What We Can Learn From The Stock Market Isn't All Financial, Nor What The Headlines Tell Us

The stock market is not the economy, as some neophytes might assume. If it's up, it doesn't mean we're doing well; if it's down, it doesn't mean we're not. Rather, it is a survey of the economy and its future, as the profitability and expansion trends (or unprofitability and contraction) of publicly traded companies in all sectors of the economy are monitored. It's a pretty good gauge of how our nation is doing financially as well as its prospects. In fact, markets are nothing more than people and how they react is a telling not so much of the current, but a foretelling of what they expect in the future. It's called investing after all, not purchasing — which is in, and for, the moment. So, it's with much perplexity that people look at the Dow Jones Industrials, the S&P 500, the New York Stock Exchange and the Nasdaq and wonder what exactly is going on these days. The political implications for the fall campaign are enormous. When the stock market goes up, those invested, at least 60 percent of the country (not only the "one percent"), feel wealthy — perhaps wealthier than they actually are — and spend more. A rising stock market signals not only corporate profitability, business investment, economic expansion and job growth, but may propel actual consumer spending. When this happens, prospects for incumbents (presidential and congressional) improve.

Of course, the larger factor determining the "wealth effect" is the value of one's home, the largest single investment most people ever make. This only adds to the schizoid nature of the economy now: The market is up (kind of, despite the hyperbole of its March rally as we'll see below), while home values in many parts of the country remain in the tank.

Kent Engelke, one of the country's best known market commentators and chief economic strategist at Capitol Securities, a Richmond-based investment brokerage firm with offices throughout the East, has brought some clarity in his daily commentaries this week, breaking through the media's contrived euphoria. (Not for the first time do we quote Mr. Engelke's expertise. Earlier this week, Brendan Conway of Barron's Focus on Funds blog quoted him as did Jonathan Cheng at the Wall Street Journal.)

On Wednesday, Mr. Engelke wrote this in his daily commentary:

I have penned many times I believe society and the economy is undergoing a tectonic change, a change where the country is reverting back to its core culture and beliefs. Change is always difficult for the outcome can be unquantified thus creating market volatility. All must remember the market is a microcosm of every variable in society, variables that today change daily regarding their degree of significance.  ...

In other words, he sees a return to a more traditional America, which doesn't foretell an Obama re-election. Who said the culture and the economy are not interrelated? As to the actual economic nature of current market trends, as much as the administration and its Chief Financial Flak at the Treasury Department try to make of the market's current rise, take this in:

Bloomberg states more than 82% of companies that have reported quarterly results since April 10 have topped estimates. ...

Equities are valued by corporate cashflows discounted by a risk free interest rate. Earnings are at a record. Interest rates are at a record low. Hypothetically stocks should be at an all time high but it is clearly evident the lack of confidence is prohibiting such an advance.

While Mr. Engelke doesn't see a massive decline unless there is an absolute catastrophe in Europe, China or the U.S., today, he expounded upon the reason why cash is sitting in banks, losing money at negative interest, rather than invested, and what will happen when confidence returns:

I have written at length about the lack of confidence in our elected leaders. Can I remotely suggest there is the lack of confidence in the analysis or the reporting of data partially predicated by the fact other than the few who were then viewed as outliers did not see the 2008-09 implosion brewing?

Speaking of missing a potential major outlier, there has been little discussion of today’s massive cash balances. As I have penned a gazillion times excess bank reserves are over $1.5 trillion versus the historical average of $1 to $2 billion. Based upon Federal Reserve statements these funds will earn close to nothing for another 2 ½ years.

When inflation is factored in, the real return is a negative 2.5%. If the inflation rate stays at this level, these funds would purchase 6.125% less goods by the time the fed alters its monetary stance.

A similar conclusion can be made with the massive cash hoard of the S & P 500 companies, an amount totaling over a record $2.1 trillion as per recent Fed data. Depending upon the source cash balances are historically around $600 billion.

In other words there is $3.7 trillion or about 25% of annual GDP generating a negative real return. Economics 101 dictates cash gravitates to the highest and most productive use. It is one of those non debatable rules similar to day always follow night.

I will continue to argue once confidence rises and the outlook regarding regulatory and tax policy is quantified, these funds will be utilized in a more productive manner. It is the proverbial extremely dry kindling that will eventually ignite.

It's amazing what the stock market can teach us. It's not always what we think and those numbers on the screen with red and green arrows next to them rarely tell the story. What many have been trying to say, and what Mr. Engelke demonstrates, is that the marke's recent run-up is more of a natural correction based on, if anything, anticipation of a political change, reflective of the gauge that is millions of people participating in the markets. It's current leveling is actually a negative because given the massive liquidity on the sidelines, between bank reserves and corporate cash that would be otherwise put to work increasing their value, are sitting in record low interest bearing accounts which generate negative returns when factored for inflation. That's a lot of devaluation, even in the age of the devalued president.