The Wrong End of the Telescope

The Clinton Administration will often be remembered for balancing the budget and creating a surplus. I’ll leave it to you to decide whether that was brilliance or being in the right place at the right time. Whichever fits your world view, the mechanism by which that was accomplished was clear: surging values in the stock market.

That lesson is not lost on the Bush Administration. One of their first efforts to boost the stock market, dividend tax cuts, has not worked as well as they hoped. (No surprise to me, if you’ve read some of my prior opinions on that subject.) I would expect more policy-based stimulus in the second act of this administration.

The liquefaction of the money supply can be seen as an effort to boost consumer spending, make loans cheaper, or any one of a number of other theories you’ve seen in the pages of Minyanville. The primary purpose of these actions, in my view, is to boost the stock market.

It’s exceptionally fashionable to bash Alan Greenspan and the rest of the powers that be in the US government for this policy. Oddly enough, such bashing is often coincident to a nascent economic recovery in order to taint that economic recovery. If you can’t make the case specific companies should not rise in value, perhaps the fallback position is to attack the macro market.

These rants are initially pitched as imminent disasters in the making with much advice to abandon the equity markets and run for the hills – usually hills covered in some sort of precious metal or commodity. When the imminent disaster turns out to be not so imminent, the refrain usually turns to one of “wait until next year.” When next year becomes last year, then the refrain changes to “Well, if [insert event] happens, then disaster will strike.” When that doesn’t work either, the standard fallback position becomes “I don’t know when it will matter, only that it will matter eventually.”

These views are enormously seductive, and that’s the problem. One doesn’t have to be a rocket scientist to know high debt levels are bad and imputed inflationary pressures surrounding soaring money supplies are problematic. This seductiveness has a cost, however, when you try to translate it into equity strategy.

Here’s the rub: If the equity markets do rise, these problems go away. Tax receipts soar without the need of a growth-stalling tax hike. Increased tax receipts reduce the need for financing debt, so the need for foreign investment in Treasuries is curtailed. Strong stock prices reduce the overall need for debt financing on the corporate level. Reduced corporate and government need for debt financing drops interest rates. Stronger incomes from the stock market act as their own stimulus, reducing the need for growth in the money supply – in fact, they can cover withdrawal of money supply stimulus from the stock market. Many of these items cause budget deficits to shrink and the dollar to rise.

It’s folly, or worse, to presume the powers that be don’t understand this. The impression left by many who constantly criticize Alan Greenspan and others like him is the Greenspans of the world fiddle with things they don’t understand. Puh-lease. Alan Greenspan knows exactly what he is doing, the rewards inherent in the game, and the risks involved. To assume otherwise is to assume you are orders of magnitude smarter than everyone else and that’s a dangerous bet, in my experience.

Don’t get me wrong, I respect many of those who espouse the doom & gloom endgame. It takes a broad and exacting knowledge of the financial markets to uncover and understand these issues.

What I don’t agree with is the conclusion they derive: Sell your equities and run for the hills. They seem to forget that equity prices are the key here. The doomsday scenarios they paint are not the cause of equity pullbacks, they are the result. It’s a causation issue.

That may seem a small distinction, but it is a damn important one. It means that your focus should be on equities, not on the doomsday scenario. If and when equities break, it won’t be because of the doomsday scenario. The doomsday scenario may make a persistent decline in equities much worse, but it won’t cause that decline. If equities don’t break, then the scenario is largely relieved even though some of the underlying issues will remain.

As a check and balance, watch what happens to money supply and the nation’s debt given a sustained rise in the stock market. As we rise from here, watch to make sure some fiscal discipline wanders into the halls of 1600 Pennsylvania Avenue and Congress. Keep an eye on money supply and see that it stabilizes and even declines. Watch debt offerings from the government to make sure they slacken in pace. If the market rises significantly and these events do not happen, then there is something else going on and a re-evaluation is necessary.

Turn that telescope around, friend, and focus on what’s important. Concentrate on picking good stocks and choosing smart positions. Keep that doomsday scenario in the back of your head, triggering it to become a louder voice in sustained declines in the equity market. Until then, don’t let it get in the way of making money in equities.