th the U.S. House Ways and Means Committee approved legislation that eliminated tax deductions for interest costs associated with a corporate takeover. Perversely, bond yields went up. The U.S. Dollar went up. And stock prices started down. The market actually dropped a few hundred points before Black Monday (October 29th). The pressure was on. Once it got high enough the system cracked as program trading and portfolio insurance operations kicked in, amplifying the downturn to record proportions.
None of this means the same thing will happen today. But the correlations aren't that far off. And the people in charge seem to have that portfolio insurance mentality, that everything is under control. The easy money policy is there. The Japanese are disrupting the apple cart in international finance. ETFs provide all the protection anyone would need. And computer trading is more prevalent than ever. The Flash Crash took the market down for no reason in 2010. If an actual catalyst emerges, the next swing could be considerably bigger.
The pressure will build over the next 6-12 months as the economy stalls. If interest rates rise at the same time, fueled by Japan's money printing operation (equal to the U.S. in absolute terms), maybe it will create a phenomenal economic boom, just as they say. More likely, unexpected problems will rule the day. The U.S. got part of it right by starting up the adjustment process. But it left the Federal Reserve Board on the loose. And it has set a poor example. The rest of the world now is following its lead.
Our advice is to maintain a conservative investment strategy. Price-to-earnings multiples for the Blue Chips are at 15x, far in excess of those companies' growth rates. Corporate earnings in general are beginning to moderate, moreover. Profit margins are at peak levels. Small growth stocks are valued at 30x earnings, using the Russell 2000 index as a guide. That includes non-cash stock option and acquired intangible expenses. The genuine valuation probably is closer to 25x. That still is a lofty metric, one that typically marks the top of the range. Individual opportunities remain. Worthwhile gains continue to be available. Still, overall exposure should be measured in light of the macroeconomic situation and the lurking potential for another computer fueled trading meltdown.