Is The US Rally Sustainable?

By: John Browne | Fri, Feb 4, 2011
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This week, the financial media celebrated as the Dow closed above the 12,000 mark for the first time since June 19th, 2008. For many, this milestone is another sign that the financial nightmare of the past three years will soon fade in the rearview mirror.

The euphoria over share prices has been bolstered by recently released data which catalogs rising consumer confidence and spending, and corporate earnings reports that have beaten estimates. In the meantime, the bond markets have remained resilient, despite evidence of massive public debt problems that bubble beneath the surface. But is this optimism based upon enough sound evidence to support long-term investment?

The recovery in the Dow, to within some 15 percent of its all-time high, should not be much of a surprise to our readers at Euro Pacific, nor should it count as a mark of confidence to anyone. We have always held that ultra-low interest rates distort the investment landscape by forcing yield-starved investors from bonds into equities. Driven by this massive government subsidy, along with a high real rate of inflation, the stock market cannot help but rally. Indeed, the only surprise is that our current rally took so long to develop.

The rally even appears to be immune to the uncertainties created by the unrest in Egypt, which is arguably the largest global political crisis we have seen since the invasion of Iraq in 2003. The big question is: can this rally be trusted for the longer-term? Three factors highlight the risks.

First, much has been made of the fact that consumer spending rose by 7.1 percent over the past quarter. But, over the same time period, personal incomes rose by only 1.7 percent. So, exactly how were consumers able to spend 5.4 percent more than they earned? The sad truth is that the vast bulk, or 76 percent, of the recent increase in consumer spending was financed by a reduction in savings and investments.

During a prolonged period of recessionary belt-tightening, as the pressure to replenish consumer items and splurge on non-necessities builds, consumers will eventually reach a point of frustration, and their willpower will fail. Steep discounts offered by aggressive retailers become too tempting. This is all understandable; but, to get to this point, wise economists like to see an extended period in which savings accumulate significantly. The United States never experienced such a period. The modest increases in savings in '08 and '09 are not enough to finance current levels of spending for very long.

How much longer can consumers be expected to liquidate their savings and investments, particularly once inflation leads to an increase in interest rates and more reasonable returns?

Second, US corporations have used the recent recession to increase their efficiency significantly. Workforces have been scaled back and worker productivity has risen. As a result, corporate profitability has increased, and the stock market has responded favorably. However, the heightened regulatory environment in the US, with unknowable healthcare burdens for employers at the forefront, continues to discourage hiring.

Indeed, many of the jobs lost in the recession will likely never return under the current regulatory regime. Under such conditions, it is hard to see genuine long-term consumer demand recovering to reach anything like pre-recession levels.

In the meantime, government spending is making up the shortfall. But with political pressures mounting to arrest spending growth, if not attempt actual cuts, how much longer can the government act as a surrogate for the American consumer?

Third, when interest rates rise, bank savings and relatively low-risk investments will become more competitive. At that point, assets such as Treasury Inflation Protected Securities (TIPS) may draw funds away from US equities. And, in a rising interest rate environment, with fear of inflation a primary concern, investors will increasingly eschew US stocks in favor of hard currency-based foreign equities and precious metals.

In short, the impressive recovery experienced recently by the US stock market is unlikely to be sustained through natural means. When the markets do ultimately turn south, the Fed will surely arrive on the scene with more liquidity. When that happens, the very currency upon which these investments are based will erode from under them.

 


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John Browne

Author: John Browne

John Browne, Senior Market Strategist
Euro Pacific Capital, Inc.

John Browne

John Browne is the Senior Economic Consultant for Euro Pacific Capital, Inc. Mr. Brown is a distinguished former member of Britain's Parliament who served on the Treasury Select Committee, as Chairman of the Conservative Small Business Committee, and as a close associate of then-Prime Minister Margaret Thatcher. Among his many notable assignments, John served as a principal advisor to Mrs. Thatcher's government on issues related to the Soviet Union, and was the first to convince Thatcher of the growing stature of then Agriculture Minister Mikhail Gorbachev. As a partial result of Brown's advocacy, Thatcher famously pronounced that Gorbachev was a man the West "could do business with." A graduate of the Royal Military Academy Sandhurst, Britain's version of West Point and retired British army major, John served as a pilot, parachutist, and communications specialist in the elite Grenadiers of the Royal Guard.

In addition to careers in British politics and the military, John has a significant background, spanning some 37 years, in finance and business. After graduating from the Harvard Business School, John joined the New York firm of Morgan Stanley & Co as an investment banker. He has also worked with such firms as Barclays Bank and Citigroup. During his career he has served on the boards of numerous banks and international corporations, with a special interest in venture capital. He is a frequent guest on CNBC's Kudlow & Co. and the former editor of NewsMax Media's Financial Intelligence Report and Moneynews.com. He holds FINRA series 7 & 63 licenses.

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TRUE MONEY SUPPLY

Source: The Contrarian Take http://blogs.forbes.com/michaelpollaro/
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