Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Economy Tugs, Market Shrugs

Good news is getting hard to find. This week, equity markets reverted to moderate profit taking as they dealt with a series of challenging headwinds domestically and abroad. US corporate earnings season (3rd quarter) has begun. Analysts are predicting another quarter of negative earnings growth (-2.7% YoY). The IMF cut its global growth forecasts for 2013, citing increased risks in the European debt crisis. S&P, in turn, downgraded Spanish debt to one level above junk. OPEC cut its global growth forecasts, citing lower demand for oil. The People’s Bank of China is hesitant to ease further, despite China’s beleaguered economy. Worldwide, inflation expectations are escalating as slowing growth has prompted central banks in Australia, South Korea, Brazil, and others to cut rates, subsequently lowering borrowing costs in an effort to stimulate their respective economies. We could go on, but it’s safe to say this hasn’t been your typical “recovery,” as Fed officials have claimed.

Still, the US stock market continues to take these developments in stride – unlike its many counterparts in places such as Italy, Spain, Australia, China, France, Germany, and Japan. All of these countries’ markets trade either below their interim highs or not far from their all-time lows of the last few years. Is it that the US is simply more industrious and efficient than other nations, or is it due to some other dynamic? Unfortunately, we believe the latter possibility is more likely. US stock market success has much to do with the infinite promises made by the Fed as of late. Confidence levels are up, and, as a result, so is the use of leverage (debt). Margin debt that money investors borrow for speculative purposes is nearing all-time highs not seen since before the ’08 crisis. Homeowners have rushed in at a record pace not seen in seven years to refinance against the Fed-backed mortgage market, and corporations have taken widespread advantage, once again, of record low rates. Heavy spending, the flipside of debt accumulation, has therefore been maintained in our favor. Folks in other reaches of the globe haven’t been so fortunate.

The question is, of course: How long can we keep up the spending/debt binge here in the US, especially in the face of “uncontained” economic threats emanating from around the globe?

What’s surprising is that the Fed has yet to expand its balance sheet as promised. In fact, its balance sheet has contracted from the moment it announced a cumulative $80 billion per month in intended purchases of longer-dated (mortgage-backed) assets. So sure is the market that the Fed will print it has decided to borrow in advance of the event. What concerns us is that when the Fed does decide to make good on its promises, the markets may be less inclined to make use of the funds in productive ways – instead opting to use the cash to work down balance sheets bloated with liabilities.

That leaves the Fed in a precarious position that it may already sense, as evidenced by its current inactivity. It may suspect that its monetary commitments are not enough to inspire the markets, or that its stimulus measures are at risk of becoming ineffective altogether (as we have mentioned here ad nauseam with regard to the inflation such measures create). In any case, these are simply thoughts based on the observation that the markets have stalled out when there should be runaway animal spirits at the prospect of infinite QE. With corporate earnings on the decline, short-term profit taking (affecting the metals, as well) will likely prevail until such time as the Fed ups its ante in a fit of panic – as we suspect it will.

Best regards,

David Burgess
VP Investment Management