Two years ago we summed up the first three years of the Obama Administration by comparing it to the movie "Groundhog Day." It's hard to believe Washington still is frozen in time. But here we go again. The Federal Reserve kept its printing press running longer than usual on this go around. The bell finally has tolled, though. Commodity inflation is beginning to gain momentum. Monetary policy has begun its pendulum swing in the other direction. At this stage in the economic cycle that normally would be a positive development. Rising prices would signal a pick-up in production, wages, and well-being. Real output is not expanding, though. This is the fourth time the Fed has withdrawn its quantitative easing activities since the economy collapsed in 2008. And it will be the fourth time it's done so without anything to show it. (Except $2.5 trillion in excess bank reserves, which nobody knows what to do with.)
Washington implemented a crackpot stimulus plan in 2009. It didn't prime the pump. The spending went into pet projects instead of tried and true building blocks like highway and airport construction, investment credits, and employment incentives. It's understandable that the Obama Administration paid back its supporters, having just won the election. Once those gifts were handed out, though, it needed to get serious. Regrettably, the pet projects have continued. The Federal Reserve has been hung out to dry. There is no fiscal plan to put all that money to productive work. Here we go again.
The stock market has seen the handwriting on the wall. In January we pointed out that biotechnology and new age software stocks were trading at elevated levels, fueled by Benjamin Bernanke's easy money. The business fundamentals weren't there to support those valuations in the event the cash was removed. In fact, the punch bowl hasn't been taken away yet. The Federal Reserve is continuing to buy $55 billion of bonds every month. The plan is to reduce those purchases over the rest of 2014, though. Wall Street wasn't sure how to respond the first three times that happened. This time it knows what to do. It's selling.
Most market experts predict the pullback will be contained to the high fliers. That could be an optimistic view of things. Earnings and sales have stalled in the March quarter. The weather may have contributed to that. But things aren't picking up that much. Low interest rates probably will support equity prices even if earnings growth flat lines in upcoming periods. But P/E multiples in general are at the high end of their historic range. If investors conclude that Quantitative Easing alone isn't capable of fueling a rebound -- ever -- those valuations may come down. The stock market won't "look over the valley" if all it sees is an endless plain.
"The business of America is business." Today the Government is interfering with that. Pockets of innovation always spring up in this country, though. Energy, medical technology, software, and industrial automation are creating a better life despite the obstacles of regulation, taxes, and ineffective programs. Companies with unique products and services can succeed in virtually any environment. Our advice is to remain invested in a diversified portfolio of Special Situation stocks. Let us worry about the general market.