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Is the stock market rally premature?

Posted by admin on May 27, 2009 in Investment Information

Even with a slight short-term correction, the stock market has been on an extended rally this spring. Yesterday’s news that the May consumer confidence numbers leaped unexpectedly has the bulls giddy that we will head into the summer with surprisingly positive news on the stock market front.

But is this all premature?

President Obama admitted in an interview over the weekend that: “Well, we are out of money now…” in discussing his health care reforms (full transcript of the interview can be found here) and governments all over the world are reporting or preparing their citizens for record high deficits (in both absolute and relative terms).

Politics being politics, politicians like to deliver the bad news but do not finish the unpalatable thought. Yes, deficits are sky high and (the unspoken consequence) we have to either RAISE TAXES or cut services to tame the deficits. Thus, has governments solved one problem (a global liquidity crisis) by creating another one?

Specifically, massive government deficits can stifle private enterprise over the long term and result in an unproductive economy. The term “crowding out effect” has not been used for some time but it describes the economic theory that increased government spending reduces private consumption and innovation.

Simply put, if government is borrowing so much money, there is less capital for private enterprise. With less capital, businesses do not grow as much. There are several ways to solve the crowding out effect. The first is to reduce government borrowing by increasing revenue through increased taxation. The second is to simply print more money which results in inflation. Neither is exactly a desirable effect.

Increased government spending is not necessarily a bad thing since many the public sector does buy from private enterprise but, in a competitive world economy, if the pendulum swings too far the other way to an overly active public sector, are we served any better than when i-bankers ruled the world? It is not that i-bankers are better than government policy wonks; they just both bring a separate set of problems.

While America’s deficit continued to climb during the bubble, it has begun to rocket under dual pressures of falling tax revenue and increased spending and President Obama, who is really America’s Pierre Trudeau (I’ll explain in another post) rather than the next JFK, can do little to halt it (or anyone who would be President). The American work force has aged significantly since the 1991 recession. Demographically speaking, it is in a different and less consumptive life stage to spend again for such sustained periods of time.

Thus, I have a tough time reconciling a stock market rally when the government ledger in the short term looks so bad which sets off a corresponding adverse impact on the economy as a whole.

For the bewildered retail investor, rather than focus on products or short-term trends, focus on a long term strategy that can survive all economic cycles.