This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Monday, November 2, 2009

Experts Agree Correction Coming

Looking back over my past articles this morning, I have been calling for a pullback in the markets now for the last six weeks. Now, six weeks later, after some ups and downs, the stock market is essentially right where it started (the Dow is up less than 0.5%, while the S&P 500 is down about 1.5%).

After six weeks and little or no movement, investors in the broader stock market haven’t made a dime. And still, after six weeks, the markets still have us awaiting a correction.

But, oh how vindication can be sweet. After six weeks of telling investors that the economy hasn’t turned, and that this rally is built on nothing but air, finally we’re seeing more and more market technicians and other professionals on the markets follow our lead.

What’s more, they’ve been turning bearish for precisely the same reasons we’ve been harping on for more than a month. They say, as we have been, that the credit markets haven’t loosened. In aggregate, more debt is being paid off than taken on.

Credit cards are a prime example. In an industry built entirely on financing purchases – helping people pay for something today with money they’ll [hopefully] earn tomorrow – credit card companies, who have access to vast sums of credit through the Federal Reserve, have been raising rates to astronomically high levels (Citi Jacks Credit Card Rates…, Vince Veneziani).

What other experts are realizing is that with credit continuing to tighten, the flow of money through the global economy (velocity) has slowed incredibly. We would liken it to blood circulating through constricted veins. All this means that, in the short-term, deflation is still a very real threat in the United States.

Perhaps more importantly to investors, this means that the recent market rally is not based on economy, just added liquidity. Prices have been driven higher by money flowing into the market from the sidelines. Some of that money is from banks that were given bailout funds in the stimulus packages.

When they were given these stimulus funds, banks needed to do something with that money, but considered it too risky to loan it out. Instead, the vast majority of those funds were left in the Federal Reserve System, where the Fed pays interest on excess reserves. Some funds eventually made their way into global markets, and have contributed to supporting share prices.

While deflation is a serious threat in the immediate term, inflation is still a larger, more long-term worry. We believe, as we have for some time, that the United States may very well be on the road to more 1970’s-style inflation. In fact, we begin we are already beginning to see this on the horizon. Now, as in the ‘70’s, unions refused to make wage concessions (Opposition Builds to Ford Union Concessions, Jeff Bennett), and this later contributed to massive wage inflation, despite high unemployment.

In the meantime, we continue to wait for the approaching market correction. The big question investors now need to be asking themselves [or their advisors] is where to weather the coming storm. Unfortunately, this correction is likely going to be very similar to the one that occurred last year; perhaps not in depth, but certainly in depth. In the coming correction, like last year, diversified portfolios are going to take a serious beating.

The market is overpriced across nearly all sectors, with few exceptions. However, more bank failures are almost a certainty. In addition, interest rates are so low right now that they simply can’t get much lower, meaning that bond positions are not likely to perform well.

However, looking past the storm, with election season coming up for many Congressman in just over a year, we can say beyond a doubt that the Fed is going to be getting quite a bit of political pressure to do something in order to get this economy going before voters go to the polls next year. We also know that changes in monetary policy by the Fed usually take at least six months to take effect.

With all this in mind we can construct a rough timeline of the way things will likely play out over the next six months, year, and two years, which are pretty good time horizons when considering investments.

First, with each passing day a major market correction draws nearer. Hopefully investors have been getting prepared to buckle down. If they haven’t, they certainly need to.

Second, once the market corrects the Fed is likely to work with the Treasury to make major shift in monetary policy in order to appease pressuring politicians. Knowing what we do about monetary policy, major changes will need to be made by the time it’s getting warm in spring, at the very latest.

Lastly, once the economy and the markets begin a sustainable recovery, inflation is likely to reach levels not seen in the US since the ‘70s. While this may alarm some investors, and inflation on the scale we see coming is certainly never fun, it’s nearly always better than the alternative.

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