We have all heard numerous pundits talk about the distortions in the markets brought about by the Federal Reserve's policy of continuous low interest rates and monthly purchases of Treasury and mortgage backed securities. While it's getting more obvious by the week that the U.S. equity market is no longer directly linked to macro-fundamental trends, few have measured the distortions in equity indices relative to the level they would likely be without such aggressive monetary easing. However, when we examine the equity market and measure its price trend relative to correlating asset classes, the true level of distortion becomes much clearer. The evidence suggests it can be argued that without quantitative easing, U.S. equity prices would likely be in the area of the 2010 and 2011 lows. In this discussion, we will illustrate some of the distortions present in the current environment in a manner that will help the subscriber better visualize when the equity market distortions began and how far off kilter equity prices have become. From this, investors will be better able to define the current elevated level of risk inherent in the equity indices artificially supported by monetary policy. In addition, we provide example correlations that argue the most recent level of distortion is not entirely the fault of the Federal Reserve.
To visualize the impact of the Federal Reserve on equity prices, we must first understand historical economic sector behavior along with intermarket correlations, and how and why they have changed in recent years. In the decades post 1940s U.S. markets were faced with periods of growing inflation and disinflation. During that time a "normal" business cycle evolved in such a way that students of the market were able to develop models of standard economic sector rotations and intermarket correlations between currencies, commodities, Treasury bonds and equities.
The Classic Inflation & Disinflation Model
The classic inflation and disinflation model of intermarket correlations and sector rotation is evident during those prolonged secular bull trends where, despite cyclical bear market corrections, investor faith in the long-term uptrend of the equity market is steadfast and unshaken. During a normal economic growth cycle, stages of consumer and business demand impact various portions of our economy in a manner that generates a rotation of demand for the different market sectors.
As most investors are keenly aware, the equity market tends to lead the economy. In an idealized model of the equity markets from 1950 to 2000, equity indices typically begin their uptrend just prior to the end of an economic recession. It often starts as the efforts by the Federal Reserve to lower interest rates finally begin to positively impact consumer demand. Lower interest rates spark an increase in home buying and home building. Homebuilders and the retailers most impacted by the growth in new homes are often the first group of stocks to begin to trend higher in a new bull market. This is followed by strength in those companies that transport construction material, followed again by a chain reaction that benefits the other retailers who investors anticipate will perform well with the improved consumer sentiment. At the same time, interest-sensitive areas like finance and utility stocks begin to strengthen.
The next stage of the textbook bull cycle is where inventories are drawn down or depleted to such an extent that manufacturing demand is rejuvenated. This is often the point where the economic recession officially ends. The growth in manufacturing demand sparks demand for industrial stocks and continues into the final stage of an economic cycle. During the final stage of an economic up-cycle manufacturing capacity is maximized and the increased demand for energy and raw materials drives commodity prices higher. Energy and other commodity based equities are typically the last sectors to lead the cyclical bull trend in equities.
From a market segment view point; the early stage of a bull cycle starts with small-cap stock leadership, followed by large-cap growth and then large-cap value. It also starts with rising Treasury yields viewed as a benefit (a symptom of pulling out of a recession) and ends with rising yields high enough to negatively impact economic activity and the equity market.
The point is that during a normal economic growth cycle, stages of consumer and business demand impact different portions of our economy in a manner that generates a rotation of demand for the various market sectors. Investors may sell utilities to buy industrials, or sell technology to buy pharmaceuticals and so on. Most importantly; there is little correlation between commodities and equities, varying correlations with bonds and occasional negative correlation between select major economic sectors within the stock market. As I recall, for example, many brokerages were touting commodities in the 1990's as providing a benefit to asset allocation because it was a non-correlating asset class. The chart below shows commodities, equities and Treasury yields from 1984 to 2000. It's evident that periods of correlation between equities and commodities were few and far between. ETF investors can use the S&P 500 ETF (NYSEARCA:SPY) or Dow 30 SPDR (NYSEARCA:DIA) to substitute for the actual index and DB Commodity Tracking ETF (NYSEARCA:DBC) as a proxy for the commodity index.
Equity, Commodity and Treasury Yield Trends 1984-2000
Even the mildly astute investor is aware that current economic and market behavior is nothing like the classic model described above. The reason for this is simple and is why the current environment is so much like that of the 1940s; the model of rotation and market behavior described above is active during periods when investors are most concerned about the deteriorating effects of inflation. When investors fear the sharp negative impact of deflation more than inflation the intermarket correlations change completely.
The Classic Fear of Deflation Model
The classic deflation model of intermarket and sector correlations is what creates the "risk-on" "risk-off" environment that has defined the markets since early 2009. Investors often fear a repeat of events that have already happened. I recall in my early years in this business, back in the last two months of 1987 and through much of 1988 investors I spoke with were hesitant to commit more funds to equities because they feared the market would crash. Of course, the market already did crash. It crashed in October of 1987, retested the low that December and never looked back. But investors nearly always look back. When famed economist Milton Friedman wrote of investor behavior in the 1940s he noted the investor mindset was established by the two most recent sharp contractions; the crash from 1929 to 1932 erasing -89.49% of market value and the decline of -50.17% into March of 1938. He wrote that investor behavior was driven by a fear that the market would repeat the severe bear trends of the 1930s stating there "… was a continued fear of a major contraction and continued belief that prices were destined to fall… Despite the extent to which the public and government were exercised about inflation, the public acted… as if it expected deflation."
Moving forward about seven decades; investors find themselves in a market environment with two recent severe corrections; a -50.50% correction into October 2002 and a -57.69% correction into March 2009 that included a brief period of deflation. Both of these declines are still fresh in investor memory, especially the memory of those whose life saving were committed to the markets during those periods. Investors find themselves in a very similar situation from a behavioral standpoint to the 1940s; the biggest investor fear is a repeat of one of the last two major bear trends. Considering, too, that the yield on high quality bonds is so low as to make generating a reasonable real return near impossible many baby boomers simply cannot afford another experience like those of the recent past and have nowhere to hide. There are no low risk investment vehicles in which they can park their assets to wait out this period of low confidence in the long-term trend while generating a reasonable return.
We could call this model a "Fear of severe Correction" model, but considering the historical overriding environment in which this crowd behavior has most often occurred (in both the U.S. and Japan), a Fear of Deflation is the more accurate term. The persistently low global GDP and inflation rate is part of the equation that sets this crowd behavior. We find of interest very recent comments from Dan Arbess, a partner at Perella Weinberg and chief investment officer at PWP Xerion Funds where he said; "What's kept us afloat has been monetary policy, but that's now reaching its limits... The threat of deflation is once again rearing its head… The persistent risk in our economy is deflation not inflation." Clearly, the risk of deflation remains a concern and, of course, with deflation comes contracting real earnings, contracting price to earnings ratios and sharply contracting prices.
How does this sentiment impact intermarket and sector behavior? It creates the Risk On, Risk Off environment we have all become so accustomed to. When central banks enact a loose monetary policy it creates the expectation of higher inflation. When deflation is a threat, higher inflation is good. As a result we see equities, commodities and Treasury yields all rise at the same time. When the psychological boost from a loose monetary policy has run its course, or investors foresee a weakening economy; equities, commodities and Treasury yields all decline in unison. Within these groups, Treasury yields and commodity prices tend to be the most sensitive, often leading equities. Currencies are also a part of this equation, but for simplicity's sake are not included in this article.
Take a look at the chart below illustrating the trends in equities, commodities and Treasury yields from 1998 to present and compare with the behavior of the same asset classes pre-2000 in the chart above. It can be observed that the correlations started to come in-line in 1998, as markets recovered from the international currency crisis of 1997-1998 (Remember the feared domino effect and the collapse of the Thai Baht?) and continued with an even stronger correlation once China joined the World Trade Organization in 2001.
Equity, Commodity and Treasury Yield Trends 2000 to Present
In addition to the higher correlation of intermarket asset classes, after the 2007 correction, the major economic sectors have all become tightly correlated. Investors are either in equities (Risk On) or out of equities (Risk Off). While the relative performance of defensive sectors may be stronger during risk off periods, the nominal performance is typically still negative. This specific behavior is what is most responsible for the abundance of 90% days on the NYSE since late 2006. A 90% day is a day where 90% of the volume and points changed are on one side of the market; a 90% up day is when 90% of the volume is buying volume with 90% of points changed as gains. A 90% down day is when 90% of all volume is selling volume, and 90% of points changed is points lost. It should be no surprise that the number of 90% days from 2000 to present is unmatched except for the decade of the 1940s. This is best illustrated in the table below and is clearly a reflection of the Fear of Deflation Model of asset class and sector behavior.
# 90% Days
Measuring the Distortion in Equity Prices
With the historical context out of the way, let's look closely at some of the correlations and distortion caused by recent central bank policies. Correlation, of course, is defined by the direction of the trend and not by its intensity. Starting with the same intermarket relationships discussed above, the chart below offers a close-up view. The second U.S. effort at quantitative easing was the unsterilized QE2 hinted at during the August 2010 Jackson Hole meeting. It can be seen that each of the three asset classes responded positively and with vigor. After QE2 came Operation Twist. It's evident from the charts that while the correlations remained in-line, the trend in equities benefited more from Operation Twist as it was from that point that the upside momentum in equities diverged from the momentum of commodities and yields. Still, the most significant divergent behavior was due to the reaction to Japan's Abenomics as this was when U.S. equities jumped higher as both yields and commodities trended lower. Visually, it can be argued that if the correlations and intensity of trend in equities remained in line with the other asset classes, then U.S. equities would likely be near their 2010 - 2011 price lows.
Equity, Commodity and Treasury Yield Trends 2009 to Present
Another correlation worth studying is that between the S&P 500 Index and Japan's Nikkei 225. We first wrote of the correlation as growing evidence of a fear of deflation in 2002 and had used the correlation to confirm changes in trends ever since. However, once Federal Reserve Chairman Ben Bernanke hinted at embarking on an unsterilized QE2 in August of 2010, the correlation between these indices started to deteriorate. What is evident in the chart below is that without QE2, Operation Twist and QE4 the performance of the U.S. equity market would have been more like that of the Nikkei 225 from late 2010 to late 2012. Note in the second chart below that when Shinzo Abe was voted his party leader in September, '12, the yen/USD began to contract sharply, which helped support the Nikkei 225. (The Bank of Japan buying equities didn't hurt either.) Of course, the end result can also be seen in our chart with the S&P 500 as Abenomics not only helped the Nikkei 225, it supported a faster uptrend in the S&P 500 as well. When we pair this chart with the charts of asset classes above, it becomes apparent that the price distortions are as much or more a result of Japan's new extreme quantitative easing as it is the continuation of QE4. Here, again, a simple visual analysis of the past correlations suggests that without QE2, Operation Twist and QE4, the U.S. equity market could be trading near the lows of 2010 and 2011. ETF investors can use Maxis Nikkei 225 (NYSEARCA:NKY) to substitute for the Nikkei 225 index and the Japanese Yen Trust (NYSEARCA:FXY) for the Yen.
Nikkei 225 vs. S&P 500 Index
Nikkei 225 Negative Correlation to Yen in U.S. Dollars
As a side note: in the chart of the S&P 500 and Nikkei 225 above it is shown in the bottom panel that the Nikkei 225 is currently outperforming the S&P 500. Since 1999, whenever the Nikkei 225 is outperforming the S&P 500 both indices were in intermediate to long-term uptrends. Only when the Nikkei 225's relative performance trend was declining have both indices also declined. In other words, the relative performance trend of the Nikkei 225 can be used to confirm or refute an intermediate trend correction in the S&P 500.
Gold vs. Index of Equity Market Generals
Last, but certainly not least, is distortion evident as our index of market generals has diverged from its historical correlation with the price of gold during the most recent bull cycle. In my article titled, "The Link Between Gold and Equities," I detail the possible investor behavior responsible for creating this particular correlation, noting that the index of market generals correlated better with gold than with the S&P 500... until now. Here, too, the distortion is coincident with the Bank of Japan's new monetary policy combining with the U.S.'s QE4. It can also, visually, suggest that without such distortion the equity market would be trading nearer its 2010 to 2011 lows. ETF investors can use the Gold ETF (NYSEARCA:GLD) in place of the price of Gold. There is no ETF to represent market generals.
It is quite evident that the persistent uptrend in U.S. equities has been driven by central bank loose monetary policy more than any other single factor. As a result, distortions are visually apparent between the strength of trend in U.S. equities relative to the historical correlations with commodities, Treasury yields and currencies. As with any relative performance analysis, distortions in correlations can be resolved by any of three ways; the strong groups can weaken, the weak groups can strengthen or a little bit of both. From last week's price activity, it appears that investors are attempting to pull the weaker commodity based segments and Treasury yields higher. However, both Treasury yields and commodities tend to be more sensitive to underlying macro fundamentals, and their recently weak behavior only serves to highlight the disconnection between broad market equity performance and the economy. As such, in order for leadership from commodities and Treasury yields to be sustainable, forthcoming economic data will have to improve enough to support a rising trend. How long can these commodities and yields advance in an attempt to close the distortion gap without support from economic data? Sometimes these moves can be very short term, but even without better economic data will often continue for 30 to 60 days before losing investor support.
Absent an improving economic condition, from a purely unscientific visual analysis of past correlations, it could be argued that without quantitative easing U.S. equity prices might be trading closer to their 2010 to 2011 lows rather than at new all-time highs. This difference underscores the risk that equity investors face as they trade a market where reading the Federal Reserve and other central bank intentions may be of greater value to determining the persistence of an uptrend than the ability to forecast macro-fundamental cycles. That is, at least until market distortions normalize.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.