Markets at the Crossroads?

Robert Johnson

Sometimes a couple of simple questions are all that's necessary. Is Fed policy easy and is fiscal policy stimulative? If so, I'm jumping in.

The economy has come through a period of unprecedented robust fiscal and monetary policy, necessary to extricate an economy mired in quicksand and sinking up to its eyeballs in the Great Recession of 2008. On the fiscal policy front, payroll taxes were cut, the Bush tax cuts extended, and the Federal deficit pumped up to $1.4 trillion. Not long ago, economists pulled their hair out over $600 billion deficits. Times have changed.

On the monetary policy front, short-term interest rates were cut to zero and two episodes of quantitative easing carried out. This amounts to  nothing more, of course, than printing money which has always ended badly when carried to an extreme.

On the international front, the dollar has imploded, thereby lowering the price of U.S. goods on global markets.

Cheered on by Fed Chairman Bernanke, the market has embraced it all. Stocks have been on a moonshot since 3/2009, and over the past 12 months the S&P 500 is up more than 26%. Last week, markets were even reminded of the dot.com era with the LinkedIn IPO.

Much of the above is viewed by many, especially Fed Chairman Bernanke and Treasury head Geithner, as highly successful policy.

Now, however, markets are approaching a cross roads reminiscent of Blues great Robert Johnson's journey-- although there is likely to be no pact with the devil this go around.

Although jobs are finally being added at a meaningful rate, inflation is picking up and the citizenry is clamoring for Washington to get its spending under control amidst wrangling over the debt limit.  The Fed has an exit plan, at best viewed as shaky, that necessitates wrapping up its money-printing binge and raising short-term interest rates. The dollar has shown signs that it wants to rise.

The question turns to whether the economy has its sea legs  and can take it from here. The problem with artificial stimulus is that there always comes the point where it should be reversed and needs to be paid for ( for members of Congress - this means chronic deficits lead to a day of reckoning); and when it is reversed, it is a tightening. For example, if you pass a temporary tax cut and you want to reverse it, it then becomes a tax increase. The Fed increasing the fed funds rate (expected in 2012) will be viewed as a tightening.

To say the least, it will be interesting. Most economists predict GDP growth north of 3% for the balance of the year following the surprisingly weak first quarter report that is expected to be revised upwards. Most observers put the market P/E ratio at slightly on the pricey side. It is important that investors have a well thought-out asset allocation plan to ride out the potential  choppiness.