The point we have reached in the market today is very different from 1999 and 2007. If you think about it, in simple terms, when we reached the all-time high at those points in history, the Fed was taking action to put out the fire. In 1999, Alan Greenspan was testifying about "irrational exuberance". In the mid-2000's, the sub-prime market was a problem, until it was not, then it was contained, until it was a fire that spiraled out of control.
In both of these cases, the Fed actively intervened as the market churned higher, to tighten and constrain what it believed was over-priced assets in the economy. Their policy was enacted at a time that the general growth of the economy was either slowing or no-growth, and inflation was not evident - except for the asset bubbles.
This time is very, very different.
- This time the Fed is going to double down its accommodation, rather than withdraw it as it did the past two times we hit 1500.
- This time, we have a foundation of aggregate GDP to support a 1500 valuation given the low interest rate environment which Ben Bernanke has publicly stated he is going to keep in place, and he has actively publicized the way he is going to intervene in the open market to keep the interest rates at their current levels.
The bottom line is, this time, at least in our Fed-driven market, the party will go on as it always has in the past, until it does not. The question is, where do we end up by taking this path?
Where are we in the Fed Cycle - What it Means
Many investors are beginning to put this puzzle together. What they cannot understand is what it means now.
In the Fed cycle we are now at an inflection point, which is being re-vectored as a new starting point. The Fed is doubling down with cheap money on top of cheap money at a time when the valuation of the general stock market is at fair value - not too hot - not too cold. History shows the Fed will continue to do this until there is meaningful real growth in the economy to take over, and this "activism" has consequences.
In the past 30 years of history of this country, dating back to 1980, actively pursing a "money printing" policy at this point has not been the norm. Since Paul Volcker got the country off the addiction to targeting rates in the 1970's, the Fed policy has been to back away and let the market take over at this point in equity valuations. The Fed just has not implemented this type of policy since the price control era of the 70s. The price control today is targeting interest rates - holding interest rates below inflation. As an investor, you don't have to agree or disagree with the policy. What you have to do is react properly to the policy, or you will lose money!
The graph above shows the S&P value since the mid 1970s. The graph shows a predictor line which is a function of real GDP, Inflation, and the term structure of interest rates.The graph a Predictor line which is a function of real GDP, Inflation growth adjusted for the term structure of interest rates. The red line is the proxy for what an investor in the U.S. market should be willing to pay for stocks given real GDP growth, inflation and long term interest rates. It is what a banker, like Ben Bernanke, would view as a rationally priced market. (for the math behind the predictor line see my recent article, "Equity Valuation Model for an Activist Fed Driven Market".)
The inflection points on this graph are:
1 - The first 8 years of this graph show a general sideways move in S&P valuation. It was marked by inflation driven GNP, not real GNP growth. Policy accommodation was in place throughout and rates were held at or below inflation for extended periods of time. The Fed policy in the 1970's led to a chasing up of the long term interest rate structure over time, but not in a way that allowed asset values to deflate. This is the exact same policy that Ben Bernanke is putting in today and if history is the judge, it is at least an 8 year process before it is reversed to what we saw for the majority of the last 30 years.
2 - During the run up in the S&P 500 value from the beginning of 1995s to the dot-com bubble peak above 1500 in the summer of 2000 the market grew to be very expensive on a relative basis to the "rational banker" pricing line. The beginning of the rise was at the end of Bill Clinton's first term as president. Money supply (M2) growth between Oct. 95 to Jan. 96 showed an almost overnight dramatic jump up from very slow rates, but only to a range of that kept inflation in check in the 2-3% range. Interest rates really did not change dramatically throughout the period until late in August 1999, when the Federal Reserve signaled by beginning to steadily raise the Fed Funds rate that it felt there was "irrational exuberance". Real GDP growth was solid at 2%-4% through the period, and the national debt balance as a percentage of GDP was in a comfortable 50% range. The Federal Reserve in this time period was passive. The private sector through bank lending was the primary influence on real growth in the economy. Eventually the Fed tightening destroyed business exuberance and the economy slowed. The stock market then corrected back to the S&P predictor line.
3- The reversal of the S&P market in 2003 was marked by a Fed policy in which the Fed Funds rate was dropped dramatically to 1% through the spring of 2003, and remained there until July 2004. The Fed open market operations at the beginning of 2003 do not reflect any significant QE activity. Money supply (M2) growth throughout this time frame showed much slower than normal growth. The fast run up in the S&P again led the Fed to start raising the Fed Funds rate to signal that the stock market (and other markets such as real estate) appeared to be in a bubble - above the S&P Predictor line in the graph. The Fed Funds rate peaked at 5.25% in June of 2006 and was held there until September of 2007, just past the time the S&P peaked for a second time just above 1500. Eventually banks again lost confidence and the market eventually "crashed". Ironically, Ben Bernanke began his term as Chairman in February of 2006, and Fed Funds was raised 3 times under his watch from February to June of 2006.
4 - The 2008 stock market crash is a well chronicled point in history. In September of 2008, rather than using only interest rate policy to respond to a crisis, the Fed entered with a $1.2T increase in open market operations beginning almost overnight with the failing of Lehman Brothers in September of 2008. Additionally, interest rates were dropped to zero on Fed Funds by Dec. 2008. The Federal Reserve through the time period to the present has actively rather than passively managed the term structure of interest rates through open market operations (QE).
5 - Leading up to January of this year, the predictor line in the graph shows that stocks have re-trenched to 1500. On a relative basis to the past 50 years of history the S&P500 is no longer over or under valued. This is an important inflection point for the market. The big difference is that the Fed is now an active market participant, rather than a negative force against rises above 1500. Its balance sheet is now $2.9T as of February 2013. It is planning to grow the balance sheet by $85B per month in 2013. Money supply is now growing faster than it has in years, in a range of 7.5-10.0%. And the interest rate structure is being held at all-time lows with rates repressed below the rate of inflation. The "elephant" in the room is the balance of the national debt, which is over 100% of GNP (constant dollar).
The beginning of 2013 is indeed a different time than we as a country have ever witnessed in the markets.
Buy, Sell or Hold the S&P at this time?
Currently the S&P will churn higher, so in that sense it is a definite buy as long as it stays in a contained range - but not for reasons you might expect or like.
The policy efforts by Ben Bernanke will have an impact on valuations going forward. History shows this to be the case. The money being printed is going somewhere! Asset values will expand. What is missing is a place for the money to expand in real terms. The US needs a market catalyst producing real GDP growth similar to 1996 and 2004. In 1996 it was the Telecom Act combined with the Internet that drove investment. The communication sector of the economy is a multi-trillion dollar segment. In 2004, the "drink" of preference was real estate by policy makers, combined with a financial sector growth wave based on de-regulation.
Am I missing something? Where is the growth opportunity! Is it healthcare technology to track people from cradle to grave? Not likely ... The only sector that has any semblance of major real GDP growth impact is the energy investments for gas and oil in the U.S. That is why I am bullish on the companies which are building out the infrastructure to handle this capacity through MLPs (AMJ).
The current Fed recipe of pushing major accommodation on a low growth prospects economy can only lead to higher inflation than we have experienced in the recent past. It will begin to show up after this next round of QE. The stock market can, and will, levitate to higher and higher valuations as long as accommodation continues. The accommodation will continue - it has to continue.
The end result of this cycle over the next 4 years will be a sideways trade in the S&P adjusted upward for the pace of inflation. The market does not need to fear inflation in this part of the cycle because Ben Bernanke does not have a choice but to continue to provide accommodation - else his withdrawal of support will be the reason the market tanks. He knows this. He experienced the impact of doing this when he became chairman in 2006. He does not want to relive this scenario in his lifetime. It would be a very "depressing" thought.
Managing Your Portfolio at this Market Inflection Point:
I continue to recommend the following asset allocation strategy for your portfolio:
- Review the duration of your entire portfolio and match it through the date in which you expect to need funds.
- Some percentage of your investment that is in cash-equivalent savings now may need to be re-deployed just to preserve buying power overall in your portfolio. If you invest in the S&P, make sure the value you enter is "anchored" to reality which includes the Federal Reserve.
- Keep Hard Asset inflation protection in your portfolio - assets such as income producing real estate and oil are two I would look for value opportunities.
- Maintain a "get paid for investing" mentality when choosing stocks so your money can be re-cycled to other alternatives as market conditions change. For pure equities, this means search for companies with a high dividend coupon which can be maintained and grow through time.