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Stock Markets – the Cult of the Fed

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June 9, 2014

(This comment is uncharacteristically light on chart content, as I am posting this from an island off the coast of Africa where internet connection speeds are a bit slower than I’m used to. I will be back in Germany next week and will try to update this comment with additional charts at that time.)

Over the past several weeks I have read a great many articles by various market strategists, technicians, traders, money-managers, journalists and bloggers outlining their case for an imminent correction (or worse) in the stock market. Some of them have been at it for months now, and their various arguments can be summed up as follows:

  • The market is overpriced – High P/E ratios, especially when adjusted for economic cycles (like the Shiller P/E), should revert back to their historic norms.
  • The market is overbought – The S&P500, as of the June 6 close, is more than two standard deviations above its 30, 50, and 100 day moving averages, while the daily RSI has risen well above 70, indicating that additional near-term gains will be increasingly difficult to come by.
  • The rally is getting old –Markets can’t go up in a straight line forever, and the current bull market is now in its sixth year. The S&P500 hasn’t had an honest 10% correction in two years, and hasn’t so much as touched its 200-day moving average in 17 months, leaving it long overdue for a decline.
  • The rally is exhausted – Declining trading volumes suggest enthusiasm is waning.
  • Market internals are weak – Fewer individual stocks are making new 52-week highs or trading above their 200-day moving average, while many “low quality” stocks are outperforming, suggesting that recent gains have been driven by capitulatory short covering, indicative of a market top.
  • Investors are complacent – Low implied volatilities and near record high margin debt indicate that investors are unconcerned and ill unprepared for downside risks. Even a number of prominent central bankers have expressed concern about signs of complacency and excess in the financial markets (though none have yet uttered the phrase “irrational exuberance”).
  • Overseas markets are vulnerable – A Chinese debt bubble and housing market correction threaten the global growth outlook while heightened geopolitical tensions threaten international trade.

SPX060914

Taken together, these arguments make a pretty convincing case that major additional gains for equities might be harder to come by in the weeks ahead, but does that necessarily mean that stock prices must now go down? The market may indeed be overbought, over-ripe, over-valued, and over-confident, but it remains firmly entrenched within a strong upward trend, and trends like these don’t simply reverse themselves without good reason. Barring some unforeseen shock, a stable, growing economy and negative real interest rates are likely to provide ongoing support for stock prices, cushioning potential declines and keeping the “buy the dip” mentality alive.

There is, however, one thing that can change all that.

At present, the market still seems to place an extraordinary faith in the world’s central banks. Just as the Internet Revolution fueled the late 90’s rally and the Great Housing Boom fueled the 00’s rally, the Cult of the Central Bank is fueling the current one. Economic and other fundamental data are no longer interpreted for what they tell us about the economy itself, but for how they will influence the actions of the central banks. For many investors, the basic equation is as simple as this: either the central banks succeed, economic growth accelerates, and stocks go up, or the central banks fail, print more money, and stocks go up. Until it is shaken, that faith in the Fed Above will keep a firm and ever rising floor under stock prices, so what will it take to change that mentality? To my mind, that question is best answered by another question: what if current policies actually succeed?

Consider the case of the Bank of Japan. Massive new quantitative easing policies have been put into place in order to arrest the deflationary cycle and promote demand-growth from within. Thus far, the policy has helped to weaken the currency, lift stock prices, and boost annual core inflation from consistently negative readings to positive 2.3% in April, an increase of some three percentage points in just over a year. Headline inflation, meanwhile, has risen to 3.4%, its highest level in over 20 years, as consumer spending increased sharply ahead of a proposed tax hike in May. Japanese Government Bond (JGB) yields, however, have remained steady, supported by ongoing purchases by the BOJ despite having had their real yield eroded by more than 4 percentage points over the past 14 months.

JGBRY060914

If the BOJ’s current policies succeed and inflation growth continues to accelerate, then the BOJ will have to reign in its quantitative easing policies and begin to prepare for an exit, much as the U.S. Federal Reserve is doing now. At that point, private investors will most likely reduce their JGB holdings (on which they are already rapidly losing money in purchasing power terms) in anticipation of a reduction in BOJ support. As yields then eventually begin to rise, pushing the Japanese government’s borrowing costs ever higher, the moment will arrive when the BOJ must decide whether to allow the government to face insolvency and default on its debts, or to fully monetize that debt and allow the Yen to collapse and inflation to go unchecked. Indeed, with an interest expense already exceeding 50% of revenues at these record low borrowing rates, any meaningful, sustained rise in borrowing costs will rapidly push the government’s fiscal situation over the edge. The Nikkei, at that point, will also most likely stop going up.

This is what the BOJ faces if it succeeds.

But if the BOJ fails, it will only be a matter of time before investors lose confidence and realize that no amount of money printing will build a productive, self-sustaining economy. After all, additional quantitative easing at that point will only serve to further weaken the Yen, eroding consumers’ purchasing power amid ongoing increases in food, energy, and other import costs.

The Japanese case is much more acute than our own, but we actually face a similar outcome here in the U.S. as well, as do the Eurozone economies across the pond. With the Fed now well into the initial stages of its own exit strategy, we will also soon need to ask whether our central bank has failed or succeeded. This is why incoming wage and inflation data will soon take on an even greater significance and why our confidence in the Fed will also soon be tested. Firming labor markets have pushed average hourly earnings growth above 2%, while core inflation is also set to accelerate back above 2%. Further progress will mean eventual normalization of rate policy, rising borrowing costs, and the advancement of the day of reckoning for our own fiscal and monetary authorities, while failure will mean a dismal loss of confidence in the Fed and its quantitative easing policies.

Whether it happens in a few months or a few years remains to be seen, but it’s really only a matter of time before the markets must grapple with their final judgment of the central banks, and only then will the prevailing, dip-buying psychology of the Cult of the Fed be put to the test. Until then, corrections are like to be both shallow and short-lived.

I am short a few S&Ps here simply because the market does seem near-term overbought, but I will use trailing stops on my positions and be quick to exit on any signs of dip-buying.

Good luck and happy trading,

-D


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