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As
a former army parachutist with a bad head for heights, I
recall standing in the doorway of an aircraft while my
jumping instructor shouted: "Don't look down!"
He understood that my unease with parachuting combined
with the sight of thousands of feet of open air could be
enough to elicit panic. Many investors in today's
American stock and bond markets appear to be getting the
same advice. While in my predicament, I had a parachute
and a rudimentary understanding of how to use it, I fear
that American investors have nothing to break their
fall.
Looking down from the lofty nominal heights of today's
American stock and bond markets, there is cause for real
concern.
First, the Dow has risen 62% over the past ten months.[i]
Despite the fact that a market collapse appears to have
been averted - for a time, at least - this normally
would be considered an unhealthy speed. This rapid
rise may be the result of government and media
cheerleading, which have been based in part on
government statistics whose accuracy gives additional
cause for concern. In short, the stock markets appear to
be heavily overbought.
Second, the somewhat surprisingly solid earnings posted
by American companies over the past year have been
achieved largely by savage labor cuts, inventory
depletion, margin reductions and reduced research and
advertising expenses.[ii] It is doubtful that such cuts
can be continued over the longer term. At the same time,
the top-line revenues of many companies have been in
decline, threatening future earnings. These are not the
types of metrics that would normally inspire long term
confidence.
Third, in addition to these pricing concerns, the stock
market corrections of last week appear to have been
reflecting a growing wave of uncertainties, which
markets detest. The biggest questions involve the
outlook for interest rates. Despite the
"extended period" language that seems to be
permanently chiseled into the Federal Reserve policy
statements, interest rates are set to climb sooner or
later, threatening both the bond and stock markets. Now
that Ben Bernanke has been re-appointed as Fed Chairman,
he will try to hold rates down far into the future.
However, the massive Treasury borrowing program,
together with reckless government spending proposals,
are forcing rates upwards, especially at the long
end.[iii]
Fourth, the prospect of an imminent economic recovery is
far from certain. With the U.S. jobless rate continuing
to mount towards depressionary levels[iv] and China
announcing a curb to its high economic growth,[v] it is
likely that the economy will soon face a dramatic
aftershock of falling demand and asset prices. In
addition, major governments abroad, yielding to
taxpayers and bond buyers, may be winding down their
stimulus packages. Although the removal of these
government interventions is a long term positive, in the
short run this would certainly pull the rug out from
under this recent rally.
Fifth, and most alarmingly, developments in recent
months have exposed great uncertainty in the policy
direction of the U.S. government. In particular, Scott
Brown's victory in Massachusetts, in the minds of some
investors, has raised the possibility of Republican
election victories, which could favor the kinds of
pro-business policies that are beneficial to stock
prices. However, since the days of President Ronald
Reagan, the Republican Party, much like the Democratic
Party, fosters big government, the antithesis of what is
needed for economic revival.
If investors in the American stock and bond markets
adhere to my parachute instructor's advice to not look
down, they may remain happy for a time. However, without
a parachute, unable to recognize the faults in their
financial equipment, and instilled with baseless
confidence, they may well regret going so high and
risking such a massive free-fall.
My advice would be to look for a good parachute -
preferably a golden one.
[i] 2009/03/09-2010/01/09. Dow Jones Industrial Average
historical chart. Yahoo! Finance.
[ii] 2009/08/09. "Corporate Earnings Are No Sign of
Recovery". Wall Street Journal.
[iii] 2009/01/01-2010/01/28. "Daily Treasury Yield Curve
Rates." United States Treasury.
[iv] 2010/01/12. "How nation's true jobless rate is closer
to 22%". New York Post.
[v] 2010/01/27. "China Tightens Reins on Loans". Wall
Street Journal.
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