Saturday, August 2, 2014

Don't Cry for Me, Argentina

Everybody had a good to reason to explain why the stock market caved in last week.  Our comments last month discussed how investors had ignored a series of threats while bidding prices up to record levels.  Last week those threats caught up.

Potential policy changes at the Federal Reserve are the greatest concern.  The decision earlier in the year to eliminate "quantitative easing" created a sell-off in April.  That proved to be a shot across the bow.  At last week's meeting, though, the bond buying program dropped to $25 billion per month -- down from the $85 billion pace Ben Bernanke originally set up.  That grabbed people's attention.  By October it will be zero.  Whether it's myth or reality, most investors believe (deep down) that stock prices levitated 30% in 2013 because of quantitative easing's stimulative powers.  Now they're afraid valuations will reverse course once the money is withdrawn.  Corporate earnings have expanded 15% during the two years that QE-4 has been in place.  So even if valuations return to where they began the pullback shouldn't be a full retreat.  Still, in this day and age most money managers are graded on how well they do every quarter, if not every month.  There are a lot of itchy trigger fingers out there.

Argentina's bond default got a lot of people thinking about the potential for unexpected side effects.  That particular situation is small potatoes.  Argentina had the funding in place to complete a refinancing -- one that included a substantial write down.  An American hedge fund insisted on full repayment and hung up the deal, causing a technical default.  The larger question investors began to ask is, "What about Russia?"  That's a big time country with complicated and vast financial ties.  Might the bank sanctions now going into effect cause some missed payments?  And what would that cause?  And while we're at it, if the Federal Reserve tightens how's that going affect the Third World?  The U.S. Dollar already is undervalued.  If it just returned to normal currency values could plummet in some weaker economies, like Brazil.  If interest rates go up in America, that would make it even more of a pressure cooker.

Those are genuine concerns.

Lucky for the people who live in America, none of this presents a major problem.  Indirectly it sure could, if you're invested in a Philippines rubber plantation or something.  But the U.S. economy is well insulated from those financial dangers.  And quite frankly, the fighting in Syria, Israel, the Ukraine, and Africa doesn't have anything to do with us, either.

Some economists say the U.S. economy is gaining momentum.  Others say that may be true but it doesn't matter because so many idle resources still exist.  The official unemployment rate is 6.2%.  But if the same number of people were in the work force today as there were in 2007, before the crash, the rate would be 10.2%.  Clearly, some people have left the work force and are never coming through that door again.  Still, if there was money to be made a lot of those non-workers would be back in a flash.  On top of that, corporations have amassed unprecedented cash reserves.  Capital spending has been low and the outlook remains mediocre.  If a pick up ever does materialize a handful of companies might have to borrow to fund their expansion efforts.  On balance, though, the spending would be financed internally, alleviating any pressure on interest rates.

The economy could be slowing down a little, in fact.  Consumer spending is going nowhere.  Housing is nothing special.  Government spending is up in some areas (health care) but down in others (military).  Back to school spending is off to a ho-hum start.  Things could change.  Right now, though, it looks like 2%-3% real GDP growth is here to stay.

The stock market is its own animal.  The elimination of QE-4 could exert a direct impact on market liquidity.  Then the question becomes, "Where do you put the cash instead?"  It's not going into the economy.  Dodd-Frank continues to prevent small businesses from starting up and expanding.  The Affordable Care Act adds further costs and regulations.  The regulatory apparatus in general weighs on businesses of all stripes and sizes.  Corporate buybacks will continue.  Money created by the European Central Bank will gravitate to America.  And quite frankly, the U.S. money supply grew at 7% a year before QE-4 and it grew at 7% a year while it was in place.  The extra money was siphoned away and deposited as "excess reserves" at the Federal Reserve.  The whole thing has been a smoke and mirrors job.  Market liquidity is unlikely to change much, if it all.

We think the market will be fine.  We think America will be fine.  Over the long haul corporate tax rates are certain to decline, increasing earnings.  Economic activity should accelerate once the more onerous regulations are modified to encourage more realistic and productive behavior.  That will boost sales growth, leveraging profit margins.  The rest of the world should grow.  U.S. companies will participate in that, too.  American oil and gas production is on the rise.  Less money for OPEC.  Lower costs for us.  And less need to defend far flung oil reserves.

Don't worry about Argentina.  Don't worry about the stock market.  Remain invested in a diversified portfolio of high potential Special Situations.

Walter Ramsley
Executive Editor

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