"Up and Away in My Beautiful Balloon" (Nic Colas)

"Up and Away in My Beautiful Balloon" (Nic Colas)

- in ETFs, Markets

Up and Away in My Beautiful Balloon

by Nic Colas, BNY ConvergEx Group

My newly-turned-85-year old mother recently informed me that she is “Having a bit of a middle age crisis.” Since English is not her first language, I tried to tell her that this particular turn of phrase was usually reserved for people turning 40 or perhaps 50 years of age. The typical symptoms are a desire to trade in the family car for a convertible. In its more virulent form, that urge extends to trading in the first spouse for a newer, flashier model. For my mom, it seemed to signal an uncertainty about whether to start knitting another scarf, or go all-out and begin working on a sweater. I talked her off the ledge – we settled on a Rastaman-style knit cap. Crisis averted, at least for now. I just hope she doesn’t expect me to wear it.

Still, the urge to use large round numbers as an excuse for some navel-staring is a common one; consider the attention around the 14,000 level for the Dow Jones Industrial Average. Most institutional investors benchmark themselves against the S&P 500, which closed Friday at a distinctly non-large-round number of 1513. Still, the Dow is the longest running measure of the performance for U.S. stocks. Started in 1896 with 12 constituents and formed by adding stock prices together, it essentially the financial equivalent of an aging movie star who still makes headlines when they take an eighth husband or go into rehab for the umpteenth time.

So let’s use the Dow’s crossing of the Rubicon of the 14,000 level to consider both how we’ve gotten here and ponder the way forward. Three topics fall readily to hand:

#1 – Equity prices are now much more a tool of central bank policy than in past economic cycles. Consider the “Traditional” equity market storyboard that defined the start of every economic upturn over the last 30 years. It begins with a slowdown in economic activity and the customary Federal Reserve response to lower interest rates. This tends to jump-start bank lending in the mortgage and auto markets, since the Fed has effectively lowered the cost of money to the banking system. Over time, homebuilders and auto assembly/parts plants add more workers, and the unemployment rate begins to decline. While these sectors of the economy are relatively small, the incremental activity here sparks demand in other sectors. This virtuous circle feeds on itself and the domestic economy begins a period of lasting expansion.

This cycle has followed that path, but at a much more sluggish rate as both the financial sector and consumers try to reduce their debt loads. House prices have apparently bottomed, but excess supply of foreclosures means new construction is still distinctly sub-par. Auto demand has finally returned to “Normal,” but that’s come a full six years after the downturn. Previously cycles have been more like 4-5 years from trough to normal.

You don’t need to be tinfoil-hat conspiracy theorist to appreciate that the Federal Reserve’s liquidity measures – Quantitative Easing I, II, III and IV – have pushed capital into the equity market. With interest rates still in the 2.0% neighborhood for 10 year Treasuries, thanks to the Fed’s bond purchases, where else would you expect capital to flow? I am sure the Federal Open Market Committee understands this shift and welcomes the possibility that rising equity prices will spur some “Wealth effect” spending.

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