We’ve Seen This Movie Before

The dramatic news on Friday (re Goldman Sachs) has a more narrow impact (directly on Financials) and a far more limited impact on the broad market as the economic recovery and its sustainability are significantly more important to equity prices overall.

The limited broad market impact would be for Financials to begin to struggle and potentially produce a negative contribution to higher prices. However, the likely offset is a rotation away from Financials and into other sectors where less governmental activism exists. This is similar to what occurred with the Healthcare sector, as the debate became law. Healthcare stocks may have underperformed but the overall bull market remained intact. The same is very likely to occur going forward re Financials and the broad market.

Concerns re an activist government (greater regulation, lower profit margins) appear to be somewhat overblown. The Obama administration's axiom – “Don’t let the perfect be the enemy of the good” – demonstrates both a pragmatic approach to issues and no intention of destroying whole industries and the companies within, the histrionics of the right wing opposition notwithstanding. The price that is being asked to be paid (in the form of greater/tighter/smarter regulation) appears to be a very reasonable one given the economic debacle that succeeded the more laissez-faire approach to regulation.

What may be some concern to investors is the masterful manner in which the Obama administration has finessed their opposition. In a series of events that can only be viewed a classic Clintonian, consider what occurred the past week:

• On Wednesday (April 15, 2010), President Obama meets with congressional leaders at the White House to discuss financial regulatory reform.
• Senate Republican minority leader Mitch McConnell (providing an outstanding example of Pavlovian behavior) steps out of the meeting (fresh from his recent sojourn to the titans of Wall Street) to declare that President Obama is on the wrong side of this issue.
• On Friday, the Securities and Exchange Commission charges Goldman Sachs with investor fraud.

At this point, someone needs to hand Senator McConnell a towel to wipe the egg off his face.

This week, more bank earnings results will be reported, including those from none other than Goldman Sachs (Tuesday, April 20th). The results are sure to further inflame the public outcry re bank bailouts and buttress the efforts of the Obama administration and the Democrats to push through financial regulatory reform.

The consequences of a victory in financial regulatory reform will have repercussions in this fall’s midterm elections. Moreover, it is the manner in which Obama handled the Republicans this time around that is yet to be fully digested by most investors (think Bill Clinton and his famous triangulation strategy). It does appear that the Obama administration (and President Obama, in particular) have relocated their political voice and have combined that with a governing style that needs to better appreciated by investors.

Investment Strategy Implications

Right now, what matters more to equities is the global cyclical recovery. The challenge will be whether the economic handoff (from government spending to sustainable private sector growth) can truly occur. That is a question that still remains to be answered. Despite the solid earnings results of 4Q09 and thus far from 1Q10, it is hard to determine whether growth can be sustained without the life support mechanisms put in place by governments around the world. And the growth in debt, the extraordinary and inventive governmental actions (quantitative easing, for example) and the generous amounts of liquidity cannot go on indefinitely.

The longer-term structural problems (e.g. debt levels, consumer demand in emerging economies, imbalanced domestic growth policies in key emerging economies (notably China), the currency straightjacket on weak economies within the Eurozone, among others) along with the aforementioned Obama’s emergent political skill wait in the wings and may become the rationale for the long overdue market correction. These fault lines are to be monitored closely for signs that they will become the focal point for investors. This is where market intelligence earns it pay*.

In the meantime, the excess liquidity and encouraging cyclical growth remain center stage for most investors. A clear case of the cyclical over the secular. Accordingly, there is little reason for investors to move to the sidelines and adopt anything more than a cautiously bullish position. There will come a time for a more aggressively conservative view. That time does not appear to be now.

*The absence of traditional investors is also a worrisome sign as trading continues to be dominated by the fast money crowd. More on this in a future posting.