Compromise in Washington is not the 'grand bargain'
we have seen more downward pressure in the stock market the last several weeks than we have witnessed in a while.
There have been several factors causing this situation. First, there has been a fear of what would happen when the Federal Reserve started easing its bond buying program. There are some good reasons for this fear.
A recent Forbes magazine story said, “You can thank Ben Bernanke for 100 percent of the stock market gains since 2009.” The magazine credits Michael Cembalest, chairman of market and investment strategy for J.P. Morgan Asset Management, with discovering this fact.
He found that every week during this time that the Fed bought treasury bonds and mortgages, the stock market went up. Every week that it did not, the market went down.
The Fed has to start winding down its $85 billion-a-month purchasing program sometime. The market reacted in September when there were some signs that the program was going to start easing. However, the Fed held off at that time because of the impending government shutdown.
The shutdown damaged the economy and illustrated how the gridlock in Washington is hurting everyone. There is enough blame there for all sides.
Now, Congress has announced a tentative agreement to avoid another shutdown at the beginning of the year. While this should be good news, it is contributing to the market's concerns because the Fed will have an easier time starting the easing now.
Remember, the Fed is doing all of this purchasing with newly printed money, which has the potential to cause serious inflation. This has not happened yet, but there is historic experience that this is a common outcome of such actions.
The economy has been having a slow recovery. Inflation may pick up when the economy improves, and inflation erodes purchasing power.
There are a number of reasons why the Fed's purchasing has benefited the stock market. We will discuss three of them.
First, companies have benefited from lower interest rates. They are able to borrow from banks and issue bonds at less cost than if interest rates were higher. This obviously improves profit.
Second, many companies have borrowed at low rates and used the money to buy back shares of their own stock. This automatically increases earnings per share because there are fewer shares outstanding.
Both of these factors increase stock prices because many investors look at price-earnings ratios when determining a stock's value.
The third reason is with bond interest rates at such a low rate, many investors have taken on more risk in the stock market to try and achieve a respectable rate of return. When interest rates go up, these investors may move out of stocks and into other investments.
All these factors could have a negative effect on the stock market.
When the Fed starts easing, which means buying less than $85 billion per month of government debt, interest rates will go up. Rates are set by auction, and when the major buyer is cutting back, other investors will be able to demand higher returns for their investments. This means the value of longterm bonds will go down.
Shorter duration bonds will not be affected as severely. CD rates will start to rise slowly, but not as fast as overall interest rates. This is because many banks will use this as an opportunity to increase profits. Do not take out multi-year CDs because you will be locking in long-term low-interest rates. Bond holders need to be prepared for this to happen.
The Fed is not as predictable as it has been. Bernanke will soon be replaced as chairman by Janet Yellen. Also, because we are in the important Christmas selling season, the Fed will want to be careful not to scare the economy. Retailers make most of their profits at this time of year, and their sales now will influence their future orders from manufacturers. There are questions about how much selling investors will do and what the timing will be before the end of the year for tax reasons.
The stock market has risen faster than the economy has improved.
While the compromise in Washington is better than another shutdown, it mostly kicks the can down the road by eliminating some short-term sequester cuts for promised future cuts. It is not the “grand bargain” that must be reached to truly improve the economy.
The Forbes article does not think a grand bargain can be reached until we have a new president. The grand bargain must deal with all the entitlement issues that in a few years will consume 100 percent of our tax revenue. How will the rest of government function without an income stream?
Gary Boatman is a certified financial planner and a local businessman who serves as president of the Monessen Chamber of Commerce.