Is Confidence Returning?

Stock market history can be very useful as a guide in developing portfolio strategy, but it should never be used as a precise predictor of the future.  It repeats itself, just not in the same way or at the same time.  In 1990, the S&P declined over 20% in the weeks following the invasion ofKuwaitbyIraq.  But it did not rally in 1991 until it became clear to investors that the coalition forces would be successful in turning back the Iraqi invaders.  The S&P increased by 18% in just three weeks following the market low on January 15,1991.  This time investors did not even wait for the war to start.  In the past seven days the S&P 500 and the Dow Jones Industrials indexes have risen over 5%.  Global markets are reacting positively as well. 

While today’s circumstances differ from the last major U.S .military conflict of twelve years ago, generally, history is repeating itself.  Investors believe stocks are artificially cheap and that the economy stands a better chance of recovery once the outcome inIraqis known.  The looming conflict has put immense pressure on the relatively fragile optimism that was building for the economy.  Purchase decisions have been put off at every level, from consumer spending to business capital investment.  It remains highly likely that planned spending will resume as the Iraqi uncertainty diminishes.

The foundation of our economy is solid.  Unemployment, while up in the last couple of years, is not high by historic standards.  We remain at levels labeled ‘full employment’ by Fed Chairman Alan Greenspan as recently as five years ago.  Interest rates are at historic lows, keeping consumer loans, credit card rates, and home mortgage rates affordable for many new consumers.  The low rates combined with stable employment for most, keeps money in consumers’ pockets.

Business spending, in recession for eight months, will likely improve going forward.  One key reason is that business inventories have reached historic lows.  If sales simply hold at current levels, inventories will soon have to be replaced.  That replacement cycle will help manufacturers and importers increase their business, giving them the confidence to hire and to add capacity.

But the majority of our economy is service based.  Service companies focus their capital improvement spending on technology.   The recently released gross domestic product numbers showed rather significant up-ticks in the purchases of computers and software by these companies.  Improvement in this vital area of our economy has already begun and will likely increase as the ‘war’ shackles are loosened.

The negative impact of the war buildup on the economy was clearly demonstrated in two Fed reports released this week.  The Empire Manufacturing Index, which represents manufacturing in the state of New York, fell by 2.5% in February for the first time since October of last year.  Economists blame much of the drop on the war uncertainty.  The Philadelphia Fed report, released yesterday, tumbled an even worse 8%.  The drop was the first in five months and placed the index at its lowest point since December 2001.  A negative reading in both surveys indicates that business deteriorated during the month, not surprising given the intense war coverage and global division over the best way to deal with Saddam Hussein.

Inflation is NOT a problem for this economy.  Consumer price information was released this morning and it revealed that for the past twelve months, with food and energy removed, we have had the smallest increase in prices since March of 1966 (37 years ago).  The energy component of CPI obviously inflated the headline number to 3%.  The combined effect of the Venezuelan strike and the Iraqi war premium has sent oil prices spiraling to historic highs.  However, sentiment is growing that the conflict in Iraq will be over sooner than earlier feared and oil prices have plummeted in recent days to a low of $27.64 yesterday.

You don’t want to hear my predictions about conclusion or outcome of this war.  There are plenty of retired generals, colonels, and analysts on television for that.  But, I can say with conviction that an incredibly strong U.S. economy lies in wait just beyond the smoke of this war.  Investors are beginning to believe it and are voting with their dollars.  John Chambers, CEO of Cisco, announced a few days ago that his company would add an additional $5 BILLION to its stock repurchase program.  That amount increases an existing $8 billion program.

Now that’s confidence!