Streetwise

Lauren Rudd

Sunday, July 3, 2011

Summertime Once Again

It is summertime once again and the living is easy...or at least it used to be. The fourth of July is the unofficial start of the beach and barbecue season. It is also when everyone asks the same question...is a summer rally in store for the stock market?

Statistically, July is the best month for stock prices in terms of percentage gain. Furthermore, the Dow Jones industrial average has rallied during 59 of the past 66 summers. And the preponderance of data indicates that there are seasonal quirks within the markets.

Of course, if you subscribe to the theory that the stock market represents a series of independent events, then a rally has exactly the same statistical probability as no rally. At the same time, there is no doubt that the annual expectation of a summer rally is partially the byproduct of the fiction and fantasy that always seems to envelop Wall Street.

At its worst, the folklore simply contributes to the market's overall mystique. Yet, long-time observers of the stock market are willing to concede that the stock market does exhibit seasonal tendencies.

Of greater significance is that Wall Street is considered to be a forward looking indicator for the economy and currently, the latest rally aside, the financial markets portend potentially difficult times ahead. One quandary is the high level of unemployment and its symbiotic sister, consumer demand.

Adding to the severity of the problem is the apparent disdain both Congress and many State legislatures have for the plight of the unemployed, as evidenced by the reduction of extensions in states such as Florida. One repeatedly voiced undercurrent of concern is that providing extensions restrains incentive and therefore magnifies and sustains the level of unemployment.

Not true. A study by the Federal Reserve Bank of San Francisco showed clearly that the absence of extended benefits does not reduce unemployment and providing benefits does not encourage people not to work. By reducing benefits you are merely piling additional pain and suffering on those already facing severe economic hardship.

So what about that nettlesome inflation issue? Ever since Milton Friedman wrote in 1963 that "inflation is always and everywhere a monetary phenomenon," central bankers have been on notice that excess printing of money jeopardizes their guardian legacies.

No argument. However, despite the degree to which the Fed has added to its balance sheet, the net result has merely been a dramatic increase in excess bank reserves. As Richard Koo so carefully elucidates in his book, “The Holy Grail of Macro Economics,” we are facing a balance sheet recession. Specifically, the private sector is immersed in balance sheet repair by decreasing leverage, meaning reducing debt.

With the demand for borrowing diminished, low interest rates become immaterial. Therefore, to stimulate economic activity the government must continue to put borrowed funds to productive use (military conflict does not qualify). To do otherwise would mean a reoccurrence of the same trap that Roosevelt fell into in 1937 and Japanese Prime Minister Ryutaro Hashimoto in 1997.

Those who worry about inflation and excess government spending do not fully grasp the ramifications of the problem. Deleveraging is good for the long-term health of the economy. In the short-run it impairs consumer spending, which accounts for about two-thirds of our gross domestic product.

Despite comments from a certain members of Congress, a dramatic reduction in government expenditures at this time will not extricate the economy from its current malaise. Instead, it will likely only aggravate the situation. There will come a time for fiscal restraint but now is not that time.