The Economic Recovery--Real or Illusory

Perhaps the amazing thing about the data is the lack of even stronger positive economic news given the monetary and fiscal stimulus and the favorable exchange rate. Somehow with all the positive hype, it still doesn’t feel like a recovery. Perhaps the most telling discussion is how much the Fed will reduce the discount rate at their next meeting? If a recovery were underway a reduction in interest rates would be unnecessary.

Behind the numbers

Many companies have reported strong growth in profits largely due to the weakness of the US dollar. Foreign sales and profits are converted into dollars for consolidation on the US reports of profit and earnings. It appears that there was little gain in sales or earnings in the local currencies in these countries or in the US. Removing the exchange rate gains US sales and profits were only modestly better.

With the dollar dropping against foreign currencies US companies should have gained sales and/or raised prices against imports. US companies have not seemed able to raise prices and appear to have made little headway against imports. This is why so many of these companies have urged caution about future improvements.

The weakness in the dollar is exacerbating the economic weakness in Europe and Asia (with the exception of China whose currency is fixed to the dollar). The weakness in the dollar has put pressure on the European Union to lower interest rates. With the recent announcement of a cut in EU interest rates, the trend in the dollar will likely reverse, lowering US companies’ dollar equivalent foreign profits and sales and increasing competition here at home.

The tax cut is unlikely to have the stimulus expected. The benefits from capping the top rate for capital gains and dividends at 15% will largely benefit the wealthy, whose spending are rarely effected by changes in taxes. Most middle-income individual’s gross income (approximately $60,000) is below the rate where they benefit, or their dividend yielding stocks are in IRAs or 401Ks. Even for the wealthy the alternative minimum tax may eliminate some of the gain.

The depreciation and expensing benefits for small business will result in some stimulus from increased investments. However this will be limited until a recovery is clearly underway. The child credit and the change in the marriage penalty will also result in some slight stimulus as the beneficiaries of these changes are likely to spend this additional income, unless they use it to pay down debt. However, with the states still struggling with budget deficits and required to balance their budgets, all of the benefits from a federal tax cut will be offset by state tax increases and reduced spending.

Conclusion: while a return to a recession seems unlikely, any significant upturn in the economy is also unlikely before next year at the earliest.

The Stock Market

Repeat after me; the market leads the recovery, the market leads the recovery, the market leads the recovery! Could this be the proverbial bear market trap? It appears that investors fear missing a market recovery or think they can predict both when recovery will occur and when the market will lead this recovery.

The market has consistently failed as a forecaster of both recoveries and downturns. Even the best economists have missed the turning points in the economy. Stock market analysts are even more likely to miscall the economy and the market but continually encourage such belief. Could their commissions have anything to do with their economic outlook?

Like many of you, I wish I had been fully invested before this recent market upturn. I did invest in some oil related stocks but have since sold after their recent increases in value. I have also used this move to reduce stocks in my portfolio that appear particularly over priced. While it may be tempting to invest in stocks now, the market appeared somewhat overvalued before this move. It appears to be more overvalued now. I expect to see some buying opportunities in the future as the market moves lower.