back to blog homepage

Quantitative Easing, or the Pompatus of Love for Easy Money

daily-view1
Double Click image for larger view

The stock market has been on a remarkable run higher over the past year, fueled by the Federal Reserve’s easy money policy known as Quantitative Easing (aka QE). In its QE activities, the Fed creates money by paying for bonds it is purchasing by crediting the sellers accounts for the purchase with funds that didn’t previously exist.

The Fed’s theory for doing this was that they could create a wealth effect that would make people more likely to spend this newly created wealth and drive the economic momentum of the country higher.

In essence, this new money makes its way into the investment markets and drives the prices of stocks higher, giving investors a feeling of wealth (the opposite feeling to what they had after the 2008 stock market crash) and encourages them to spend that wealth, driving the GDP numbers to better than expected levels.

All-in-all, the first half of the plan worked pretty well. If you look at the graph above, you can see that the S&P 500 Index has moved higher with barely a pullback during the year. It has spent much of the year flirting with the band that is 10% above the 200-day moving average (it’s the dashed blue line). I’ve written on this blog several times in the past about the importance of the 200-day moving average and the distance of various stocks or indices from it, so if you need a refresher, please review some of the previous blog posts. However, it has only touched the 200-day moving average twice this year – a pretty amazing feat.

The question every investor and money manager should be asking themselves is what will happen to the stock market when the Federal Reserve stops printing money. Is it rhetorical to ponder whether the move higher will all be repealed once the flow of money that fueled the purchasing demand stops? I don’t think so especially if you look at what we have experienced.

Stock prices generally increase or decrease based upon two primary factors: earnings growth and investor sentiment. This year, earnings have grown 4% but the stock market is up 20% due to an increase in sentiment that has caused investors to jump in and buy each minor pullback in stock prices. The sentiment in the market now is such that people are afraid to not be fully invested – traditional risk management measures are frowned upon and any moves by an investment manager to hold onto cash are viewed negatively by clients.

If you look at what is happening inside the S&P 500 Index, you see a very different story developing than the one told to the investing public and it is leading them to be more aggressive than is warranted by fundamentals.

One very important thing I like to watch is how the companies within the S&P 500 Index (ticker SPX) are performing relative to the S&P 100 Index (ticker OEX). The OEX represents the 100 largest most liquid companies trading in the market and is a subset of the500 companies in the SPX. In the graph above, the bottom panel is a graph of the relative performance of the SPX to the OEX. You can see that for most of the year, the SPX outperformed the OEX, but as more of the investing public has gotten interested in investing in the stock market, the OEX has started to outperform (you can tell that by the downward tilt in that line starting in October).

The logic behind using this as an indicator is that when the under-invested or the outright bearish investors finally capitulate and move money into the stock market, they buy the largest most liquid companies because those are the ones they are familiar with. The same thing happened at the end of the great 1982-2000 bull market; in 1998 the OEX began to outperform as investors who normally didn’t buy stocks started to put money into the market (and many started day trading) but their focus was on the largest most liquid companies with which they were familiar. This is a classic sign that a market advance is getting long in the tooth.

Additionally, we are beginning to see that the number of companies trading above their 200-day moving average is declining. Check out the graph below:

above-200-day-sma

Earlier in the year, 85% of the companies in the New York Stock Exchange were trading above their 200-day moving average (the red line), we are now down to 65%. Traditionally, the blue line at 60% is an indicator of when stock market investors are overly excited or bullish. We have traded consistently above that level for most of the year – when it dropped below there in June and September, we used those times as entry points to put cash to work and it proved profitable.

The fact that we are seeing a weakening of this graph since October coincides pretty closely with the strengthening of the OEX discussed above. What we are seeing is money flowing into the largest companies, pushing their prices up, while the bulk of the companies in the index are weakening in price. The fact that the index continues to move higher is an oddity of how the index is calculated: the largest companies in the index are weighted higher than the smaller companies. Apple makes up about 5% of the weighting in the index and we have seen its stock move up 40% in price the past five months. This type of move is masking the price performance of the bulk of the companies in the index.

Additionally, the market continues to get more expensive. I’ve posted the Shiller P/E Ratio Chart several times in the past, and it continues to show the increase in the valuation of this market multiple. We are now well above 25 times average trailing 10-year earnings, with only two clear points in the past when the market was more expensive: 1929 and 2000 before their respective crashes.

shiller-pe-2013-12

I think that in the next several weeks, maybe sooner or maybe toward the end of the first quarter or next year, we will have a normal type of pullback in stock prices where we see the index meet its 200-day moving average. This is a healthy occurrence, and it will likely be brought about by the Fed’s decision – or maybe even investor’s perception about the Fed’s decision – on when to reduce the amount of monetary stimulus it is providing through QE.

If you remember back to the discussion’s the Fed had about QE, it stated that its intention was to generate a wealth effect that would translate into people spending more money – our economy is roughly 2/3 consumer driven, so for our economy to expand the Fed needs consumers to take on debt to make purchases of consumer goods.

We can tell from the chart above that the wealth effect is in full swing just by looking at the S&P 500 Index’s significant move higher. But, we really need to look at where the consumer is in their personal spending pattern. For that, lets check out the graph below from the St Louis Federal Reserve Bank:

consumer-debt

On the right side of the graph, you will notice the upturn in household liabilities levels after the big drop during the 2008 market crash. The granularity on this graph is a bit lacking, but what I’d like you to focus on is the near vertical increase at the tail end of he graph. In my opinion, this rapid increase in the rate at which consumers are acquiring debt will weigh heavily on the Fed’s decision process to reduce their QE activities. They will view this as an indicator that their plan has worked and consumers are getting more aggressive which will ultimately translate into increased economic activity.

When the Fed tapers (reduces QE activity) my assumption is that it will happen in the first quarter of 2014. They will likely go from buying $85 billion in bonds per month to something like $65 billion, keep it at that level for a bit, then continue to reduce it in step fashion until the purchase program has ended. However, if the economy softens noticeably, if the stock market corrects greater than they find acceptable (say, greater than 10%), if unemployment increases, or any other economic event happens that they feel would send the economy back toward 2008 levels, be prepared for QE to move back to current or even higher levels.

At this time, I do not expect that we will see a major selloff like the 2008 crash. The Fed has already stated that they plan to keep interest rates low until 2015 at the earliest, so monetary policy will continue to be very accommodative – it just will not provide a direct source of funds to go into the stock market. That accommodation will provide price support to the stock market so that if it goes down it likely won’t be past the 200-day moving average which would be a roughly 8% correction based upon today’s levels in the index.

From a more systemic standpoint, I believe the market is probably 40% over-valued based upon measures like price-to-book and price-to-sales. However, with interest rates and inflation still at low levels, and corporate earnings at historic highs with steady albeit low growth rates, that over-valuation could continue for a long time into the future until interest rates rise, inflation increases or earnings fall. Until then, or some other systemic event occurs, we will likely continue to be over-valued on the more traditional measures. This will likely add to the investor complacency and risk management aversion we are seeing, but will someday matter in a very big way.

I know I am going to get some questions about the title of this post. For those of us that grew up in the 60’s and 70’s, you are likely familiar with the term Pompatus of Love from a couple of songs – I’ve posted both of those videos below for your enjoyment.

In essence, this entire post is saying that investors have grown complacent and willing to pay an ever-increasing price for stocks in spite of the fact that earnings are growing much slower than justified by the increase in valuations. They are experiencing the totality of love for easy money and throwing caution to the wind – particularly those folks that are just now getting into the market near its all-time highs – just at a time when risk management should be a more prudent option.

For me all of this results in a set of tactical moves relative to our investment management activities. We will implement the plan discussed multiple times this year – when the index exceeds the blue dashed line on the graph that represents a value that is 10% above the 200-day moving average we will raise some cash in the holdings that have gotten furthest away from their intrinsic value (as we calculate it). I’ve shown you historic graphs that depict the market’s movements in relation to this level, and statistically it is important to raise cash when you get there because the market has always moved back toward the 200-day moving average and a more realistic valuation level.

Since we are still below the dashed blue line, we will stay invested but rotate out of certain companies that have had big runs and into others that have not or that may have pulled back in price (remember the graph above of the decreasing number of companies trading above their 200-day moving averages). For new clients with recently added money, we are selectively buying those that have pulled back in price but will add more when we get a broader move of the market toward the key 200-day moving average.

These tactical moves are subject to constant review and adjustment. If we see something systemic coming at us – watch for this month’s Macro Update in a few days, or refer back to last months since there hasn’t thus far been much change – that is cause for a significant increase in cash levels in portfolios, we will make those changes and advise you here on the blog (unless you have told us to be 100% invested at all times).

Until then, let’s enjoy some rock n’ roll history…this first video is probably one that you weren’t expecting to hear:

This second video is likely the one you expected:

Mark