This week's FOMC meeting could be the most important event of the year - at least up to this point. It can be argued that we are at an inflection point in the cyclical bull market that has added over 1000 points to the S&P 500 (SPY) since putting in a low back in 2009. The S&P 500 has put in a bigger gain in pure point total and on a percentage gain basis than any comparable period in time with the exception of the dot.com bubble bull.
We bottomed out in March of 2009, at 666.79 and put in a peak of 1687.18 in May of 2013 - a gain of 1020 points in just 52 months. In percent terms we are now up roughly 250% from the 2009 lows. That is impressive by even the most optimistic standards.
Here is what the current bull market looks like viewed from a long-term vantage point:
It has been a thing of beauty unlike anything ever experienced in that it has been driven to a large degree by the most aggressive monetary and fiscal policy in history. For those who wish to reject the notion that the bull has been policy driven I have noted the cyclical bull that preceded this one as reflected in the chart above as Cyclical bull A and the current cyclical bull as Cyclical bull B.
Cyclical bull A was a high participation, increasing volume bull market. Cyclical bull B was a low participation, decreasing volume bull market. I haven't done the work to see if we've ever had such a low participation, declining volume bull market in periods past but I would give 2:1 odds on a small wager against it.
To fully appreciate this incredible bull one must take into account the fact that it has been accomplished right in the face of one of the most dismal economic recoveries we've ever seen. Let's look at a few charts courtesy of Dinah Walker to put the matter in perspective. The full presentation by Ms. Walker can be found here.
The red line is the current recovery, the blue line is the postwar average and the dotted lines present the best and worst case incidents. Here's GDP:
Real GDP is currently below the worst-case incident - in other words the recovery as far as this metric is concerned has never been worse.
The next chart is nominal housing price. Those who are banking on a housing recovery are likely to be a little disappointed with this chart:
This again reflects that this is the most lackluster recovery in history and can't even be viewed as a recovery at all as this metric is lower today than at the end of the recession and lower than the worst case as reflected by the dotted line.
The non-farm payrolls chart is also disappointing:
This metric is also well below average and I will argue that it is much worse than presented in this chart due to data manipulation involving labor participation rate but that is another subject.
This next chart is more significant than most might think. The goal would be to avoid deleveraging as it implies a contraction in M2 and money velocity - not what we want if we are trying to stage an economic recovery.
Enough said - we have managed one of the most impressive bull runs in history during a period where all metrics of economic health are at or near all-time worst-case scenarios. That is an incredible feat and accomplished only as a result of the most aggressive monetary and fiscal policy in history. A quick look at the Fed's balance sheet and the public debt should leave no doubt that this bull market was based on stimulus and nothing else.
Here is the Fed's balance sheet:
I used this chart in another article and note the periods where Fed policy was most aggressive. The point is this - the Fed balance sheet has been increased four-fold in an attempt to ignite the economy and reach escape velocity. That is a lot of stimulus and the returns as reflected by the charts above are as dismal as anything we've seen in periods past but even more so in light of the massive stimulus.
That is the monetary policy contribution. The next chart shows the total U.S. debt and presents the fiscal policy contribution:
The chart above shows where we are with total debt and what it shows is that we have accrued debt at a rate that is unprecedented in history. The chart shows that since the recession public debt has nearly doubled. To put that in perspective that means that we have incurred more debt during this 5-year period than all the debt incurred by all the presidents collectively in times past going clear back to GW the First.
So, I think it is safe to conclude that the current bull market was built on the back of massive fiscal and monetary stimulus and not on the back of a healthy and vibrant economy. That sets up the discussion going forward and the focus is on what we can expect from the Fed and from Congress as it relates to further stimulus-driven stock market gains.
What might we expect from the Fed this week?
That is a tough question to be sure. Here is what I said a few days ago on this subject in another article:
I admit that I have underestimated Bernanke's resolve regarding QE and ZIRP. I was stunned when he announced QE3 and speechless when he followed that with QE4. I was equally stunned when the BOJ went into turbo charge mode with QE after decades of failure with just that policy. For those who have forgotten, here is a look at the 30 year Nikkei chart. I think it tells all and one wonders what exactly made Bernanke think QE would work in the first place?
Here's the point - Bernanke has been particularly determined to keep stocks and bonds in the stratosphere and he has done just that but what can we expect for an encore? Equally important is how will Bernanke construct his remarks and what will his objective be in terms of influencing investor behavior?
Do you think Bernanke wants the stock market to move higher from these levels? I don't and in fact I think he might be content to see the market hover at these levels indefinitely but that isn't likely to happen as markets tend to move. That said, he has managed to talk the markets out of moving into a Fed-induced parabolic spike with the rumors of Fed tapering.
Here is what the Fed has managed to accomplish with these rumors of tapering:
The 50-day MA has provided a ton of support this year and continues to do so but the three times so far this year that the market has pulled back to the 50-day MA it has bounced hard and pushed back to the 2 standard deviation Bollinger band. The most recent trip has been a little subdued. This time we haven't managed to make it back to the upper Bollinger band in spite of pushing off of the 50-day MA twice.
Here is a better view of potential topping action:
What matters here is how effectively Bernanke can manage to back investors off the cliff without creating a crash. For those who don't think Bernanke is concerned about investors chasing yield and pushing stocks any further from these levels take a look at CAPE:
To encourage further stock price increases from these levels would be irresponsible on Bernanke's part. As the CAPE chart above shows PE ratios are at extreme levels by historical standards. It is doubtful that Bernanke wants to take responsibility for a dot.com type bubble in stocks. The Nikkei serves as another reminder of what happens when stocks get ahead of themselves.
On the other hand it can be said that he doesn't want stocks to go into free fall mode either so the big question is this - can he construct his written statements and comments in such a way that prevents a euphoric and irrational spike in stocks and also prevent a sharp sell-off? If he manages to do so my hat's off to him but I have serious doubts.
A final issue that confronts Bernanke at this point is adequate bond supply. To date the fiscal stimulus programs have expanded total debt by roughly $7.4 trillion over the last 60 months. That works out to be $122 billion a month on average. That by the way might seem a little high but here are the numbers: January, 2008, total debt was $9.437 trillion and January, 2013, the total was $16.796 trillion.
Here's Bernanke's dilemma - as the Fed has moved to buying $45 billion a month in Treasuries or $540 billion a year Congress has moved to reduce the deficit. Here's what the CBO says we are looking at for 2013 as far as the budget deficit is concerned:
If the current laws that govern federal taxes and spending do not change, the budget deficit will shrink this year to $642 billion, CBO estimates, the smallest shortfall since 2008. Relative to the size of the economy, the deficit this year-at 4.0 percent of gross domestic product (GDP)-will be less than half as large as the shortfall in 2009, which was 10.1 percent of GDP.
If we are talking about continuing the Fed's $45 billion a month treasury purchase program then the Fed will purchase $540 billion in treasuries in 2013 and that represents 84% of the projected new issue of the treasury this year. Here's an excerpt from an article published by CNS News that addresses the matter of the Fed's current purchase schedule:
Since Jan. 2 of this year, the Federal Reserve has increased its holdings of U.S. government debt by $62,359,000,000.00. At the same time, the Treasury has increased the overall debt held by the public by $87,084,476,752.86. Thus, the Federal Reserve has bought up the equivalent of 71.6 percent of the publicly held debt that has been issued by the Treasury so far this calendar year, and 14.8 percent of all of the U.S. government's publicly held debt that is now extant.
Here's a problem few seem to consider regarding continued QE - Congress isn't cooperating by creating new debt issues at a rate that allows the Fed to continue with their aggressive QE. The Fed has purchased the equivalent of 72% of all new treasury issues this year and that is indeed troublesome.
The Fed's purchase schedule prior to QE4 was relatively modest - in particular considering the amount of deficit spending that resulted in an average of $1.48 trillion in new treasury issues a year over the last 5 years. Now, as the Fed has ramped up their purchase schedule the government has sharply contracted new treasury supply. This is not an insignificant problem for the Fed and they must deal with it in some fashion.
You can see the problem facing Bernanke this week can't you? First, continued QE at the current rate isn't even feasible as the supply simply isn't there based on the decision by Congress to attack the deficit. Second, the psychological impact of holding firm on current policy is likely to push stocks well beyond what can be supported based on the prospects for higher corporate profits. On the other hand, to taper back QE is certain to have an immediate and dramatic impact on stocks and bonds.
The talk of tapering has already had a significant impact on bond prices. As stocks have stalled a little bond prices have fallen as reflected by (TLT) significantly.
This is a serious problem for the Fed. If rates normalize the interest cost on the U.S. debt will move substantially higher. Here is a look at the yield curve pre-recession:
If rates move to 5% which seems reasonable what happens to the cost of carrying a $17 trillion debt?. Five % of $17 trillion is $850 billion a year and necessarily pushes deficit spending back up to well over $1 trillion a year. The point is that the Fed has a vested and mandated interest to deal with interest rates but no mandate to deal with stock prices.
The Fed's logic to date has been to keep rates down to induce investors to move into other assets - for instance stocks and real estate. As I stated in a recent article the Fed may be losing control of the bond market and that could have a much more serious impact on the economy than a healthy correction in stocks.
Perhaps this week the Fed will begin the process of signaling to investors that stocks pose a real risk at current levels. In fact, it may be to the Fed's advantage to do so and to get investors to move back into bonds and out of equities as a sharp move higher in interest rates could be devastating to the economy. My guess is that initially any comments by the Fed that easing is on the table will produce a sharp drop in both equities and bonds but I suspect at some point bonds will once again gain favor.
As I stated in my opening paragraph we are at an inflection point in the stock and bond markets. Markets don't typically remain static - they either move higher or lower from whatever level they are currently trading at. It is the nature of the beast and the market has been driven largely by the psychological impact of QE in recent months.
The recent talk of tapering the Fed's asset purchases has had a dampening effect on stocks and actually pushed bonds significantly lower. I'm not sure the sharp drop in bonds makes a lot of sense but neither does the stock market at these prices. It is hard to get to enthusiastic about bonds at current levels but even more difficult to get enthusiastic about stocks.
I am making no guess on how Bernanke handles the issue this week as he never ceases to amaze me but I will say this - I won't be surprised if his comments are construed as bearish to bonds and stocks. How he frames his statements is another matter. Perhaps he mentions the supply issue. Maybe he suggests that the risk of continued policy is beginning to outweigh the benefits going forward. I don't know what he will say but I do think it will be construed as bearish.
The truth is we are at a level where we are desperately in need of a healthy stock market correction. As noted above conditions are deteriorating as stocks continue to hover at all time highs. Despite those who want the party to continue forever it won't happen. At some point stocks will correct.
We have what appears to be a top in the market from a technical perspective. That can be negated based on Bernanke's comments that reignite investors if he chooses to do so. However, the risks are real that he says the wrong thing or that what he says is interpreted as bearish and I think the risks are high enough to take precautions ahead of Bernanke's comments on Wednesday.