Thoughts From Joe - May 10, 2013May 10, 2013 Posted by: Joe Morgan, CFA
TFJ is taking a few weeks to explore the European situation up close and personal. From the land of sequester to the land of austerity! We will return June 7.
Steppin’ OutThe Permanent Income Hypothesis
The Permanent Income Hypothesis states that in order for increased wealth to drive increased consumption and investment, people need to believe the wealth increase is permanent rather than temporary.
This is the Fed’s primary challenge concerning the stock market.
The Fed’s QE3* (or QEternity as some call it) pumps $1 trillion into the markets each year. That equates to about 6 percent of total stock market capitalization, meaning if all those funds go straight into the stock market, valuation must rise by at least 6 percent (likely more due to the multiplication and crowding out effects).
But the challenge this has translating to economic activity is two-fold. First, creating higher asset prices does not directly translate to higher wealth for all Americans. And second, they can turn off the spigot anytime they want.
As a result, today’s market levels are seen to be falsely supported by the Fed’s actions and therefore are not leading to a long term shift in economic behavior.
One way to see this is looking at the sector performance within the stock market which shows defensive stocks leading the way and cyclical stocks dragging performance. This should never be the case in a healthy, long-lasting rally.
But before you think about shorting this market, consider the Fed has an open checkbook and can play the QE game for a very long time. Or as one of the long time Wall Street maxims states: “The markets can remain irrational longer than you can remain liquid.”
*Quantitative Easing (QE) was enacted initially to combat a fear of deflation but given QE3 was enacted when no such fears existed, it seems obvious its purpose has now shifted to supporting the equity markets.
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