There’s an old saying on Wall Street that the market will always act in a way that frustrates the majority of market participants. If that is true, then it goes without saying that the majority must be bearish because this market has had ample opportunities to move lower and steadfastly refuses to do so. Coming into last week the conventional wisdom was that the Fed and ECB – particularly the ECB after Draghi had thrown down the gauntlet – had to do something dramatic or the undertow of lousy fundamentals would finally pull the market into the maw of the bear. Well, the Fed did nothing, the ECB did nothing and the bears are still scratching their heads wondering why this thing won’t cooperate and just go down, damnit.

Based on the details of that report though I wouldn’t get carried away on the bull side of the argument. The US economy is still weak and the employment report offered little solace. While the headline number was better than expected, it probably didn’t escape the notice of the President’s campaign team that the unemployment rate ticked up to 8.3%. The household survey, from which that rate is derived, contrasted sharply with the establishment survey, from which headlines are derived, showing 195,000 fewer people working last month. There are now fewer people working than in May and the number of unemployed is now up 3 months in a row. It has been my experience over the years that the household survey tends to lead at turning points so this is definitely not good news and bears watching closely.

But markets don’t really move on actual data; they move on expectations and last Friday’s move up in stocks was merely a reflection of the extreme negative sentiment that has pervaded this market for months. We actually had several better than expected economic reports last week – personal income, Case Shiller home prices, Chicago PMI, consumer confidence, jobless claims and the ISM non manufacturing index were all better than expected. There were also some reports that didn’t meet expectations, most prominently the ISM manufacturing index and factory orders, but overall expectations may have overshot to the downside. I certainly don’t think the economy is improving much, if at all, but it does seem to be doing better than expected and that is enough – for now – to keep the bears in their place.

The market is also bucking the consensus and having a pretty good year so far. Wall Street’s crystal ball gazing strategists are as bearish as they’ve been since the mid 80s and doing the opposite of what that crowd recommends is about as reliable a trading strategy as I’ve ever come across. Individual investors have largely abandoned stocks for bonds and mattresses but those who remain are still largely bearish on the stock market as a whole. The only kinds of stocks they seem willing to buy are the dividend paying sectors such as utilities, REITs and the defensive sectors like drugs. In fact, they’ve been buying so many of them that I’d venture to say the lot of them is overpriced and not worthy of the marginal investment dollar. I don’t know when all these yield chasing investors will get burned but singed they will be.div

Unfortunately, better than expected does not mean good  and I think there is a limit to how much the economy can improve and therefore how high the stock market can go. The rally Friday was accompanied by a lower dollar and higher commodity prices, the exact opposite of what I would expect at a true turning point for stocks and the economy. The fact is that it will take some pretty radical changes in our political economy to produce a durable and robust expansion. Based on what I read from Glenn Hubbard in last week’s Wall Street Journal about Romney’s economic plan and what we already know about President Obama’s economic approach, this crop of politicians isn’t up to the job.

The market’s emphasis on monetary policy is a reflection of the sorry state of the rest of the policy making apparatus. Market participants, like their political counterparts, know that monetary policy can induce economic activity in the short term – money is not neutral over the short run even if it is over the long run – and care little whether the activity is sustainable. There is this notion that if we can just get the economy up to escape velocity, it will somehow magically return to the 3% + growth rate to which we’ve become accustomed. I don’t think that is true in the current circumstances – if it ever was – and I think we are nearing the point where further monetary expansion just gets us more inflation. The era of monetary activism is what brought us to this point and only less activist policy can get us out of it. If anything, Draghi seems to understand this better than Bernanke. By refusing to move on bond purchases last week, Draghi kept the pressure where it belongs – on the politicians who need to reform the real economy.

We are reliant on monetary policy because the fiscal and regulatory policy making apparatus is paralyzed and as last week demonstrated, monetary policy is nearing that point too. The Fed is tasked with the dual mandate of inflation and employment but in the long run can only affect the first. Policy cannot target two variables and right now it seems obvious that even if the Fed could focus on the second it would come at the expense of the first. One of the areas where I agree with the market monetarists is that NGDP targeting would require monetary policy to target one variable that is within its means. By maintaining a constant rate of NGDP growth, real growth and inflation become a consequence of either fiscal and regulatory policy or the natural ups and downs of a capitalist economy. There are still plenty of problems with the regime – what NGDP target do we choose and how do we know we’re hitting the target? – but it would be a vast improvement over what we’ve had for the last 40 years.

Last week’s stock market rally does not signal that the economy is out of the woods. This is just a cyclical bull market in the context of the ongoing secular bear we’ve been in now since 2000 and at some point it will turn into another bear phase. I don’t think we’re there yet, but absent better policy, it will come. A new secular bull market will come only when we get better economic policies that affect real growth. I won’t bore you with the details of what I’d like to see since it isn’t likely to happen but the basic formula for all policies is that they be simple and fair. The market will tell you policy is improving when stocks and the dollar rise while gold falls. This isn’t the rally we’re looking for.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or  786-249-3773.

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