Seeking an improved economy to pull U.S. out of rabbit hole

The "rabbit's hole" by definition is a bizarre, difficult situation or state. That is precisely where we find ourselves economically today. The Federal Open Market Committee (FOMC), the Fed's committee that makes key decisions about interest rates and the nation's money supply, has been overly optimistic in its expectation for U.S. growth since the last recession that ended in 2009. If its annual targets had been realized over the past four years, the U.S. economy should have been approximately 6 percent or $1 trillion larger.

The FOMC track record on predicting where things are headed is sketchy at best. This calls into question the current FOMC forecast of Gross Domestic Product (GDP), the measure of all goods and services produced within the U.S. in a year. The FOMC is predicting a 2.9 percent GDP for 2014 and 3.4 percent in 2015. That said, the just-reported first-quarter GDP contracted at 1 percent. I don't claim to be a mathematician, but to hit that year-end target of 2.9 percent, we're going to have to see a substantial pickup in economic activity. The FOMC has incorrectly viewed the effectiveness of quantitative easing, which depends on what side of the monetary equation you sit.

The FOMC is working under a plan of boosting stock prices and keeping interest rates artificially low. The idea is/was to create a "wealth effect" through stimulating both main drivers in the economy, which are the stock and housing markets. The thought was that if consumers felt wealthy, through the stock market and seeing home values start to climb, then this would spur consumer spending and in turn create an economic chain reaction. In theory, the increased spending leads to higher profits for business, which then helps increase the number of jobs and helps to boost business investment and improve incomes.

This theoretical economic movement also has been the Fed's justification for the quantitative easing programs. The comeback in the U.S. housing market has been a very bullish economic story since the end of the financial crisis. Sales, construction, prices and starts have all trended higher. More recently, though, the housing market has begun to stall. A look at recently reported annual change in housing permits, from April 2013 through 2014, indicates that single family permits are down 3.2 percent, while there has been a surge in multifamily (rental) permits, up 14.4 percent. U.S. homeownership rate has fallen to a 19-year low.

Numerous reasons have been given for the recent back-up, among which are the weather, higher mortgage rates (which since have come down) tight credit and the job market, with first-time buyers not being able to obtain a mortgage. Another reason given is the fire sale of distressed property has been cleared out. Additionally, there is a more interesting component to the housing market that is seldom reported, which has to do with the housing sector cash buyer that hit a record high of 42.7 percent of all U.S. residential property sales in the first quarter. This figure is up 37.8 percent from the previous quarter, up 19.1 percent from the first quarter of 2013 - and also at the highest level since Realty Trac began keeping records of all cash purchases.

Surprisingly, the key to the "all-cash" purchases is the little-known fact that the National Association of Realtors is exempt from anti-money laundering requirements. So, you might guess that crime or illegal off-shore money is fueling an unknown portion of the "all-cash" bid in the real estate market. For example, in the Miami area, 67.1 percent of all sales were transacted in cash. In New York, that figure is 57 percent; Las Vegas, 52.2 percent; and Atlanta, 53.2 percent. Some have theorized that we have Central and South American drug lords buying up the Southeast, Russian mafia buying the East Coast, and Asian criminals purchasing on the West Coast.

If illegitimate activity is behind even a portion of the sales, it makes an impact and can cause artificial inflation of the market. Neither Realtors nor developers want to hear this idea because they're running to the bank or trying to sell units. The municipalities are a beneficiary also with increased real estate tax revenue. This money flow trickles down to other parts of the economy, which makes this a tough problem to address.

As for the stock market, it faces headwinds. We have November elections coming, which may turn out to be a positive. The budget battle hasn't gone away - it is just postponed - and the scheduled end to quantitative easing is in October. I think I've seen the ending to this movie twice before (trying to end quantitative easing 1 and 2). If we look back at the previous two times this program was to stop, it didn't have good implications for the stock market. I'm told not to worry and that "Mister Market" has already figured this in. However, for the market to keep chugging higher, we will also need to see earnings growth. This past earning season saw companies meeting or beating expectations, but overall there isn't much to speak of in organic revenue growth.

So, I liken our journey to that of Alice following the white rabbit down the hole: nothing seems as it really appears and it just get more surreal as we venture down the hole. In the end, Alice is gently awakened by her sister just in time for tea. We can wish for such a smooth transition.

Ken Hanley is a Vice President and Financial Advisor for D.A. Davidson & Co. This information is not intended as specific investment advice. D.A. Davidson & Co. does not provide tax advice. Please consult your tax professional. Information from sources deemed reliable include D.A. Davidson & Co., member SIPC.