"Sunrise doesn't last all morning
A cloudburst doesn't last all day
Seems my love is up and has left you with no warning
It's not always going to be this grey
All things must pass
All things must pass away"
--All Things Must Pass, George Harrison, All Things Must Pass, 1970
The shutdown and debt ceiling debacle in Washington is finally over. And despite all of the talk about the tensions in financial markets over the political wrangling these last few weeks, the stock market was largely unmoved through it all. In fact, it emerges in the aftermath a mere hairsbreadth away from fresh all-time highs. The performance and resilience of the stock market these last few years has been undoubtedly remarkable, and perhaps it will persist into the future. But before jumping on board for the next potential rally higher, it is prudent to consider after so much time exactly what has been driving the stock market to this point and how much longer it is likely to continue. For the one thing we know for certain is that eventually all things must pass including the current bull market in stocks. And one certainly does not wish to be caught unaware when the love is up and the stock market has left us with no warning.
The stock market rally is currently running on 56 months and counting having begun in March 2009. This already ranks it among the longest lasting cyclical bull markets over the last century. With this in mind, it is worthwhile to examine the fundamentals behind this rally to assess its sustainability into the future.
A number of forces are typically critical in supporting sustainably rising stock prices.
Leading among these is the health of the underlying economy. This, of course, can be measured through the trend in U.S. Real Gross Domestic Product. And while the economy and stocks have been advancing higher together since early 2009, it is worth noting that stocks have raced ahead of the underlying economic growth trend since late 2012. The two past instances during the current cyclical bull market rally when stocks moved ahead of the economic growth trend, they subsequently corrected to return back to trend. Thus, a short-term correction in stocks would certainly not be beyond the realm of possibility at this stage on this point alone.
The strength of the underlying economy plays an important part in driving corporate revenue and earnings. And it is in this regard where the sustainability of the current cyclical bull market starts to come under increasing scrutiny. In regards to sales growth, after a strong advance in the early stages of the post crisis recovery, it has effectively stalled over much of the last two years. But stocks have advanced strongly over this same time period, thus vaulting stocks well beyond the relatively weaker sales growth trend.
The same can be said of corporate earnings. After recovering smartly in the first three years of the post crisis period, profit growth has essentially ground to a halt over much of the last two years.
All of this is notable for the following reason. The stock market began 2012 trading at 1257 on the S&P 500 Index (SPY). By the middle of 2012, stocks had effectively revisited this price level. But only 16 months later, the stock market is now trading at fresh all-time highs of 1721 on the S&P 500. In other words, we have seen the S&P 500 Index increase by an astounding 464 points, or roughly 37%, in less than an year and a half despite a sluggish economy that included little in the way of sales growth and virtually no earnings growth. This suggests that investors are now willing to pay 37% more today for what is essentially the same stock market they could have bought a little more than a year ago at a much lower price.
Putting this into perspective, would you as a consumer be willing to pay 37% more today for the same television or automobile that you could have purchased a year ago? Most consumers would balk at such a proposition. But when it comes to the stock market, investors seem increasingly eager to buy the product the more expensive it becomes.
So exactly what explains the continued rise in stock prices over the last 18 months despite the fact that underlying fundamentals have all but ground to a halt? The answer is balance sheet expanding monetary stimulus program known as quantitative easing (QE) from the U.S. Federal Reserve, of course.
The Fed & Stocks: A Torrid Affair
"What I feel, I can't say
But my love is there for you anytime of day,
But if it's not love that you need
Then I'll try my best to make everything succeed"
--What Is Life, George Harrison, All Things Must Pass, 1970
The Fed's devotion to stocks remains unwavering. Since the beginning of the financial crisis, the Fed has tried its best to make everything succeed for the stock market. And the moment we have even the hint of any trouble for stocks, the Fed's love is there anytime of day through speeches, daily asset purchases and general words of uplifting support.
What is the stock market's life without the Fed's love? Not very good at all as it turns out, as it seems that stocks are the tempestuous one in the relationship. For the moment the Fed has walked away from QE related asset purchases, stocks have quickly tumbled sharply lower within 15 trading days after the Fed has left on average. A torrid affair indeed.
But while romance is always exciting, some critical questions must be raised about the substance of this relationship between stocks and the Fed. For like so many wild relationships, they often end badly unless it can evolve into something more sustainable and real.
Unfortunately, the Fed's track record with its other post crisis dalliances across various other asset classes suggests that it may only be a matter of time before the high profile affair between stocks and the Fed's QE ends badly. For U.S. stocks are far from being alone in getting caught up in the Fed's QE spell.
In fact, stocks from around the world found themselves caught up in the Fed's QE trance. And through the summer of 2011, they were all enjoying a similar ride higher.
For example, stocks across the much beleaguered euro zone (EZU) were on the same trajectory before suddenly breaking up and never truly being able to get back together.
The same can be said of emerging market stocks (EEM) including major countries like China (FXI). After rallying along with U.S. stocks through the summer of 2011, they have broken down and flat lined ever since.
Even a number of major stocks within the U.S. have fallen off of the QE road higher over time. For example, mega-cap companies like Ford Motor (F), Apple (AAPL) and ExxonMobil (XOM) all found themselves deviating widely from the path set forth by the Fed's QE during the 2011 to 2012 period.
And more recently in 2013, income generating areas of the market such as real estate (VNQ), high yield bonds (HYG), preferred stocks (PFF) and AT&T (T) have all broken away to the downside while the investor romance with the overall stock market in general continues without seemingly a worry in the world.
The notion of inflating asset prices should also fall directly to the benefit of the industrial metals and precious metals complex, but this has been anything but the case in recent years. The price of copper has been flat at best for several years running much to the dismay of major producers such as Freeport McMoRan (FCX) and BHP Billiton (BHP), while other major base metals such as aluminum (JJU) and nickel (JJN) have fared even worse.
Gold (GLD) and silver (SLV) have also suffered mightily despite the fact that record volumes of fiat currencies have been printed by major global central banks in recent years. So while one would be hard pressed to come up with a better fundamental environment suited to support rising precious metals than what we have today, the underlying price performance of these metals has recently been abysmal despite ongoing QE.
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Even the more conservative asset classes have lost their way in following QE higher in recent years. For example, traditionally more stable and predictable investment grade fixed income categories such as TIPS (TIP) and Investment Grade Corporate Bonds (LQD) have recently been cast aside by the QE trend.
Mortgage REITs such as Annaly Capital (NLY) that had long been beloved by income seeking investors and had moved in lockstep with the QE curve for much of the post crisis period have also recently found themselves kicked to the curb from this relationship in recent months.
Ironically, the only major asset class that has traveled its own path largely independent of the forces of QE is the one that the Fed has claimed that it is trying to directly influence with its asset purchases. This category, of course, is the U.S. Treasury market. But despite the lack of correlation to the Fed's balance sheet expansion, it too has been suffering over the past year.
These are only a few of the many examples of stocks and asset classes that were also once wedded to the upward trajectory paved by the Fed's ever expanding balance sheet thanks to QE. And they all provide a critically important lesson for investors that markets can be most fickle, and stocks seem most overdue for a break in this same regard, particularly given the lack of real fundamental support behind their advance to this point.
Investor Heartbreak Ahead
"Isn't it a pity, now, isn't it a shame
How we break each other's hearts and cause each other pain
How we take each other's love without thinking anymore
Forgetting to give back, isn't it a pity"
--Isn't It A Pity, George Harrison, All Things Must Pass, 1970
All of this is highly problematic if not dangerous for investors for the following key reason. Many stock investors are now completely driven by one key assumption: as long as the Fed is applying QE stimulus, stocks will rise and nothing else matters. Unfortunately, this basic "if QE, then rising stock prices" conclusion is grossly misguided. For while this has been true so far, it does not necessarily mean that this relationship will continue to hold into the future. And one has to look no further than the heartbreak so many other asset classes have already suffered at the expense of this overly simplistic assumption.
As a result, those investors that ignore the fundamentals and simply try to take the Fed's stimulus love without thinking anymore increasingly stand the risk of becoming the greatest fool by buying in as the market is finally topping out. And this could happen today, a month from now or a year from now. Just as with the bursting of the technology bubble in 2000 or the housing market in 2007-08, nobody exactly knows when it will finally take place. But the break up for QE and stocks is coming. It's only a matter of time at this point.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.