Monday, June 23, 2014

Finally leaving the runway??

Last week's release of the Index of Leading Economic Indicators came in positive for the fourth consecutive month. This morning's U.S. Flash PMI (Purchasing Managers Index) report (from Markit) indicates "the strongest upturn in overall business conditions since May 2010". The most recent reads on the Institute for Supply Management's Purchasing Managers Indexes were positive as well. Even this morning's existing home sales report (real estate indicators have trailed the other majors until very recently) beat expectations. While there's yet more, like the NFIB Small Business Optimism Index, suffice it say that most arrows are pointing in a positive direction for the U.S. economy.

What's it all mean for stock prices? Great question. Of course I don't know, but I can speculate, or gauge, somewhat intelligently (I hope).

While the above is indeed good news for earnings growth going forward---and could very well point to a meaningful pickup in employment---faster growth has to bring a new mindset to the market. While I've never joined the this-bull-market-is-all-about-the-Fed camp, I do believe that the Fed's next policy move has the potential to inspire that long-awaited stock market correction (10-20% decline)---and I believe the Fed believes it as well.

As I've been hinting of late, I'm seeing hints of inflation brewing beneath the numbers. Now, a slight pickup in inflation---particularly through the Fed's lens---isn't necessarily a bad thing, that's why their inflation target is 2%, not 0%. Higher trending prices can incite optimism and encourage increased production and, thus, jobs, wages, etc. Too much inflation, and its attendant higher interest rates, however, can kill a party faster than your grumpy next door neighbor.

As I reported last week, the Consumer Price Index (CPI) increased 2.1% over the past 12 months. Uh oh (remember the Fed's 2% target)! However, Personal Consumption Expenditures' (PCE)---the Fed's preferred gauge---last read was 1.5%. I wouldn't be surprised if this Thursday's number comes in a titch closer to that 2% line in the Fed's sand.

But last week Janet Yellen said the latest inflation numbers are "noisy", and, for the most part, dismissed the notion that inflation is a worry at this juncture. I presume, therefore, that if PCE comes in near, or north of, 2%, that a new line will be drawn. And the market will love that---the new line---to death. For it'll mean that the Fed is not nearly ready to take away the punchbowl. I, for one, however, wish they would. I'd much rather see the Fed sober us up here and allow the marketplace to respond to real world signals, to allocate resources to their most productive use, as opposed to where artificially low interest rates, etc., direct.

While he'd never admit it, I would bet ya that if Alan Greenspan could do it all over again, he'd not nearly accommodate the real estate market and the financial sector to the extent he (and his committee) did. The Fed essentially stimulated its way (so it would seem) out of the bursting tech bubble only to inflate its way into the great real estate bubble. Of course that's not the whole story, and it's not the story Greenspan tells.

The good news, for the moment, is that we're not pushing against the classic extremes that suggest things are overheating. Not hardly. In fact, it appears as though the economy's engines are just warming up enough to finally allow it to leave the runway. The question, alas, that nobody can answer is: how long before it reaches the altitude where it'll have to deal with the headwinds created by a bond market (interest rates) adjusting to reality? Many "experts" think (they can't know) it'll be awhile...

In summary: All that you just read should make you feel pretty good about the market's prospects for the foreseeable future. But never forget, even while in the economic sweet spot, and amid reasonable valuations for much of the market, an exogenous event, or no apparent event whatsoever, can send the market tumbling when you least expect. In fact, that---the periodic tumbling---is the one thing I can always predict with 100% confidence. I just can't predict when. Which is why I only work with patient, long-term investors.


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