Growing access to capital as well as the decreasing cost of capital has created concern among Federal Reserve governors, but many are too afraid to end the stimulus. Few believe that doing so will have little effect one way or the other and fear the drastic swings that may be associated with quitting the stimulus cold-turkey. Meanwhile, as stimulus continues to work for the market, bulls cite the biggest risk might be missing the next charge to new highs and beyond.
Janet Yellen, Vice Chair, Board of Governors of the Federal Reserve System and Paul Volcker, Former Chairman of the Board of the Federal Reserve System spoke recently on opposite sides of the Fed's bond-buying program at the National Association for Business Economics. While they differed on the timing of a stimulus end date, both would agree that while there is continued stimulus the biggest downside would be the associated increase in potential excessive risk-taking. The main concern with continuing the stimulus efforts is that consumers would become overleveraged with inexpensive capital. Volcker would have the punch bowl of stimulus taken, but while that is most likely the best advice, Yellen promoted continued stimulus, and the market should interpret this positively for the near term.
Until recently when personal saving as a percentage of disposable personal income decreased (2.4 percent in January, down from 6.4 percent in December), the average American had been saving more and deleveraging since the recession began. The last crisis has been a governor for all, even the risk-tolerant U.S. citizen, as households have been deleveraging since the last recession after many years of increasing their debt burdens. One can infer that this is an indication that consumers are not as financially careless as in previous runs up to new highs in the market indexes and are prepared for the end of Federal stimulus.
The Federal Reserve measures the consumer's financial obligations ratio, it is an estimate of the ratio of debt payments to disposable personal income. It includes outstanding mortgage consumer debt, lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments. The last published data is for third quarter 2012 and after rising nearly to 19% leading up to and just after the most recent recession, the latest data is 15.74%, the lowest level since the early 80's. All of 2012 numbers were below 16%.
This is further evidence that Volcker is feeding us the medicine we do not want but need, our economy could withstand the loss of further stimulus. Yellen, who was so prophetically cautious prior to the last financial crisis, is not denying this fact. She is instead showing how she will be good to markets if and when she succeeds Bernanke by not gearing down the stimulus too soon. To Volcker's point, are we risking more by waiting and adding to the Federal balance sheet? Nearly all would agree that we are. They might also agree that the marginal return for stimulus has continued to decrease as it becomes a greater percentage of our GDP. Yellen and Bernanke are not blind to this consensus, yet view the current reward of staying in stimulus mode and generating economic growth outweighs the future risk to markets from inflation and stimulus exit.
This data supports the fact that although debt has been inexpensive, fear has governed the risk-tolerant into shoring up as much as possible. The Fed is concerned about excessive risk now that the economy is positioned with more budgetary freedom and associated access to capital. Yellen, and therefore most likely current Federal Reserve Chairman, Ben Bernanke, continue to support the bond buying program because they would rather risk what would hopefully be a moderate increase to inflation than decrease access for U.S. households to capital now. This means that capital should continue to be available to foster growth and encourage investment. On a large scale, the market can stabilize from this crutch of Federal stimulus.
As the BEA report showed the effect of the new taxes leading to the significant fall in personal income, many bearish analysts find this as not only reason to continue Fed bond-buying but also as an indication that equities are overdue for a classic correction. Interpreting the data as we approach all-time highs in the SPDR Index ETFs for the Dow (DIA) and S&P (SPY) gets very interesting. Bernanke told Congress that he did not foresee an equity bubble, there is sufficient evidence that it will continue for the foreseeable future. Some bears are placing more weight on the Fed's exit from bond-buying than its continuance, furthermore their biggest concern may be for the uncertainty around such depreciated assets after rates will inevitably rise after Fed bond-buying ends.
The data presented shows that personal budgets have rarely been clearer on a 3 year average, despite this, the Federal stimulus is likely to continue. Coupled with the fact that inexpensive debt that is not due to get more expensive for awhile is positive for the market in the short and medium term. Meanwhile the data also shows increased, albeit delayed, economic risks from inflation and bubble creation. Through the Fed increases in printing money as well as consumer income decreases, consumers could be over exposed to inflation risks in the future, among other negative outcomes associated with continuing stimulus.
Some inflation protection might come from the SPDR Gold ETF (GLD) as it is known to hold value against inflation especially during times of fear. The ETF has closed near 52-week lows recently and may have bottomed, and as stimulus continues, the ETF may benefit. The SPDR Consumer Discretionary ETF (XLY) is benefiting from the previous expansion in disposable income, however, this ETF may face challenges after a long journey up to its current price, especially after the recent drop in disposable income. To play these as inflation protection, buy the GLD and sell the XLY. A preferred method would use options, wherein it would be appropriate to buy out of the money GLD call spreads and sell out of the money XLY call spreads with tight expiration dates.
As I have indicated, near 156 in the SPY, I am very bullish on volatility and plan to be long the iPath S&P volatility ETF (VXX). New highs are all but seen as money makes its way into the market. The concern that every opponent of the bond-buying program cites is the exit plan. Until the exit plan is actually considered, it would be wise to invest with the current facts and realize that this stimulus is in fact positive for the market as well as U.S. exports through a weakening U.S. dollar.
Volatility ahead, growth beyond; after a bump up in VXX, a longer term play for this call could be the FactorShares 2X S&P 500 Bull/USD Bear ETF (FSU). Until the expectation for Fed action against stimulus is more viable, I view weakness in the dollar and strength in equities. While it is unclear how the Fed will unwind the entirety of its stimulus measures, if the TARP exit is an indication, the exit will be as unobtrusive as possible and possibly profitable. One thing is certain if anything; the Fed will continue stimulus until they feel unemployment is manageable or fear they will lose control of inflation. Beyond the volatility of all-time highs, there is still a bull case for as long as the Fed continues stimulus.