Government policy and financial markets have a rather strange relationship. Sometimes the markets are highly reactive to policy; while other times it seems as if no one on Wall Street reads a newspaper. The Reagan administration is one example from recent history where policy had little impact on the markets - mostly because the policies coming out of Washington were centered on the idea of not interfering with the private sector.
This is hardly the case at present, however. Instead, Wall Street reacts almost daily to any bill, executive order, or rumor coming from D.C.
Unfortunately, it is policy that has caused the economy to slow back down in recent months, and for the financial markets to enter a lull as a result. Since the end of April markets have fallen roughly 7%, and despite a recent rally, the correction looks poised to continue.
In fact, we expect the market's troubles to continue until there is a definite shift in policies coming out of Washington.
Few realize that, though stocks have rallied more than 80% since their post-crash bottom in March of 2009 (with only one substantial pullback roughly twice the one we're now facing), there are some serious fundamental problems with this economy and the markets, most of which can be traced back to poor policy.
Though stocks have rallied over the past 27 months as corporate earnings have recovered, investors have lost motivation to push money into the markets - or even keep it there - as little of those earnings have been transferred to equity stakeholders. In short, investors haven't been compensated for the risks they've taken in the markets.
When an investor buys a bond, they are lending money to a corporation in exchange for interest; when they buy stocks they're purchasing shares of a company's future earnings.
Over the past two years, though stocks have made substantial gains, Americans' interest income has remained completely flat - mostly thanks to the Fed continuing to keep interest rates inexplicably low. As for stocks, dividend income paid to Americans has made very little recovery since March of 2009.
According to the St. Louis Fed, personal income receipts on assets have risen only about 8% since the market bottom in March of 2009, while stocks have risen more than 80%. It's simply unreasonable to expect investors to continue supporting the markets without adequate compensation for the risk they assume in doing so.
That's not to say that many of these fundamental flaws couldn't be corrected with some sensible policy. Quite the contrary, the US economy is currently positioned to experience growth not seen since the early 1980s. Unfortunately, the Obama Administration seems totally unmotivated to make the necessary changes, and will likely snatch defeat from the jaws of victory, as the saying goes.
[For more on these issues, please see Obama and the Anti-Investor Class, recently published on BigGovernment.com.]
Another factor weighing on the markets as of late has been the financial turmoil in Europe, especially Greece. It should come as no surprise that a bailout is in the works; as we discussed on CNBC's The Kudlow Report, bankers always bail each other out. While the potential bailout is no surprise, it's also no solution.
The realization has been quickly spreading that a bailout of Greece will not make the country anymore viable in the long-term. At this point, the only way for Greece to get its house in order is to go through some sort of structured default.
While the situation in Greece continues to deteriorate, the US and the dollar continue to look better and better. For the most part the critics, who, after the financial crisis, had pushed for abandoning the dollar as the world's reserve currency, seem to have been silenced.
In the long-run we expect the turmoil in Europe to bode well for America and the US dollar, though this should come as no surprise to long-time readers, who are no doubt aware of our long-term bullishness on the United States as manufacturing comes back from overseas.
The problems facing Greece also remind us of an extremely important lesson for investors to always know what it is that they own and what risks they face, or at least employ a sensible advisor who is aware of these things. With Greece possibly in the midst of a default, many investors are just now beginning to realize that they have exposure to the country, and may be at risk in the event that a default actually occurs.
As headlines continue to come out on the economy, policy in Washington, and the problems in Greece, it's important to take market action over the next several weeks with a grain of salt. We are quickly approaching the end of the second quarter, and as such are likely in the midst of profit-taking and, more significantly as recent market action hints, portfolio "window dressing."
(To recall, "window dressing" occurs when portfolio managers purchase investments that have performed well over the quarter in order to give their clients the idea that they know what they're doing.)
In short, whatever stocks do between now and the end of the quarter means little or nothing for the long-term prospects for the market.