ICangles Investment Post…

Prospects are excellent for a positive year in the stock market in 2011. Odds are good also for that strength to carry over into 2012, although it’s a bit early to prognosticate on next year. This bull market is still relatively young and should have further to run.  Although I am no fan of the accommodative monetary policy of the Federal Reserve believing it led to the housing bubble and is fueling rises in commodity prices today, I am also quick to admit that in the near term it is a positive for the stock market.  “Don’t Fight the Fed” is a popular saying among investors for good reason. The economy is growing, stock prices are rising and these trends will likely continue for a time.

The Fed’s low interest rate policy and aggressive expansion of the monetary base (see last post “Bubble Trouble“) is an almost irresistible force propelling stock prices higher. The current bull market that began in 2009 is only now entering its third year, and the Federal Reserve is still keeping the throttle down on expansionary monetary policies first implemented to get the economy out of recession. Short term interest rates are near zero and the Fed has followed up its first round of quantitative easing with a second round, whereby hundreds of billions of dollars of U.S. debt in the form of Treasury bonds have been purchased by the Federal Reserve.

The yield curve—the difference between short- and long-term interest rates is also extremely steep. A steep yield curve encourages investing in the economy. For banks it means it’s profitable to lend money out long term. For bank customers with savings accounts and certificates of deposits that are paying next to nothing in the current environment there is similarly a strong incentive for them to put money in longer-term investments, like stocks. Furthermore, rising long term yields adversely impact the value of existing bond investments with their lower yields. As a result investors are encouraged to move money out of bonds and into stocks.

Source Bloomberg

Beyond the Fed, there are also other reasons to be positive on stocks. Despite growth in the economy and the employment environment being relatively weak, it is nonetheless growth. The corporate earnings picture is healthy. The current political situation is also positive in the sense that no major government policies that could disrupt the stock market are likely. The Obama administration is in its third year, when administrations shift their focus from making policy to pursuing re-election. In addition after the mid-term elections the U.S. has a divided government. Also favorable for the stock market is that in December a two-year extension of income tax rates was signed.

Another important positive is that stocks are cheap. The valuation models used by my firm (which compare stock market earnings to risk-free Treasury bond yields) indicate that “fair value” for the S&P 500 is around 1,650, well above the current level of the index. Add it all together and it is a very positive near-term environment for U.S. stocks. Monetary policy is accommodative. The political environment has become more favorable. Stocks are cheap and traditional investment alternatives are not attractive. So, what is the catch? Beyond the simple caveat that there is nothing absolutely certain in life other than death and taxes, the further out in time one goes the more uncertain the picture for stocks becomes. For instance the political environment will change to some degree in 2013 with the start of another presidential term.

Longer term there is a lot to worry about, especially in terms of unintended consequences of today’s accommodative Federal Reserve policy. It’s important to keep in mind that the last time the Fed sought to grow the economy with low interest rates it created both a bull market and a nasty bear market— the S&P 500 stock index nearly doubled in value over almost five years (2003-2007) before the real estate bubble powered by easy money policies popped and the market gave back all of its gains. In that instance Fed policy was clearly a mistake, but it still produced a bull market. In the last market cycle it didn’t pay to fight the Fed, even though the Fed was wrong. Only as Federal Reserve policy became less accommodative did it pay to become negative on stocks.

History never repeats exactly and even if the Fed is again wrong in its very accommodative policies it is likely this cycle will see some consumer inflation in place of asset inflation. There is reason to worry already that a portion of the growth in the economy and stock prices is due to inflation and does not represent real gains for investors. For instance despite the Commerce Department reporting GDP growth of 0.8 percent in the fourth quarter of 2010, that number is almost assuredly overstated. A lot of that gain came from retail spending, with a good chunk of that due to rising energy prices not accounted for by the government. Such a scenario of rising stock prices, amidst inflationary pressures, in the near-term is not without precedence. In 1975 the S&P 500 rose over 30 percent against a backdrop of inflationary monetary policy.

This year should be positive for stocks. But the longer one goes out in time the more reason to worry. Monetary expansion can be a bit like alcohol—healthy in moderation, but in too great of quantities producing an unnatural high followed by a hangover. The lesson here is to be positive on stocks in the near term, not fight the Fed and hope it is getting things right and today’s monetary policy is one of healthy moderation and not what appears to be the kind of excess that will later lead to an economic hangover. However, because of the global nature of capital one should keep an eye out for signs of excess and impending trouble beyond just the borders of the United States. As the market rises and time passes, so also will the potential economic risk increase.