No Bubble Yet -- But The Compressor Needs To Be Shut Off

Includes: IGM, RYT, TBF
by: Kyle Rudduck

In a recent article published in the Wall Street Journal, Philadelphia Fed President Charles Plosser was quoted as saying: "I believe that labor-market conditions warrant scaling back the pace of purchases as soon as our next meeting. Unless we see a significant reversal in current trends that jeopardizes my forecast of [a] near 7% unemployment rate by the end of this year, then I anticipate that we could end the program before year end [1]."

Mr. Plosser is 100% accurate in his assessment that the Federal Reserve needs to begin scaling back the size of the asset purchases currently being made and plan for an exit sooner, rather than later. While the health of the stock market lies outside the responsibility of the Fed's duel mandate of full-employment and controlled inflation, the current access to "easy money" that the quantitative easing program affords may be finally starting (emphasis added) to form a bubble that could be detrimental to both.

In December of 2008 the Federal Reserve officially began the quantitative easing program by agreeing to purchase up to $600 billion in agency, mortgage-backed securities ("MBS"). Now, nearly five years later, the Fed continues to purchase MBS at a level of nearly $85 billion per month as a means to stimulate employment in an economy that is still recovering (it's most recent expansion of the program was announced in September of 2012). Recent employment reports continue to be positive but while inflation remains in check, the Fed has little incentive to reduce the size of the program-but is lack of inflation actually causing us to take our eye off of a potentially larger problem?

The stock market collapse in 2008 may have inflicted as much emotional pain on investors as it did financial pain but as people lost their jobs and saw their savings vanish, a shift in personal philosophy began to emerge. People no longer saw their houses as credit cards and piling on higher and higher levels of debt began to make less and less sense. As the economy began to recover and those that had lost jobs found new employment, people used their incomes to pay down their debt (see chart below on the debt level of US Consumers). This desire to pay down debt was accommodated by the Fed's policy, as low interest rates led to a boom in home refinancing and afforded people the opportunity to consolidate higher priced debt at historically low levels.

(Click to enlarge)

Now however, with interest rates having been held near record lows for an extended period of time, the argument can be made that those that had an interest in refinancing and/or consolidating debt have already done so. Moreover, as consumption figures continue to improve, they still lag historical averages. This, combined with the muted inflation figures, leads one to believe that inexpensive capital, rather than being spent on goods and services must be getting put to work elsewhere (i.e., invested). This is supported by the chart below from which we observe just that-personal savings rates dropped prior to the financial collapse in 2008 and significantly increased in the months subsequent.

(Click to enlarge)

Accordingly, while the low interest rates helped many alleviate much of their debt burden (a positive for the consumer), the net saver of today faces increasingly more difficult times as interest earned on their deferred consumption (i.e., savings), decreases. As a result, investors are finding themselves needing to take more and more risk to achieve a rate of return or income level comparable with those achieved historically. This is demonstrated in two primary ways:

  1. The yields of high yield (junk bonds) have fallen below 5% as demand for income has driven prices for the securities up (fixed income yields move inversely to prices). This is troubling because as recently as 2007, the yield on the 10 year treasury was at 4.76% and the average yield dating back to 1950 is 5.79%. Why is this significant? Because, whereas historically investors have been able to achieve a rate of return greater than 4% (the rate commonly associated with annual retirement withdraws capable of funding living expenses without risk of depleting one's assets) using a "risk free" investment in U.S. Treasury securities, they must now shift into securities rated BBB or lower to earn the same level of income [2]. This increases the likelihood of a potential loss of investor's principal which could lead to compounded problems in funding future income needs. With nearly 10,000 people in the U.S. turning 65 each day, this has the potential to be a very significant issue, going forward.
  2. Record low yields have driven investors out of the fixed income market and into riskier equity investments. As the stock market touches all time highs, it has largely been driven, thus far, by securities that perform very similar to fixed income. Contrary to typical market rallies in the midst of an economic recovery which see cyclical stocks lead the way, the defensive sector has provided much of the run-up of the most recent rally. A strong argument can be made that this is likely a result of net-inflows from investors that would customarily hold fixed income instruments moving into high dividend, blue chip stocks as a means to generate higher income. Again, this is troubling given the increased risk profile of equities as compared to traditional fixed income and the potential future impacts on the investor's standard of living given the increased potential of a reduction of principal.

Though it is my opinion that the market is not in bubble status currently, the Fed needs to act soon to remove the artificially "cheap money" from the markets and prevent one from being inflated. Further, given that the historical price to earnings (NYSE:PE) ratio of the market at interest rates below 6% [3] is 19.92x, though a Fed exit would likely increase interest rates, it is unlikely that the impact on the equity markets would be as harmful as the doomsday forecasters currently project (the current price earnings ratio of the S&P as of 5/13/13 was 18.89x). In fact, it is my opinion that based on the evidence above, by the Fed continuing to leave its easy money spigot open, it is doing more harm to the economy through its forcing of investors into investments outside of their optimal risk tolerance, than the good that is supposed to be accomplished through increased employment and consumer economic demand. To be certain, a pull-back in the markets at some point is a given. And though the overall severity, in large part, will depend on how far the Fed will allow a bubble to inflate, given the current need for investors to move further and further outside of their optimal risk tolerance in search of income, such a pull-back could invariably lead to the most severe impacts being felt by those least capable of sustaining the hit.

Funds of Interest Based on Market Expectations:

ProShares Short 20+ Year Treasury TBF: This fund is designed to return the inverse of the Barclays U.S. 20+ Year Treasury Bond Index. Should the Fed decide to end its purchases, long-term rates will almost certainly go up. If so, this fund would stand to profit nicely from the increased rates.

iShares S&P NA Tech. Sec. Idx. Fd. IGM: With the defensive sector having lead the way thus far, growth oriented, cyclical sectors currently have attractive relative valuations. For example the healthcare and consumer staples sectors have year to date returns of 24.23% and 21.31%, respectively. By contrast the technology sector has a YTD return of only 10.37% (the S&P 500 has returned ~14% since the Fed's announcement of QE3 in September). It stands to reason that sectors such as tech will need to see increased gains if the market is to sustain its rally and the fund IGM is a potential option for participating in its catch up.

Rydex S&P Equal Weight Technology RYT: If you like tech but are not so sold on the typical large players in the space (i.e., Google, Apple, Microsoft) check out the fund "RYT" which is an equal weight ETF that tracks the tech sector of the S&P 500. The equal weighting of the index (as compared to market cap weighting) provides increased exposure to smaller companies than is traditionally provided through S&P tracking ETFs.

1 Quote courtesy of Wall Street Journal

2 As measured by S&P. Moody's equivalent rating Baa

3 Yield on the 10 Year Treasury

Disclosure: I am long TBF, IGM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.