As investors, we have found that over the years and certainly over an investment cycle there is a high correlation between an economy and that nation's stock market. For the moment, that relationship seems to be broken in the United States and in other markets around the world. The US economy is limping along at an unhealthy sub 2% rate, and growth in the global economy is slowing, too. Yet stock markets seem to be very healthy. Why?
Let's review how we got here. It began in early 2007 with the collapse of subprime mortgages. As the problem mushroomed, affecting the entire mortgage market, investor confidence collapsed, requiring government guarantees of short-term financial instruments and bank deposits to preclude runs on the banking system. Despite the $150 billion Economic Stimulus Act of 2008 enacted in February, consumer credit disappeared, and housing prices nose-dived. The United States entered a deep recession. Stock markets plummeted in the middle of 2008 amid fears of a financial meltdown. By August, the Federal Reserve began reducing short-term interest rates, eventually cutting them to zero. Lehman Brothers went bankrupt in September. The Fed flooded the market with liquidity, including establishing swap lines with other central banks to assure availability of dollars in an uncertain market.
Yet, that was not enough. The Bush Administration pushed through Congress the Troubled Asset Relief Program (TARP). While it was designed to buy up troubled mortgages to support the markets, it was ultimately used to bail out the banks through direct injections of capital. In February of 2009, at President Obama's urging, Congress enacted the huge $830 billion Recovery Act of 2009. Although the recession officially ended in the summer of 2009, stimulus and low interest rates failed to induce banks to lend and creditworthy borrowers to borrow.
Conditions in Europe, also related to excessive debt and real estate development, continued to worsen. The European Economic Union and the euro were coming under severe stress and threatened to unravel. Greece was the immediate concern in the summer of 2010. A €110 billion bailout was intended to enable Greece to implement fiscal reforms and return to public markets. It did not work, so another €130 billion is in process. As the crisis threatened to widen, the European Central Bank lent €1 trillion to 800 banks in late 2011and early 2012 to finance government shortfalls. The crisis continues to evolve. Spanish banks expect a €100 billion bailout.
As economies flounder, central banks have come to the rescue with favorable stock market reaction. The Fed has pursued an aggressive monetary policy, first announcing Quantitative Easing 1 (QE1), followed by QE2, Operation Twist, and now - in response to poor employment numbers - QE3, an unending purchase of mortgage backed securities. The irony is that the equity markets appear to be hooked on bad news in the hope of central bank intervention. Each announcement has boosted equity and commodity prices, but with decreasing effectiveness. Even the Chinese market rallied in late August after a weak manufacturing report. Europe, too, has responded positively to weak economic numbers in the hope of further bond purchases by the European Central Bank.
This"bad news is good news" phenomenon is the result of growing economic distortions in the global monetary system. The Federal Reserve, for example, is financing around three quarters of the US federal deficit. Unwinding these distortions will come at a cost, most of it unknown, but potentially very serious. As interest rates rise, paying interest on the debt could crowd out important government programs. In the meantime, as economic conditions worsen, professional investors like us play a type of musical chairs, using every tool available to benefit from these market moves but to not be left without a seat when the music stops.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. They are those of the authors. Investing involves risk, including loss of principal.