"Should I stay or should I go?" is an apt phase when looking at the U.S. equity markets today. The Federal Reserve's recent discussion about potential "tapering" of asset purchases set off a wave of selling last week in the stock market, albeit after a 17% increase from the beginning of the year. There have been many well thought out responses that the sell-off was the wrong investor reaction, that the evidence of a stronger housing market, a pick-up in consumer spending and the mini energy boom in the U.S. are all reasons to stick with the program and stay invested, and some advisors suggesting investors move even more money off the sidelines into the market.
Is this sound advice?
Ben Bernanke did point out the promising aspect of certain economic statistics in his testimony. However, contradictions were plentiful in the testimony, which rightfully made equity markets uneasy. I point to three parts of the testimony in particular that anyone long this market needs to pay attention to:
On the Fed asset purchasing plan: "If we see continued improvement and we have confidence that is going to be sustained, then we could in -- in the next few meetings -- we could take a step down in our pace of purchases." This is the one the media paid the most attention to; enough said.
On U.S. fiscal policy: "fiscal policy at the federal level has become significantly more restrictive…monetary policy does not have the capacity to fully offset an economic headwind of this magnitude." Not a lot of news coverage, but very significant particularly given the use of the word "magnitude".
On the expected stock market reaction to Fed tightening: "a premature tightening of monetary policy ... an abrupt change in policy could lead to a large correction in the stock market." Did he just use the word stock market correction in his testimony in the same sentence with monetary tightening? Yes, he did.
On the one hand he said an improving economy will lead the Fed to withdraw its present easing policy. On the other two instances cited he said monetary policy will not be successful. In all three cases, the stock market is not the place to be invested; and in one case he outright stated it in bold letters using the term "correction".
Ben Bernanke's testimony was not one that should have built confidence in those seeking to make investments in U.S. equities. Why? Take a close look at the history of Fed tightening points presented in this article. Given the starting point that Ben Bernanke is dealt today, you will quickly understand why his statements do not foretell a bright near-term future for the equity market even if the expected economic recovery continues.
Comparable Periods in Financial History
In order to keep my own senses when the stock market starts to produce irrational moves upward in the face of no compelling economic data, I turn to number crunching. Usually anecdotes can be twisted to rationalize anything, but data if rigorously looked at through the same framework gives a better understanding of what is going on, and what the end game is likely to be.
With this in mind, I decided to test whether the current market move up is a healthy sustainable move or is just a step closer to detonation. To do this, I looked into six relevant periods in the past when the Fed withdrew accommodation. These points in time are circled in red on the BAA1 historical interest rate graph below:
Author Note: The 1960's through 1980's scenarios were not included in the article because the underlying market dynamics were not as close in similarity with the issues faced in 2013 - particularly with respect to government fiscal policy and debt levels, Federal Reserve interest rate policy and general consumer price inflation versus stock asset price inflation.
Recent Scenario Analysis - 1990s through 2005
Open market operations, or quantitative easing and tightening are a normal part of the operation of the Federal Reserve. Monetary policy is used to affect interest rates, usually in order to achieve the Fed's legislated mandate to keep inflation low and foster low unemployment in the country. The turning points from "loose" money to "tighter" money is what is relevant in the market today as the Fed signals that it may need to withdraw high levels of quantitative easing, or QE, in the coming months.
There are 3 points in time shown in the chart below which show the Fed's most recent policy turning points. These points are overlaid with the stock market performance (SPY) the year before and the year after the change.
The Federal Reserve can tighten monetary policy by raising the Fed Funds rate or selling asset holdings on its balance sheet (usually U.S. Treasury Securities). Usually they do a combination of both. The Fed Funds rate line on the chart shows when the Fed reversed interest rate policy.
In order to understand the points in time monetary operations policy changed, you have to look at the rate of change in the actual assets on the Fed balance sheet. However, it is not enough just to look at the level of holdings, because it is always changing. In general if the economy is going to increase in size, the base level of holdings at the Fed has to go up, otherwise money supply would not expand in support of economic growth. It is the relative rate of change in expansion or contraction of the Fed Holdings that I analyze in order to look at the open market operations change. It is noteworthy that the figure I have supplied in the graph is the percent of Fed holdings relative to the publicly traded U.S. Treasury securities. This gives a slightly different view than if you just divided by the total U.S. government debt level because it nets out the government accounts which are mandated to buy Treasury Securities - mostly retirement trusts, the biggest one being social security. Since the Fed is a private bank, they cannot purchase the securities held by the Trust; and likewise, the Trust has no choice but to buy government securities. So including the securities in the figure, I do not find useful in understanding the impact of Fed policy on the private economy.
In all three points in recent history when the Fed removed accommodation, not surprisingly, the stock market, as measured by the S&P 500, performed worse than the year prior. In fact in 1994 it had a down year. However, if you get beyond the 1994 drag on performance, the stock market began to do extremely well from 1996 through the year 2000.
The 1999 time window in policy change is slightly different. Many investors remember the Greenspan "irrational exuberance" statements in 1996 primarily in reference to the rapid rise in the NASDAQ. But what seems to have been lost is the fact that abundant liquidity was pumped into the market leading up to the year 2000 with QE, even as the Fed was raising interest rates to tighten monetary policy. The numbers historically reflect the contradiction in Federal Reserve actions, and the market run up in valuation prior to year 2000 is highly correlated to the increase in Fed Holdings in spite of the tightening of interest rates. Subsequent Fed quantitative tightening post the year 2000 can be linked to the sell-off of stock market investment positions, and as we know a substantial market decline.
The reversal of monetary policy in 2004-2005 is generally a good example of when the Fed withdrew both its quantitative easing support and simultaneously raised interest rates, and the stock market continued to rise. History reflects that several years later the economy was in recession, but at the time the policy move worked. There must have been something going on that Greenspan faced that would be of value in understanding today's situation.
Economic Variables Influencing the Impact of the Policy Change
Each of the turning points in Fed policy had different underlying economic circumstances, of which there are a myriad of variables that could be analyzed. But I have chosen five (5) which I believe give the breadth of major influencing factors in the policy decision and the outcome at the time. They are - the unemployment rate, the rate at which government spending was increasing / (decreasing), the debt to GDP ratio to reflect the government's financial health, the inflation rate as measured by CPI, and the nominal GDP growth rate for the year prior to the policy change. In the graphic below, I have also included the GDP growth rate for the year after the Fed policy move to give a sense of the change in GDP growth momentum.
The final variable on the chart is a relative value measure I use to review whether the overall stock market was generally inexpensive or expensive at the time policy was tightened - DOW Index Value (DIA) divided by nominal GDP. From 1941 until today this measure has averaged .765, with a median of .764. A higher ratio means the market is generally more expensive relative to other points in history.
The Jan-95 timeframe is one of the best examples of a Fed removal of accommodation followed by a dramatic increase in stock valuations, even though the first year after the policy move was not particularly good for stocks. It is the situation that the Obama administration wishes they were in starting the second term. For readers who wonder where the 6.5% unemployment target probably originated for the Fed's current policy, note the unemployment rate at the beginning of 1994. But we are not presently in a period very analogous to 1994. I particularly point to the undervalued stock market, the above target rate of inflation, a non-intrusive Federal Reserve and relatively strong GDP growth. The impetus for the growth as history shows was the spawning of the Internet Age, but there was also the momentum of the decline in interest rates from almost 11% to 7.34% which pushed private capital investment, whereas with rates as low as they are today, lending is curtailed.
The Jan-99 to Jan-00 and the Jul-04 to Jul-05 time periods are equally good examples of time periods when economic foundations were in place for the Fed to transition away from accommodation while the market propelled higher - moderate inflation, GDP momentum and a healthy government financial balance sheet. But we also know that both of these scenarios ended badly. Why?
Others have provided rationales, but I suggest big contributors were Fed open market activity combined with government spending. The contradictory policy of open market easing while raising rates in the late 1990s is the first case in point. The liquidity pumped into the market at the time was not needed for general market transactions, and as can be seen, it flowed instead into the stock market. The stock market reached a relative valuation of 1.05 times GDP in early 1999 and continued to rise. These actions ended badly for the stock market when the Fed lowered the size of its balance sheet relative to the economy post 2000.
The Jul-04 to Jul-05 time frame is well documented as a period of high household leverage and excessive speculation in the U.S. residential housing market. It was also a period of war, and government spending was high during the period as a result. Although recorded CPI never got out of control as it did in the 1960s and 1970s or the early 1940s during WWII, the numbers reflect a situation in which the Federal Reserve was monetizing a significant portion of the increase in government spending, which virtually always turns into CPI lead inflation. Ultimately the Fed had to respond to the upward pressure placed on the CPI index by tightening even more leading into 2006 - Ben Bernanke's first year as Fed chairman. It turns out that the blunt instrument of monetary policy worked its way through the economy slowly. The quantitative tightening of the Fed balance sheet in order not to monetize the high increases in war time government spending combined with the high interest rates not only eventually broke the spike up in oil prices in 2007 and 2008, it also caused a severe liquidity crisis in the banking system. The ultimate casualty marking the crisis was the bankruptcy of Lehman Brothers in September of 2008.
The bottom line in the economic variable graph shows economic and market metrics we face in May 2013. Nothing about the metrics today would predict a situation in which the stock market could stand up in the face of withdrawn Fed accommodation. In fact, the opposite appears more likely. The most recent stock market run-up, just as in the year 2000 has been generated most directly by the expansion of the Fed balance sheet, not economic growth. The relative valuation of the stock market is approaching the red zone for historical valuations. Government expenditures are at a standstill in terms of rate of change in growth, locking down inflation expectations. GDP growth is very low.
There is only one clear metric that is pushing the market today - Federal Reserve open market operations, possibly coupled with Japan Central Bank actions. It is the magic elixir that causes markets to float when reality gets in the way.
How Did the Fed Reverse the Zero Interest Rate Policy Last Time?
There is one other time in history I feel is important to share. The period is the post-war 1940s and the 1950s. This is particularly relevant today because it is the only well documented time in history that the U.S. successfully extracted itself from a debt to GDP ratio of over 100% and additionally utilized a zero interest rate policy for an extended period of time.
The graph below summarizes three successive times in this stretch of history in which the Fed tightened monetary policy, successfully reversing the country's dependency on the zero interest rate policy as well as returning the responsibility for economic growth to market forces, not dependency on government spending:
Two out of the three time periods, 1951 and 1955, were successful in outcome to the extent the stock market continued to grow even as rates increased and monetary policy tightened. The general conditions of low inflation, GDP momentum and a generally non-intrusive Fed were in place in the successful scenarios. The stock market was also not relatively overvalued in each successful case.
In 1946 through 1948 the Fed slowly implemented efforts to reverse the zero interest rate policy, and below par results were witnessed in the stock market. This is a period in which the U.S. had to deal with its high debt accumulated during WWII, and debt to GDP was at a record 120%. The metrics, and remedies being used, are in some ways similar to today and in others not. The path chosen by President Truman greatly restricted the rate of growth in government spending, much more so than the Sequester in 2013. The action taken was deflationary through time, and also constrained economic growth short-term, but not longer term. It was also a period of high inflation due to the high level of wartime spending that was monetized during FDR's tenure. The war spending level caused an order of magnitude increase in money supply that got spent not only on consumption, but also real capital formation. The capital formation allowed the wartime economy to transition to a peacetime industrial economy even as government spending was severely cut. The Fed did not increase its holdings of Treasuries during the post-war period. However, the U.S. Treasury did "work with" (some say force) the Federal Reserve to peg interest rates at low levels throughout the late 1940s until 1951 through an auction process that paid banks to use their excess reserves to insure successful low interest rate Treasury auctions, and get paid for doing so. This policy sounds very similar to the one Ben Bernanke continues to reference as part of Fed's current exit strategy. (For more information on this historical period, see my article How and Why Zero Interest Rates Ended Last Time.)
The period from 1946 through 1948 was not a good time to be a stock investor. The time period running up to 1946 witnessed a large increase in stock values, very similar to the market in 2013. However, once the combined constraints of lower government spending and lower Fed QE and slowly rising market interest rates began to be felt in the market, a correction ensued. The overall peak to through decline in the stock market during the period was 20% as measured by the DOW. The starting point for the decline was after the DOW relative to GDP rose to slightly above 1.
Requirements for a Fed Successful Stock Market Up, Fed Tightening Scenario
In reviewing the information about these six points in history where the Fed tightened monetary policy, a tighter Fed policy did not mean that stocks went down right after the policy move - on the contrary in four of the six cases stocks went up. This was because there were situational factors in place for the stock market to continue to trade higher:
Assessing the current market conditions, one can easily see why Ben Bernanke is in such a bind, and why in his testimony he said - "a premature tightening of monetary policy ... an abrupt change in policy could lead to a large correction in the stock market."
There is nothing currently in the mix of variables that could take the market higher if he were to tighten right now. In fact, the market is overvalued because the Fed holds such an extraordinary level of assets - 26.4% of publicly traded Treasury Securities on a relative basis. This is a historical high water mark for the Fed, which not only could set off a correction if assets are sold, but in my estimation will detonate a market sell-off even larger than a correction if they attempted to do so. This is why the stated policy is that the Fed will not sell assets, but rather hold them and let the holdings run-off over time. This is a quantitative tightening move nonetheless, probably only a path that will prolong the market agony as happened in 1946.
So the market wariness about the approaching deceleration of QE is fully warranted because it is the Fed buying of assets that is the primary reason the market trading at such high levels now. If the market were severely undervalued as in 1994 and there were prospects for higher GDP and better employment, then the Fed Chairman would never be using the word "correction" in his testimony. But, the stock market is starting from a perch it cannot sustain without continued accumulation of assets by the Federal Reserve. Any draw down in Fed holdings in the future will create a market correction similar to post year 2000, or looking back in the 1940s, the drop that ensue when QE decelerated sharply and the market corrected. The severity of the decline will only be buffered by the future perceived prospects for the business economy at the time tightening is truly implemented. If the Fed goes ahead and administers the medicine now and restores more normalized operations, they will be in a position to support the fiscal policies which might actually ensue to help fix the general problems faced by the country. However, continuing to be an asset accumulator and "melting up" market valuations is a poor policy choice that is fraught with risk for investors confusingly putting money to work now in an Fed inflated market.
Portfolio and Asset Allocation Strategy
The confusing aspect of this market for an investor is what to do right now. You receive nothing for investing in cash or near cash safety investments - insurance is costly. Shorting markets is also costly, and pay-off can be skewed negatively by the politically entrenched policies in place currently which prolong the time it takes for markets to correct. In my last article, Fed Tapering Comments Expose Stock Market Rally Weakness, I suggested that a "sell in May and go away" strategy for equities may be the most reasonable approach right now. Literally I doubt many investors will go completely to cash simply because of the perceived expense of being in cash. However, the inflation level is not high at the moment (1.1% TTM), Japan's monetary policy moves are deflationary for the U.S. moving forward (see my article Will Japan Create Inflation or Just Export Deflation), and the prospects for an agreement in Washington to increase government spending levels in the next year or two is very low. The only wild card is the "Affordable Care Act" which when implemented in 2014 could produce some pass-through inflationary forces, but at this point it looks like a severe drag on the economy that at best just provides a major insurance pool of funds which by law will have to buy U.S. Treasuries.
My prediction is market risk and instability is now going to increase sharply the longer the Fed stays the course with QE. The Fed needs to begin using any near-term good news to withdraw support just so it has some ammunition, and credibility, to support the economy longer term. They do not want another 2008 or 1929 to be created by the current policy measures.
My present market forecast for rates and the S&P is contained in the following graph:
The forecast shows an expected minimum 20% correction of equity price levels leading up to and post actual Fed accommodation withdrawal. The forecasted near-term trend up in rates of longer dated Treasuries and riskier credit grades is driven by the rising risk of the extremely low interest rates and the resulting run up in asset prices as a result. Currently the longer end of the yield curve has moved up even as the Fed continues to buy Treasury securities at high levels. If this trend continues, it probably means that foreign sellers are reducing Treasury holdings as rates overseas currently appear more attractive. Since foreign investors comprise 48.5% of Treasury debt outstanding, this run-off would not be surprising.
The best portfolio strategy at the present time is to become much more selective and underweight aggregate stock index funds IVV, LAG, VOO and longer duration bond funds AGG, BND, SCHZ and move money into non-correlated assets - cash is an option, but other options should also be considered, at least for some portion of the accumulated cash. No asset is likely to be completely immune, other than cash, from a down move in the market caused by Fed tightening. For those who choose to play the game of holding the equity market assets until there is a clear breakdown, keep a watchful eye on the VIX as it will probably begin to foretell when the breakdown in the market will occur. Once the correction is in full force, the interest bearing markets that are trading down ahead of the correction will likely become the assets money will move back to.
As for other options for non-correlated assets as options today, the pull-back in gold and natural resources is the best contrary area to begin looking. I like GGN and BP as two non-correlated equity plays at the present time. Each pays attractive distributions which shortens asset duration. But these are not large portfolio holding equity plays, only low percentage holdings that can keep income flowing into your portfolio with lower probability of decline in a general market correction. I also suggest looking at the gold related plays now that the market has gone through a substantial correction. It may be a dead cat bounce, but gold typically works well as equity markets become more volatile.
Other non-correlated opportunities are likely to become evident as volatility rises, and will be subjects of my future posts.