It’s hard to believe that it’s been almost four months since I shifted our portfolio strategies away from the aggressive positions that enabled us to once again outperform our benchmarks this year.  Since then our biggest single holding has been money market funds; earning a frustrating zero percent.  During that time we have only captured about 40% of the additional single digit gains of the S&P 500.  Our strategy was straightforward.  The economic recovery we anticipated was already baked into stock prices, leaving little upside.  Why take the risk that we might be wrong if the rebound in the economy and corporate profits might disappoint?  The risk of disappointment seemed high, given that the employment turnaround was so overdue.

Last Friday the game changed.  Not only did the drop in the unemployment rate provide evidence of recent job gains, but the data for the previous two months was revised upward.  This resolves the last remaining contradiction in the near term economic outlook.  The economic recovery achieved by flooding the economy with liquidity is now on solid ground, and will continue until that excess liquidity is withdrawn.

This good economic news is likely to produce a flood of forecasts of future stock market gains, but not from me.   Earnings are recovering, but those gains are likely to be offset by a drop in price/earnings multiples.  Both the 60% gain in stock prices since March and the incipient economic recovery are textbook outcomes resulting from unprecedented monetary expansion and massive government spending.  Until a few months ago, American business was trapped in the worst recession since Ronald Reagan came to office.  The only bright spot was that most businesses (unlike banks and consumers) had done a great job preparing their balance sheets for this downturn.  Businesses desperately needed sales, but had relatively large cash positions.  Consumers were deep in debt and therefore had no capacity to borrow.  Money market yields had been forced to zero, while banks were fixing their balance sheets by reduce total loans outstanding.  Where would all this new money created by the Fed go?  The obvious answer was the stock, bond & commodity markets.  Small investors moved out of zero return money market funds into higher yielding bond funds and gold, any stocks they bought were in foreign markets.  At the same time, institutional investors shifted worthless cash into US stocks which were incredibly cheap six months ago.  This sent value of the dollar plunging while bonds, precious metals and stocks (both domestic and foreign) soared.  Asset prices now fully reflect the potential of an improved economy as well as some renewed inflation risks.

Although still subsidized with deficit spending, the real economy is expanding.  That expansion will require dollars; dollars to pay salaries, and eventually dollars to update plant and equipment.  Those dollars must come from somewhere.  Conversely, the Fed must begin reducing the supply of dollars to address the long term inflation consequences of inflating their balance sheet.  It is unlikely the Fed will raise rates anytime soon, but it is even less likely that the Fed will aggressively feed this new demand for liquidity.  It is also unlikely that much new money will come from either banks or consumers who are both desperately trying to repair their balance sheets.  Absent increased availability of funds, the increased business demand for dollars to feed a growing economy means the value of the dollar will rise.  Business will be competing for dollars with stocks, bonds and gold.  The free ride for investors is over.  Further stock market gains will be hard to come by, while the current bubbles in TBonds and precious metals as well as some foreign stock markets are likely to deflate.

Anticipation of the recovery has been great for stock prices since March, but the actual recovery could prove to be a headwind.  This headwind could strengthen if inflation (which was negative this summer) is rising at a rate over 2% by year end, as I expect.  The market is already beginning to discount Fed hikes in short term interest rates next year.  While it is possible the Fed may make a token rate hike sooner, I believe serious rate hikes will begin next September or October.  Fed tightening will become aggressive as we enter 2011 and continue until 2012 (despite stubbornly high unemployment).  Expect a more detailed analysis on this topic in our Annual Forecast scheduled for publication in early January.