Stay Defensive

Confidence in the economic recovery is improving, and retail investors are moving back into equities. Here are four reasons to remain defensive in the face of this renewed optimism:

Stocks are now discounting a sustained and robust economic recovery. A second contraction in economic output is no longer priced into the market. If the economy contracts or comes up short of expectations, stocks could be in for a significant correction.
Taxes on income, capital, and possibly even consumption are going up. Higher taxes resulting from Obama’s health-care boondoggle are only the tip of the iceberg. The Bush tax cuts on dividends, capital gains, and income expire at the end of this year. And the administration is already floating the idea of a consumption tax to help pay for the massive expansion in government that is now under way. Higher taxes detract from GDP—significantly so. Economic research by Christina Romer, the chairman of the President’s Council of Economic Advisors, shows that higher taxes have a negative 3X multiplier effect on private spending. That means that each $1 increase in taxes reduces private spending by $3. The implications for the economy and financial markets are bearish.
The recovery has been bought with easy money and unprecedented fiscal stimulus. Despite what Chairman Bernanke may believe, easy money does not create a sustainable economic recovery. All the new projects and investments that look profitable when interest rates are set artificially low become unprofitable when rates are normalized. The easy-money recovery is sowing the seeds of the next economic bust.
Interest rates have no place to go but up. Short-term interest rates are essentially zero and negative in real terms, and long-term rates are far too low given the amount of government debt that will be issued over coming years. Rising interest rates have never been bullish for stocks.

At my family-run investment company, I continue to advise a defensive investment posture.