Oh what a difference two months makes. On September 14 - the day after the Fed announced QE3 - the S&P 500 hit 1474 intraday, a five year high. Under the circumstances, it seemed nothing short of ludicrous to suggest that the market was on the precipice of a precipitous decline. Not only had the Fed just committed to $40 billion in indefinite monthly MBS purchases, but eight days earlier the ECB made a similarly fantastical promise to counter pressure on Spanish and Italian borrowing costs with theoretically unlimited secondary market purchases of the countries' short-term bonds.
With central banks in the U.S. and Europe throwing their balance sheets behind the market, the idea that risk assets could actually fall in the near-term seemed not only unlikely, but outright illogical. As one asset manager said at the time,
"You never have to short again."
Fast forward 8 weeks. The S&P 500 has sold-off to the tune of 8% and, on Wednesday, touched its lowest level since July 26. It is likely that falling equities, deteriorating conditions in periphery spreads, and outperforming safe haven assets such as the U.S. dollar and eurozone core debt have left many an investor wondering what happened. How could such a sure-fire bet go so horribly wrong? What happened to "You can't fight the Fed?"
The short answer is that market participants are beginning to realize that central banks' policies are no longer working; that printing more money does not thereby make society wealthier. Put simply, returns from multiple iterations of monetary easing have diminished and are now approaching zero. Consider for example the following chart which shows real GDP growth per capita 12 quarters after the end of a recession in the U.S.:
Source: Gluskin Sheff
You can see from the graphic that trillions in asset purchases haven't managed to produce a U.S. economic recovery on par with past rebounds in terms of per capita GDP growth.
Similarly, the following chart (also from Gluskin Sheff's David Rosenberg), shows the year-over-year change in eurozone GDP growth over the past 5 years:
Source: Gluskin Sheff, Stats Office of the European Communities
Over the same time period denoted on the graphic above by the red arrow and sharp decline in GDP growth, the ECB's balance sheet has exploded to over 3 trillion euros:
Translation: central bank balance sheet expansion in Europe hasn't been effective at turning around the region's economy.
The ECB's failure to right the ship in the eurozone has meant a protracted downturn in the region which in turn has had a very real effect on U.S. exports. According to StreetTalkLive, exports have accounted for 40% of U.S. corporate profits since the last recession. This makes it especially disconcerting to note that
"...since the first quarter of 2012 exports, as a percentage contribution to real GDP, have fallen from +.60 to -.23...[as] recent announcements by CAT, FDX, NSC, UPS and others, all discussed the rising weakness with international trading partners -- primarily in the Eurozone and China. This decrease in exports is very important as it relates to current forward earnings estimates and the belief that the U.S. can remain decoupled from the rest of the world."
In other words, with exports accounting for such a large percentage of U.S. corporate profits, continued weakness in the eurozone and a deceleration of the pace of growth in China will serve as an impediment to economic stability here in the U.S. in 2013 and beyond.
Finally, consider the following three charts which, when taken together, make a powerful point about debt and incomes in the U.S. The first graphic shows the household debt-to-income ratio:
Source: Gluskin Sheff
Note that although there has been a period of deleveraging, American households are nowhere close to bringing their debt level inline with the historical, pre-bubble average. Perhaps more importantly, consider the following two charts which show the level of growth in real disposable personal income from 1990 through 2006 and the growth in real disposable personal income from 2006-current:
Source: St. Louis Fed
Notice that whereas prior to the financial crisis incomes rose steadily every single year, since the crisis, real disposable income growth has been erratic at best. No one should expect American households to either continue to deleverage or support a robust recovery via increased spending when the trend in real disposable personal incomes has changed so dramatically.
It would appear that instead of riding the central bank liquidity wave for the past two months, investors have opted to live by what Bob Janjuah has called the "golden rule" of investing:
"...what matters in the real economy and in the long run is...growth and earnings, jobs and incomes, and debt and deleveraging."
Until these fundamentals are strong again, the economic recovery will not be on solid ground and the economic data which has such a profound effect on the market will be erratic and unpredictable. In the mean time, monetary policy may be good for a rally here or there but to quote Janjuah once more,
"...investment decisions based largely on the greater fool theory and predicated by the assumption that central bankers can sustainably and credibly misprice money, supporting a significant misallocation of capital, without any major negative consequences, are in general not good investments"
Given this, it is important to remember that the market has only managed to recover to the levels it sits at today because, since the inception of QE1, the Fed has forced a misallocation of capital. Given economic fundamentals (specifically the outlook for business spending and export growth), the equity market has no business being priced as it is. Furthermore, given that the U.S. government's debt-to-GDP ratio is above 100%, it seems safe to say that U.S. Treasury bonds have no business being priced as they are either.
In both cases it is the Fed causing malinvestment. In the case of equities, the Fed's zero interest rate policy has kept rates on savings vehicles so low that investors have been driven into the stock market in search of yield. In the case of Treasury bonds (and now MBS), traders' desire to front-run the Fed and the Fed's own purchases have artificially inflated the price of debt securities. This scenario has actually led many to turn an old adage on its head. The new way of thinking about the market is: stocks for the yield, bonds for the price.
These rallies are engineered from on high and as such they will ultimately unravel as they are not supported by fundamentals. The stock market has further to fall and although the spectacular unwind of the U.S. Treasury bubble may be some ways off, it is coming. Investors should remain short U.S. equities (SPY) (QQQ) and should initiate short positions in U.S. Treasury bonds (TLT) going forward.