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The bull market this summer was clearly not a classic cyclical market rally, as some of the best performing industries over the last three months have been consumer staples and healthcare. Semiconductors, which typically lead market rallies, have been the worst performing sector. This is an unusual divergence, for while the economy is still relatively weak, the stock market is dancing to the tune played by the Federal Reserve. The S&P Capital Goods index, which measures business activity, now indicates economic contraction. The Dow Transport index is in negative territory this year. Global trade has slowed. Even with the stock market hitting new yearly highs, recall the theory of Charles Dow, the founder of the Wall Street Journal, who maintained 130 years ago that in order for a bull market to have staying power, the Transportation Index must "confirm" the movement of the Industrial Index. Right now, the former is notably failing to follow the latter’s lead, due in part to weakness in global trade and to profit forecast downgrades by FedEx among others.

What is the participation level of this rally like? Probably lower than one might guess if mutual fund flows are to be believed. Outflows from stock funds and money market funds are at 20 year highs, benefitting bond funds, whose inflows are also at record highs.

On September 13th, “QE3” was announced by the Federal Reserve, launching further stimulus to the economy. The program consists of buying $40 billion of agency mortgage backed securities per month (open ended) in an attempt to support the housing market. The Fed also announced that they would continue to keep interest rates extremely low until mid 2015.
Housing prices have gingerly begun to show some signs of improvement for the last three months, which may bring some economic benefit in the form of increased construction activity and retail sales. It should be noted, however, that housing market guru Robert Shiller of Yale University is not yet bullish on housing, seeing recent improvements as seasonal rather than structural.

The European Central Bank is now preparing itself for further sovereign bailouts. Spain has not yet officially requested a bailout, but will probably do so within the next month. Any sovereign bailouts will come with conditions attached regarding reforms and budget cuts. The ECB will provide both direct financial aid, as well as support in the form of buying the country’s bonds directly on the open market. These actions will intend to reduce systemic pressures and risk, while buying time for European governments to create a fiscal and banking union (requiring several years and hitherto unknown levels of cooperation from politicians). The good news is that there is progress being made to that end, and that Germany is slowly accepting that it may have no other option than to provide more financial support to Europe.

While debt reduction has really just begun in the ten largest developed economies, European households are deleveraging less quickly than American households. This may be explained by the fact that mortgage debt in Europe consists of recourse loans, while in the U.S. they are non-recourse loans. As Americans “walk away” from their mortgage and credit loans, their borrowing levels drop accordingly. With U.S. foreclosures slowing, U.S. deleveraging will now slow as well. In fact, defaults account for 70% and 80% of the decrease in mortgage debt and consumer credit, respectively, according to a recent McKinsey study. A Department of Education report indicated that student loan debt, which now exceeds $1 trillion and has surpassed total U.S. credit card debt, has hit a default rate of 13.4% during the first three years of debt repayment. 55% of U.S. university students have borrowed to afford their tuition, while student protests concerning rising education costs are becoming commonplace.

The issue of the “fiscal cliff” has still not been addressed by the U.S. Congress. If Obama is elected yet Republicans win a majority in the House and the Senate, there is increased risk that a deal to soften the blow of higher taxes and lower government spending will not be reached by December 31. Equity markets usually respond unfavorably to uncertainty; but they will certainly respond unfavorably if a deal is not reached.

The U.S. government has run a $1 trillion dollar deficit for four consecutive years, and total government debt has just bypassed $16 trillion. With the ever increasing debt monetization and alarming money supply growth in most major economies, it remains a good idea to be long gold.

Grant Rogers

Partner

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