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Benny and the Inkjets

S&P 500

Last week, Fed Chairman Ben Bernanke stunned the investing world by announcing that contrary to his statement in May (that sent bond yields soaring and the stock market tumbling) the Federal Reserve had no intention of easing back on their current level of monetary stimulus – or money printing to us laymen.

If you look at the graph above, you can see the really big market move (circled in blue) which followed the Fed’s announcement that took us to new all-time highs on the S&P 500 Index. On that day, investors equated money printing with a continued push higher in the stock market index.

Then, maybe a cold dose of reality began to sink in – more stimulus equates to the Fed believing our economy is in worse shape than they had hoped in May, so maybe the poor earnings growth we saw in second quarter earnings reports would continue and possibly expand. The stock market that had fallen in August due to those underwhelming earnings reports began to rise in September in anticipation of the Fed’s announcement. Since that announcement, we have had a steady albeit a small decline in stock prices.

After the big September run-up, the market was over-bought and due for a pull back. The realization that the Fed would likely be lowering economic expectations and extrapolating that to even slower earnings growth was just the excuse for investors to be net sellers of stocks.

Notice I said the word “net” in the preceding paragraph, and that was on purpose. Check out these two daily graphs from Tuesday and Wednesday this week:

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These two charts look fairly similar, the top one was Tuesday and the bottom one was Wednesday. On each, I have boxed in the daily time frame for the Federal Reserve’s Open Market Activities – that is the time of day that the Fed is printing money via purchases of treasury and mortgage bonds. Each day, there is a ramp up in stock prices as that money leaves the Fed and hits the financial markets – then as the day wears on, stock prices trail back to close lower than where they opened.

To me, this is a fairly new occurrence – earlier in the Fed’s monetary stimulus activities, the stock market would go up and stay up as the money left the Fed and ended up in the financial markets. Since investors had their Ah-Hah moment after the Fed’s announcement last week, we are now seeing “net” selling during the day with investors moving the market lower on the day in spite of all that cash coming into the market.

What this tells me is that monetary stimulus (in this case, specifically the Fed’s Quantitative Easing activities) is having less impact than it previously did. The law of large numbers says that $85 billion in money printing has a bigger impact when you first start than after you’ve already printed $3.5 trillion.

But, it is likely a bigger issue than that – the fact is that our country’s debt is now at 105.6% of GDP (including the debt owed to the Social Security Trust Fund which is promised to those of us that had FICA withheld from our paychecks – I’ll include it in spite of the fact that the Congressional Budget Office does not). If you look around the world, the list of countries with a worse debt-to-GDP ratio is a rather inauspicious list: Ireland, Italy, Greece, & Japan (no names in the news there, are there?). Even little Portugal that was in the news a few weeks ago as being a risk to take down the entire continent of Europe due to its debt issues has a better ratio than the USA.

So, here is the issue
: our government spends more than it takes in. I’ll save for a different discussion whether that needs to be fixed by tax increases or spending cuts (hint: the answer likely will have to be both – the math just doesn’t seem to work otherwise). But this gap between spending and revenue is what increases our debt – and as long as the Federal Reserve is buying 90% of the debt issued by the Treasury (as reported by Bloomberg in December 2012 – I don’t have anything more current) this can go on for an extended period of time.

However, at some point, the Fed will have to stop or at least pull back. In a normal economic cycle, this level of monetary stimulus would have led to significant inflationary pressures. We just are not seeing that right now in terms of commodity inflation that works its way into consumer price inflation. All of the inflationary impact is going into the stock market and increasing prices there to historic valuations.

Check this out:

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This is the graph of the Shiller P/E10. I’ve shown it here before but wanted you to see it again because we are now at a valuation for the S&P 500 that was only surpassed in the lead-up to the great 1929 stock market crash and the 2000 NASDAQ crash. We are very overvalued historically, but as you can see by those two other times in history, we can get a lot more overvalued before the market corrects significantly.

But, back to the Fed – when the Fed stops printing money and buying our treasury debt, we will need to have someone else to buy it or we will need to have our expenses match our revenue. The latter is unlikely as our government stands today, so we will have to find another buyer.

You might be asking: why does the Fed have to stop printing money? The short answer (as referenced above) is that eventually, too many dollars in circulation start chasing too few goods available to buy, and inflation results. This has happened several times in history (post-WW1 Germany and many South American countries in the latter half of the 20th Century, as well as Zimbabwe currently).

zimbabwe

The Fed understands that fighting inflation is their primary role (to heck with the dual mandate) and they have no interest in allowing our currency to go the way of Zimbabwe where the bill above won’t even buy a loaf of bread.

Getting back to the discussion about finding an alternate buyer of our debt if the Fed slows down or stops, in a previous blog post, I mentioned what Poland has started to do to make sure there are buyers for their debt – force their retirement system to buy it instead of stocks. That is one option, but the more likely option is that the bond market will violently react as if we have a liquidity crisis (or potentially throw us into one). Buyers of treasuries, either domestic or foreign, will require significantly higher interest rates on our debt in order to entice them to buy it.

Our 10-year Treasury Note yield is being suppressed by the Fed’s purchases to 2.65% while Portugal’s is 6.65%. Can our country, with the current level of our debt, stomach a 250% increase in our interest expense at the same time that we are layering in additional social program expense?

Nope.

That would only lead to further borrowing to pay for that interest and to higher bond yields demanded by our lenders to compensate them for that risk. Its a vicious circle and one that we have to avoid.

The most recent liquidity crisis we saw was in 2008 when Lehman Brothers failed and global credit dried up. That led to a 60% drop in the stock market until the Federal Reserve stepped in and provided liquidity to our banking system and to governments around the world. That is not a scenario any of us want to repeat – and if it is the US that is perceived by the world to have a liquidity crisis, 2008 will be minor compared to the impacts we could see simply due to the size of our debt market today compared to the size of the problem in 2008.

I’ve gotten a number of calls and emails since the Fed announced their policy of keeping the printers rolling at full steam. Everyone is worried about whether there is a calamity like 2008 right around the corner.

I do not believe we have a near-term 2008-like event right around the corner. I draw this conclusion from the following three indicators I follow: the Kansas City Federal Reserve Stress Index, the St Louis Federal Reserve’s Recession Probabilities Index, and the TED Spread. You can see all three indicators below.

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This graph above is the Kansas City Financial Stress Index. The components of the KCFSI capture key aspects of financial stress and shows that high values of the KCFSI have tended to coincide with known periods of financial stress. You can see very clearly how this index reacted to the 2008 crisis – it started rising as the issues became known in advance of the Lehman Brothers collapse and the impact it could have on the financial system became known.

You can see from this graph that we are no where near those levels at the current time indicating that we do not have a systemic issue threatening the financial system at the moment – which in turn means that the stock market is not anticipated to react in a manner similar to how it reacted in 2008.

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The graph above is the St Louis Federal Reserve’s Recession Probabilities Index. Smoothed recession probabilities for the United States are obtained from a model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.

These indicators that form the index give us a feel for whether the US economy is heading into a recession. Recessions are stock market killers as corporate earnings fall in concert with the drop in GDP.

You can see from this graph that we are not headed into a recession anytime soon – meaning that corporate earnings are not threatened from a drop in GDP and we should not anticipate a significant drop in the stock market due to this.

However, US GDP is at historic sustained low levels and we should expect corporate earnings growth to slow. This is a key difference even if it is nuanced.

An earnings decline is different from a slowing in the rate of earnings growth. A slowing in the rate of growth can also cause the stock market to decline – maybe not as steep as an actual decline in earnings – as investors reduce their excitement for equity investments and P/E’s contract.

This potential for a P/E contraction is a big concern at a time when we are at historic highs for P/E’s as seen on the graph several paragraphs above.

ted

The graph above is the TED (Treasury-Eurodollar) Spread. This is a standard measure of risk to the financial system that I have followed since the 1987 stock market crash. In advance of every stock market crash, this indicator skyrockets higher as money leaves the Eurodollar (eg, dollar denominated deposits in European banks) and moves into the perceived safety of the US Treasury (eg, T-Bills).

Unfortunately, my go-to source for this indicator has always been Bloomberg but they have stopped carrying it (at least on the web version I have). That indicator had data going back much farther into the past – this one is only goes back to the last crisis.

You can see from this graph that we are at significantly lower levels than we were during the 2008 crisis. If you saw a longer dated graph, you would have seen that this indicator started to go up during the early stages of the subprime crisis, long before the Lehman Brothers collapse.

It is the primary indicator that we relied upon here to liquidate all of our equity positions in the financial industry in late 2007, almost a year before the Lehman incident. It has been very reliable and has helped us to raise cash in client accounts ahead of every stock market crash from 1987 forward.

Right now, it is not indicating that we have any systemic issue that would cause the sort of crash we saw in 1987, 1989, 1998, 2000, or 2008.

So if the indicators are not showing the sort of data that would lead us to believe we have a stock market crash ahead of us (at least not at this time – there is always one ahead of us, you just have to watch for it) then what should we expect?

Below is the standard view of the market you have seen here several times before:

sp500

In previous posts, I have told you about the importance of the 200-day moving average. We view 10% > 200-day moving average as a key level to take profits and any drop to/below a key technical level (like either the 50-day or 200-day moving average – depending upon where you are in a market cycle) as an indication to invest some cash. An even more important level is the 10% < 200-day moving average. This level is one where we have always committed client funds to the market with confidence that we are buying at long-term valuations that will provide significant (if not immediate) profits.

From a strategic standpoint, in looking at the graph above, you can see that the market top didn’t break above the 10 > 200-day moving average (the blue line above the red line) so we didn’t take profits on existing holdings. We also haven’t dropped to the 50-day moving average (the red line) in the post-Fed pullback, which in this cycle has been a key level to be a buyer as the Fed’s monetary stimulus has been putting a floor under any pullback, manipulating the normal course of the market.

Market participants are being impacted by three things: (1) the Fed’s decision to not reduce monetary stimulus discussed at length above; (2) the end of the quarter that is fast approaching which leads the big funds to sell their losers and buy the quarter’s winners, and to put cash to work to make it look like they are more fully invested than they might otherwise be; and (3) all of the discord in Washington DC surrounding the Continuing Resolution and the Debt Ceiling – that discussion is too lengthy to get into here, but just suffice it to say that equity markets like clarity and the confusion on what is going to happen in DC is a negative influence on the stock market.

Between these three, you have catalysts to drive the market higher and lower – which is why we seem to be stuck between the two sell and buy levels (blue line and red line) for the time being.

I think – ignoring for the moment the political theater in DC – that the next big fundamental issue that will help determine the direction of the stock market is corporate earnings announcements for the 3rd quarter which should start in a couple weeks. The impact of monetary easing seems to be diminishing as far as corporate earnings are concerned. The likelihood is that we will see a continuation of the weakening in growth we have seen the past couple of quarters.

Right now, with P/E’s at such lofty levels, the stock market is priced for perfection. Any reduction in earnings growth from current expectations will be P/E reducing (or at least in a non-manipulated market it would be). However, meeting earnings expectations combined with the Fed keeping its dollar printers in high gear will likely push stock prices higher in spite of the significance of the level of our national debt.

We will continue our current tactical activities of taking profits as companies hit targets, and making purchases when something we like falls to buy levels – but we have no intention of wholesale dumping the cash we have on hand into the market in a strategic reallocation of client portfolios like we have in recent months as the market fell below the 50-day moving average (our cash on hand is greatly reduced from earlier in the year – we put much of it to work when the market dropped below the 50-day moving average that you can spot on the graph above).

We are mindful of the fact that the macro issues say the stock market should not be as highly valued as it currently is, but all of the monetary stimulus that works its way into the stock market has shown that it can keep stock prices moving higher in spite of fundamentals and valuation. Because of this, I believe we will likely we tactically making purchases and sales based upon individual company fundamentals instead of making strategic reallocations to or from cash. However, if strategic opportunities arise, we will take them.

Remember what I’ve written here before: invest what you see, not what you believe. We will continue to monitor the three indicators above – as well as others I haven’t mentioned here – and will act accordingly if they start to show signs of something extremely ugly. Unfortunately, the issues in DC likely won’t show up here so we will have to deal with those as they become clearer.

To paraphrase Hamlet, neither a buyer nor a seller be (unless the market shows you it is time).


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Mark

Full Disclosure – I didn’t come up with the title to today’s blog post – I saw it in the comments section of some other blog but can’t recall where – but I really like it!