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Investor’s Corner

By John Gudritz CFA
Principal
Front Street Investment Management LLC
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The cyclical bull market just celebrated its second birthday. It is up almost 100 percent from the March 2009 low but is still about 16 percent below its high reached in October 2007. I have been skeptical of the rally because of my concern for the sustainability of the economic recovery. The U.S. economy has been on life support by the federal government and the Federal Reserve to the tune of trillions of dollars of fiscal and monetary stimulus and it has stumbled in the past when some of the support was taken away. The sustainability of the recovery is about to be tested again.

We are approaching another moment of truth for the economy in June when both the federal government and the Federal Reserve will be removing a significant amount fiscal and monetary stimulus. The Republicans in Congress are pushing their austerity budget and the Federal Reserve is expected to bring its experimental drug program called QE2 (their second quantitative easing program) to an end.

The big question is how will the economy react? Will it continue to grow at a moderate rate or will the symptoms of the debt illness reappear and cause concerns for future economic growth as it did about a year ago? In addition, what are the possible side effects, if any, of Dr. Bernanke’s QE treatments?

The fast and furious stock market rally since last August has made people forget that the U.S. is still ailing from a disease caused by an overconsumption of debt. It took many years of bad living to get our country into this unhealthy condition and it will take years to recover. This means that the economy will not be growing as rapidly as it would if it was in a healthier state. It is also much more vulnerable to other challenges down the road.

The economy needs to grow at a minimum growth rate of 2.5 percent just to keep the number of unemployed from rising. We saw the growth rate rise above that to 2.7 percent in the fourth quarter of last year and it looks like it should remain above 2.5 percent for at least the first half of 2011.

Oil and agricultural prices have also jumped making driving a car and heating a home much more expensive. It is also putting pressure on profit margins as costs are rising faster than retail prices. This has reduced the wealth-effect somewhat from the rising equity prices. These are some of those unfortunate side effects of QE2.

There is no doubt that the economy has recovered and is growing. Many U.S. companies have begun to hire. The confidence of small businesses is at the highest level in three years. Their hiring plans have increased to levels last seen in September 2008.

The unemployment rate fell to 8.9 percent in February and some of that was because many people left the labor market. However, we are also seeing an increase in employment. We would expect to see employment increase by an average of 200,000 or more in the months to come.

Retail sales have been increasing better than I expected. They grew by 1 percent in February, with most of that coming from auto and gasoline sales. Excluding those categories sales still increased by 0.6 percent versus sales in January. Despite the significant increase in February, however, most economists believe inflation-adjusted consumer spending for the first quarter will not be as strong as the 4.1 percent rate in the fourth quarter of 2010.

Part of the reason for the slowdown in spending is because real consumer income growth has been slightly negative in the first quarter. The high unemployment rate is keeping average wage increases below the rate of inflation. Credit card debt continues to decline, however, people are taking on more non-revolving debt like auto loans, which is helping the auto companies.

So more people are working, earning money and spending it. In addition, banks are lending more to people and businesses with good credit ratings. It looks like, at least for now, there are enough vital signs of sustainability to believe the economy will continue to grow. The questions are, at what speed and for how long?

I am concerned that the stock market has assumed that the economy is in better shape than it is. It does not seem to be worried about the massive amount of debt and deficits that the United States must deal with. It is not concerned about the effects of rising energy, food and other commodity costs on profit margins and family budgets. And what about the affect of rising interest rates on the deficit?

I am worried about these things so I will continue to closely monitor those vital signs of sustainability, especially over the next six months.

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