AS THE NEW YEAR OPENS, THE stock market is behaving as if the past 20 years were about to repeat themselves: Another recession will turn into a robust expansion. Stock prices already are discounting an earnings recovery to something only slightly below the level before the financial crisis. Risk-taking is in vogue again.
The global economy, however, is like a marathon runner who ran too hard and hurt himself. This runner has been injected with some industrial-quality steroids, and away he goes. As the steroids kick in, his pace accelerates, as if the injury never happened. He's up and running, so he must be OK, judging from his speed and his progress.
We may think the runner has recovered from his injury, but steroids have their costs. They exaggerate true performance and mask pain, and the longer an athlete takes them, the less effective they are. Addiction is likely.
The world's economy suffered severe injuries last year, and to keep it going governments have injected massive doses of economic steroids called stimulus. It's everywhere, but the U.S. is one of the biggest users.
To help the auto industry, government -- more specifically taxpayers -- subsidized the purchase of cars through the cash-for clunkers program, creating artificial demand. Uncle Sam also seems to be pumping lots of money into GMAC -- the credit company that provides mortgage and auto financing and insurance and which formerly was a GM unit, but now is majority owned by Cerberus Capital and the federal government.
The housing market, the epicenter of this recent crisis, is getting steroids in several ways. The first-time buyer tax credit has been expanded to an any buyer credit. Interest rates are kept low by the Fed's "quantitative easing," the purchase of long-term bonds to keep long-term rates artificially low. And Fannie Mae and Freddie Mac, government-owned in all but name, are the biggest steroid pushers in our economy, because they now buy the bulk of mortgages being originated.
Banks are the conduits through which the government pumps stimulus into the economy, which helps them generate enormous fees.
Their profitability is boosted by short term interest rates near zero, again thanks to the friendly Fed, so they earn a healthy interest-rate spread with little risk.
Government also extended unemployment benefits several times last year, spending billions in the process, and it's likely to continue doing this well into 2010.
The last dose of steroids, though certainly not the least, is the spending on giant, multibillion-dollar infrastructure projects. They weren't "shovel-ready" last year, but they are coming on line now.
JAPAN HAS BEEN ON THE STIMULUS bandwagon for nearly two decades, yet it has nothing to show for tripling its ratio of government debt to GDP.
The Japanese economy is mired in the same rut it was in when its stimulus marathon started, after its stock and real-estate crashes in 1990. It has had a hard time giving up stimulus because the short-term consequences were too painful. Japan is proof that a zero-interest-rate policy loses its stimulating ability over time and turns into a death trap, as leverage ratios are geared to low interest rates. Now that the Japanese are thoroughly addicted to low rates, even a small rate increase would be devastating for their economy.
In many cases, the stimulative measures just accelerate future sales to an earlier date, at the taxpayer's expense. After the cash-for-clunkers program ran its course, demand for autos fell. The same will be the fate of industries thriving on government infrastructure projects.
Though the government can spend money at a high rate for a long time, economic stimulus is a finite endeavor that comes with a heavy cost. In most cases, the stimulus is financed with debt, implying higher future taxes. It doesn't take a crystal ball to see higher interest rates and lower economic growth ahead.
The harm doesn't stop there. Stimulus schemes cause bubbles. The fix for the 2002 recession involved interest rates staying at extremely low levels for a long time, which was one of the causes of the housing and liquidity mess that we're paying for today. The present stimuli will leave us with even more serious damage somewhere down the line. This transition will be slow and rocky. As today's stimulus wears off and we hit the wall in this particular marathon, investors will have to adjust to a very different economy.
Investors today should be asking what a company's true earnings power will be after the stimulus runs its course. They should avoid cyclical stocks, which are priced as if the go-go days of 2002-to-2007 global growth will soon return.
WE CAN'T BE SURE WHETHER the end of the steroid economy will bring inflation or deflation, but it's likely to bring higher real interest rates.
In case of inflation, you want to own companies with pricing power; they can raise prices and pass the price increases to their customers.
In case of deflation, companies with little debt will have freedom to maneuver. Stick with those that have little debt or have the ability to pay off debt in a few years from very stable cash flows.
The hope that we'll transition soon from government steroiding back to an economy running on its own are overly optimistic; there's just too much stimulus for that to happen. Detoxing from the massive dose of steroids won't be smooth or painless.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo. He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007). To receive Vitaliy’s future articles my email, click here.
© 2010 Copyright Vitaliy Katsenelson - All Rights Reserved
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