Dow 14,000 Causes Stimulus Concerns

Recession? Really? If you have been following the Dow Jones Industrial Average’s remarkable rise out of the darkest depths of the financial crisis in the spring of 2009 until today, you could be forgiven for questioning whether the U.S. economy has been in recession at all.

The Dow closed the first day of February, 2013 above 14,000 for the first time since October 12^th, 2007. In fact, the Dow was just a stone’s throw away from its all-time high of 14,146.53 just a few days before that.

On the first Friday of February, 2013, the jobs number was dressed for success with 157,000 added in January. Over 1 million car and light truck sales proved the auto industry’s engine is in gear. And with a PMI of 55.8, solidly in expansion territory, even manufacturing is making something of itself.

The U.S. economic juggernaut may be sailing through some very rough seas, but it’s clipping along at a nice pace.

And stock indices are not the only beneficiaries of a strengthening U.S. economy; commodities are being lifted too. Nic Johnson, commodities money manager with Pacific Investment Management, believes the multi-year run in commodities will continue.

“Improving growth prospects,” he explained in an email to Bloomberg, “are clearly positive for commodities and will help returns, which should also reinforce flows into the asset class.”

But some are voicing concern that stock and commodity prices do not deserve to be where they are and may soon return to lower levels. Frank Fantozzi, president and CEO of Planned Financial Services, told USA Today his firm is being “very cautious now”.

“If we get zero GDP growth in the January through March quarter,” he explained, “there is no way the Dow will still be at 14,000,” adding there exists the possibility of a 3 to 5% correction.

Why this a concern? Because an economy as robust as is depicted by Friday’s reports may begin opening the door to inflation.

A rise on Friday in 10-yr treasury yields to 2.01% shows that the market is expecting a little more inflation further ahead, which may prompt the Federal Reserve to take its foot off the accelerator and begin curtailing its four-year long economic stimulus measures.

Keep in mind, though, that the Fed has repeatedly stated it will tolerate some inflation, up to the 2% level. Even so, many are beginning to wonder… now that some inflation, however small it may be, is close enough for bond traders to take notice, how much longer can the Fed’s stimulus really last?

More importantly to stock investors, are the U.S. economy and stock prices sound enough to keep trucking without the Fed’s help? Or will inflation come too soon, forcing the Fed to tighten sooner than expected, before the economy is strong enough to make it on its own?

The president of Springer Financial Advisory, Keith Springer, put it bluntly when he said to CNBC, “We’re screwed.” He explained, “This has been the trend for the last 20 years. We have a crisis, build a bubble to get out of it for five years, the market makes a slight new high, and then we crash.”

Others, though, like Lawrence Creatura, strategist and portfolio manager with Federated Clover Investment Advisors, are more confident that current market levels are indeed well supported by solid fundamentals.

“It’s more than just the Fed,” said Creatura to CNBC. “Stock market indices are where they are today because they’ve earned it.” He reasoned, “There hasn’t been a lot of multiple expansion. However, there has been a lot of earnings growth since the troubles of the financial crisis.”

Whatever the result of the weaning process – whether markets crash for lack of stimulus support or they continue to soar on the back of a real growing economy – both sides seem to have increased their expectations of changes to monetary policy sooner than previously thought.

But another number also out February 1^st says, “Not so fast.” That number is the still-high unemployment rate of 7.9%, up from 7.8% a month earlier, and it is not giving the Fed the green light for ending stimulus or raising interest rates just yet.

Let us remember the Fed’s recent press release of December 12, 2012, which outlines three conditions that must be met before the Fed starts making changes to its current monetary stance…

“In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

Regarding condition one: Friday’s unemployment rate is at 7.9%; regarding condition two: the latest U.S. inflation rate is still at 1.7%; and regarding the last criterion: it is the 10-year treasury whose yield has reached 2.01%.

So far, so good. It seems the Fed is managing pretty well at keeping this giant walking upright. But all eyes should be watching inflation, as it can – without much warning at all – force the Fed’s hand to move with a jolt rather than with ease.

With unemployment still causing the U.S. economy to limp on one leg, any sudden jolt to the system from a sudden change in monetary policy before that leg is fully healed could cause the giant to take a nasty fall.

And you know the saying, “The taller they are, the harder they fall”? Well, the Dow has only once before stood as tall as it does now. And it fell pretty hard the last time it was here.

Even so, despite healthy corrections in both stocks and commodities from time to time, until the Fed explicitly indicates changes to its policies, the U.S. dollar will continue to weaken and cheap money will continue to grease the turbines.

For the time being, it is still full steam ahead.

Joseph Cafariello