Monthly Market Monitor - October 2009

The New Question is Sustainability
In direct contrast to September of 2008, stability in the financial markets has been the important story to continued stock market gains this past month, culminating in one of the best quarters in decades. Signaling that worries over a global financial system failure are indeed over, several government support programs to backstop the system are being withdrawn. More and more economists have pronounced the recession has ended. This has helped push global stock markets to within striking distance of their levels just prior to the meltdown among the financial institutions a year ago. Some have even suggested the markets strength is forecasting a much stronger economic recovery (V shaped) than the consensus a month ago. Manufacturing in August grew for the first time in a year. Bidding wars have broken out in some housing markets. Profit forecasts are being raised. But can these positives be sustained? Manufacturing may finally just be getting a boost from retail shelves that were over depleted and would naturally need replenishing. The reopening of some auto assembly plants may last just long enough to rebuild some inventory worked off by the one-time “cash for clunkers” program. Recent housing gains could be significantly inflated by the rush of buyers taking advantage of the government’s $8,000 purchase credit before it expires. Corporate profits are still being driven by cost cuts, not serious sales gains.

As in the past six months the direction of the market appears hinged on the economic recovery. Pessimists see a lot of one-time stimulus effects in the economic numbers and worry they will peter out. Given the 45-50% market gains since the March lows, that could mean a significant correction. Others believe that the most important stimulus, low interest rates, will be with us for some time. To many this is the real reason behind the stock markets continuing resurgence. The longer rates remain low, the more attractive it is for businesses and consumers to finally restart investment and consumption. While recent pick-up in merger activity is a positive sign, the important signal has to come from housing. For the Fed and most economists, getting stability in the housing markets remains the key to any sustainable recovery because it is so tied to consumer confidence. Signs of that stability remain tenuous, suggesting the Fed may try to keep rates low for a while longer and as a side benefit, provide support for the equity markets.

The Next Big Test for the Fed
Even if housing is not completely healthy, some investors have jumped ahead and begun worrying about the dangers of keeping rates too low for too long. To them, a faster-than-expected recovery could actually be a greater problem for the Fed in preventing another down turn. The reasoning: The Fed would be forced to raise rates dramatically to check inflationary worries, thus risking serious damage to business and the consumer before the recovery has fully taken hold. Whether this takes place in the short-term, it does highlight the Fed’s next dilemma --- when and how much to raise interest rates as the economy gets better. Choreographing that move coming out of this recession is especially difficult due to the severity of the drop and the amount of overall stimulus that has been injected to heal the problems. Compounding the difficulty is the impression that the Fed helped create this past boom/bust cycle by not raising rates soon enough coming out of the 2000-2001 downturn. The Fed realizes it is on notice and interest rates will move higher on their own if investors are unhappy with what they see. On the other hand, Fed Chairman Ben Bernanke, an expert on the Great Depression, realizes the damage that was done then by tightening too soon. He, and other Fed members, may want to wait until they have strong evidence that the tentative upturn will not collapse. As evidenced by the announcements coming out of the Fed’s recent meeting, their primary concern for now remains a potential false recovery. Again, the continuing uncertainty in housing was believed to be a major factor in the Fed keeping rates low. Investors seem to agree as longer term interest rates, a major indicator of inflationary expectations, have not risen. However, with more indications that the recovery is proceeding, this argument of when and how much to raise rates will develop as a major factor in what is expected be a much more volatile market. Compared to the past half year, most analysts agree that the easy part for the stock market in this upturn is probably over.

1. Wall Street Journal, 10/1/09

The views are those of Cameron Lavey, Senior Investment Analyst, Research Department/ING Advisors Network, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.

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