On Monday, November 16, the DJIA hovered at 10,427 by mid-afternoon; the highest level in over a year. For those of us in the U.S. with significant equity holdings in our retirement accounts, this is short-term good news for sure. However, before we break out the Champaign, maybe we should pause and consider the longer-term impacts of some of the accompanying aspects of this latest Wall Street rally.
To back track a bit, most investors would agree, that in hind sight at least, the 40-50 percent fall in US equity prices due to the financial crisis was an overreaction. And I do not disagree with this assessment because fundamentals do not change that rapidly. Therefore, this latest equity price run-up could be partly due to a correction brought about by more objective appraisals of true security values. Nevertheless, we should not be lulled into a false sense of security because, to me, there is more to the story.
Much of the current rise in stocks may be directly or indirectly attributed to the weaker US dollar. Companies that sell products overseas are certainly better off, all things being equal, with competitive prices against foreign rivals in foreign markets. Certainly a weaker US dollar promotes this outcome. The same is true for US companies with enterprises that consist for the most part of commodities such as agricultural products, primary energy resources and metals. Again, a weak US dollar makes commodities and their related goods look more valuable. During the last few weeks of October and the first few weeks of November we saw gold trading significantly above $1100 an ounce and crude oil prices increasing to the $70-80 a barrel range. Similar movements took place in many agricultural commodity markets as well.
However, there may be an even larger story. Everyone knows most governments of developed and developing countries have embarked upon aggressive fiscal and permissive monetary policies in order to ease the undesirable aspects of the global downturn. This is certainly true here in the U.S. Unless there are supernatural increases in production, coupled with changes in consumption patterns, it is hard to imagine any scenario, other than immediate, that does not include sustained, stubborn and persistent inflation; regardless of the actions by the Federal Reserve or US Treasury. The state and federal deficits are just too large for any other consequence, unless I am badly mistaken. Forward looking individual and institutional investors may simply be looking to protect future purchasing power by coming back into the commodity and equity markets and bidding up prices in nominal terms.
But what about the more-or-less passive American who is merely looking for improved economic conditions and who is concerned about his or her financial security? Do rising equity markets provide the "all clear signal?" I don't think so. Ordinary Americans may get three percent nominal wage and salary increases, but if inflation averages five percent over a long and protracted period, there will be a severe erosion of their standards of living. At the very least, there will be mounting political pressure to have US elected officials "do something." Unfortunately, even the most gifted politicians may not be able to "do something."
In conclusion, I believe the challenge facing most Americans is to find a way to protect our aspirations and current standards of living from inflation. And, like most professors, I do not have any easy, sure fire answers. Therefore, even with an improving US stock market, now is not the time to let our guards down with respect to our economic futures.