Understanding the U.S. Election Stock Market Rally

By: Money_Morning

Michael E. Lewitt writes: The week was dominated by the mid-term elections that produced a sweeping victory for Republicans. Whether this will translate into meaningful economic policy initiatives remains to be seen, however.

The Republican agenda includes the Keystone XL pipeline, corporate tax reform, lifting trade barriers, peeling back the Affordable Care Act and potentially making some changes to the Dodd-Frank law.

The most likely areas of movement appear to be corporate tax reform and trade, which enjoy bipartisan support and could help boost economic growth.

Markets celebrated the election results, which were widely forecasted, and could now see a nice run through year end… 

By the Numbers

The Dow Jones Industrial Average rose another 183 points or 1% to close the week at 17,573.93 while the S&P 500 added 15 points or 0.7% to finish at 2,031.92. Both levels were new closing highs. The Nasdaq Composite Index was roughly unchanged at 4,632.53 as was the small cap Russell 2000 at 1,173.32. Optimism among individual investors hit its peak for the year as 52.7% think stocks will rise over the next six months according to data from the American Association of Individual Investors. 

On Friday, the government reported that the economy added 214,000 jobs in October, 21,000 less than projected. Revisions to the two prior months' figures were +31,000. The unemployment rate is now 5.8%, a six-year low.

The household survey showed a big jump of 683,000 jobs which was only partially offset by a jump in the labor force of 416,000. The all-in rate (U6) fell to 11.5% from 11.8% and it appears that the excess supply of labor is shrinking fast, which is consistent with the Fed's policy statement after its most recent meeting.

The labor force participation rate ticked up by 0.1% to 62.8% but just above the lowest level since 1978. The take-away from this report (which included a revision of the August report that shook markets back above 200,000 new jobs) is that the economy is growing sluggishly and continuing to add about 200,000 jobs each month, which bodes well for stocks until something comes along to stop this momentum. The most likely candidates for such a disruptive event are a further drop in oil prices or an unraveling of the Japanese or European economies. The U.S. economy appears to be on a steady course for the foreseeable future.

The irony of the market's reaction to the mid-term elections is that the electorate effectively repudiated the very policies that have driven stocks to record highs over the past several years.  Federal Reserve policy has consisted entirely of creating a "wealth effect" whereby lifting the stock portfolios of the top 1% would theoretically result in job and wage growth for the remaining 99%.

Of course, nothing of the sort has occurred. Instead, wage growth has stagnated and while unemployment has dropped significantly from the depths of the financial crisis, there are still 92.4 million Americans outside the labor force and the labor participation rate is hovering at a 36-year low. Even the hedge funds in which the 1% invest their money are grossly underperforming the levitating stock market as their managers struggle to understand the disconnect among policy, the economy and markets.

What is missing from the public debate is an urgent discussion about the need for policies capable of generating the confidence needed to lead businesses and individuals to invest in long-lived productive assets. Instead, politicians and central bankers complain about increasing wealth inequality without acknowledging that their own policies are responsible for exacerbating it.

The repudiation of the Obama agenda was also a rejection of the economic regime of the last six years. And that regime includes not only Obamacare, which has rendered healthcare both less affordable and more of a bureaucratic headache for most Americans, but a less prosperous and less egalitarian society.

The question for both parties is whether either of them can articulate a vision that explains to the American people the types of concrete policies that can create economic growth and opportunity. The Republicans now have the chance to grab defeat out of the jaws of victory if they fail to build on their substantial gains among traditional Democratic constituencies, and the Democrats have an opportunity to reclaim victory out of the mire of defeat if they can recapture the political debate on key issues like immigration, healthcare and jobs. They also need to toss aside their phony "war on women" meme and focus on real issues that mean something to the majority of the electorate instead of buzzwords that sound good to minority voters who are the primary victims of their misguided economic policies.

Foreign Economies Inch Toward the Debt Trap

In the meantime, the U.S. economy is operating in a globalized world in which European and Japanese central bankers are now committed to following the same policies that failed to produce sustainable prosperity in the United States. Last week, ECB President Mario Draghi promised to add €1 trillion to the ECB's balance sheet over the next 12-18 months in an effort to battle the region's economic malaise.

This followed similar promises from the Bank of Japan to purchase the equivalent of $720 billion of Japanese Government bonds plus additional billions of dollars of REIT stocks and ETFs in an effort to revive Japanese inflation. Both regions are facing intractable demographic and structural problems that render economic growth nearly impossible to achieve, particularly in the absence of fiscal reforms. Nonetheless, monetary authorities will do what they can to stimulate growth and in the process export deflation and low interest rates to the rest of the world, including the U.S. 

These moves by foreign central banks have major implications for U.S. investors. In addition to driving down the value of the euro and the yen against the dollar, they will keep global interest rates low for a prolonged period of time. Further, the enormous volume of debt that has been created globally over the last six years has now become a deflationary force. Conventional economic thinking teaches us that massive money printing should lead to inflation. It is time to throw that line of thinking out the window.

So much debt is now weighing down on the global economy that economies can no longer grow near their potential. As a result, debt has become deflationary rather than inflationary, which explains why interest rates in the U.S. have surprised many people by remaining low in 2014. They are likely to remain suppressed for many years to come until the world experiences another debt crisis.

Many observers now expect the Fed to start raising the Federal Funds rate in mid-2015. This expectation was reinforced by the improving headline jobs numbers, which led to Treasury futures moving up the date at which they are forecasting an interest rate increase next year. 

Official inflation figures remain very subdued, however, and may lead the Fed to wait longer than the market expects. Regardless of when the Fed moves, it is likely that any interest rate increases will be extremely slow in coming.

The impact of higher rates on the economy as well as the federal budget would be devastating if the current slow economic growth is any indication of the effects of the global debt binge on the global economy.

Source : http://moneymorning.com/2014/11/09/understanding-the-election-rally/

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