Really … A Real Recovery Redux?

Since 2009 we’ve put forth a very important idea every time the consensus began to believe a real US economic recovery would take hold.

Actually, two ideas …

First, we figured there was always too much deflationary pressure for a real, sustainable recovery to take hold.

Second, assuming we were wrong about the first idea, we feared what a recovery would mean for the US stock market.

We cannot stress enough that market prices are driven by sentiment, human nature. Improving sentiment for the real economy has the potential to undermine the market.

Let me explain …

I met a friend at a coffee shop on Friday. (In case you were wondering, I’m one of the few remaining hold outs in this cultural piece de resistance — I do not drink coffee. So I drank some fancy chai thing. I think it’s some kind of tea.) He’s in the market to buy a house. And I also know some guys who are in the market to sell a house.

So we discussed how new home-buyers may be coming into the market now. There are two reasons for this (besides the typical “buy low” mentality):

1) Many past short-sellers are now eligible to get a mortgage again.

2) Buyers may be looking to seize the opportunity to lock in low interest rates.

The latter point is critical. Keep it in mind …

Also on Friday I was passed along an article by David Malpass writing in the Wall Street Journal:

The Fed’s Tapering is Already Paying Off

Malpass argues the Fed’s tapering is already making room for lending to be made to individuals and small businesses. He also argues this trend will actually, finally, create jobs and drive real economic growth.

There was one very brief mention of how Fed policy has effectively driven capital to the “Haves” at the expense of the “Have-nots.” In other words: the rich get richer. (I’ll say no more about income gap dynamics so I can avoid contracting a case of the Mondays.)

But let me take Malpass’s article to its logical conclusion for the stock market …

If the Fed is believed to continue tapering and completely end its bond-buying program in a few quarters, then soon thereafter they’ll probably be inclined to remove their very visible hand from atop the Fed Funds Rate.

Any signal to that effect will allow interest rates to rise. That’s not to say they will, but the odds are greater that they will rise once the Fed assumes a lesser role in manipulating the cost of money.

Yet well before the Fed changes its low interest rate policy, investors are likely to react.

Along with hints of economic recovery, the expectations for rising interest rates will drive the demand for lending. Small business and individuals looking to pump money into real economy investments will be looking to grab loans at near-historically low interest rates.

So … kinda sounds like gravy on a biscuit — it’s all good, right?

Not so fast.

Part of the “rich get richer” dynamic that’s been emboldened by the Fed’s extraordinary monetary policy has been the rise in asset prices. Considering that in said monetary environment the money was flowing into banks and financial institutions while much of the rest of the country remained mired in mediocrity, the eventual destination for most Fed liquidity was not the real economy but, rather, the stock market.

Now consider the levels at which major US averages are now trading — historic highs, more or less.

Indeed, there are a lot of bears out there who can’t justify these levels. (That, from a contrarian’s point of view, however, does suggest the market can still press a bit higher in the near-term.) As the opportunity for out-sized gains in the stock market diminishes, capital will seek other sources of return.

A source of return that has long been absent is investment in the real economy.

It may seem like improving economic fundamentals are a plus for the stock market too. But for now we’ve got to look at it in the context of capital flows, I think.

The Fed has created an environment where investors are addicted to capital flowing between asset markets. The Fed’s departure (and consequent expectations for a rising economy and rising interest rates) could open the door for a reversal in these capital flows.

Certainly the Fed is going to do their best balancing act to avert any significant drop in market capitalization lest their “wealth effect” efforts be thwarted.

But I think there will come a point when the market is going to run out of buyers willing to buy high and hope for higher.

Maybe the reaction to Wednesday’s FOMC meeting will offer some clues …

Have fun with that!