Comstock Partners, Inc.December 13, 2012
Market Rally Based On Shaky Assumptions
The stock market has been kept afloat only by an expansive Fed and the widespread expectation that the administration and congress would have the sense never to let the nation actually go over the fiscal cliff. As the old saying goes, however, hope is not a strategy, and this optimism is not supported by the recession in some major economies and the economic slowdown elsewhere.
Despite all the chatter about yesterday's Fed meeting, it was certainly no game changer. As expected, the Fed will buy $85 billion per month of mortgage-backed securities and Treasury securities , basically a continuation of previous policy. It also announced its intention of keeping short-term rates near zero at least until the unemployment rate dropped to 6.5%. Separately, the Fed's newly issued economic projections estimated the unemployment rate dipping to 6.0% to 6.5% by 2015. While this is the first time the Fed has set an actual unemployment target, it had already promised to keep rates down until 2015, meaning that the overall policy remains about the same as before.
Some pundits have already dubbed the policy QE4. So far each successive QE has been less effective than the last, a pattern we expect to continue. As we have previously stated, the Fed has used all of its conventional tools and lot of new ones, resulting in a huge increase in the Fed's balance sheet. So far, however, the transmission mechanism between the creation of excess reserves and a robust economy has broken down, as the excess reserves have not resulted in a commensurate increase in the money supply. Similarly, the increase in the money supply that did take place has not resulted in a strong economic recovery. In addition the new methods implemented by the Fed have never been tried before and have the potential to lead to unintended negative consequences.
As for the fiscal cliff, most of what we know about the negotiations is public posturing by both sides as they seek to avoid blame for any failure and convince their followers that they fought as hard as they can. Although it is possible that more progress is being made in private negotiations, we don't know that. The market is assuming that a settlement is likely by year-end, and has run up on that hope.
While we don't know what is going to happen, doing a deal may be far harder than it seems. Obama and Boehner probably could agree to something if it was just up to them, but that is not the case. Both of them must satisfy their relative bases in order to put together enough votes in both parties to pass the House. Furthermore, in the past Boehner has insisted upon getting a majority of his own party in addition to an overall majority in the House. As we write, it appears that a 5:00 PM meeting today between the President and the Speaker has not resulted in any more progress.
More importantly, as we have emphasized in recent comments, even a settlement will result in austerity----less austerity than no settlement at all, but austerity nevertheless. Any combination of lower spending and higher taxes means fiscal tightening at a time when Fed policy is becoming more ineffectual and the economy is slogging along at less than 2% growth. In addition, as we have previously pointed out, both the Eurozone and Japan have entered recessions while the growth rate in the BRIC nations is slowing down.
In a broader context, the U.S. economy is being held back by high household debt levels and low savings rates, a problem that is not cured by either a fiscal cliff settlement or more ease by the Fed. In our view the market has gone about as far as it can go on some shaky assumptions. The downside risk is substantial.