The Question For The Stock Market On The Federal Reserve Side

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 |  Includes: DIA, IWM, QQQ, SPY
by: John M. Mason

Summary

Right now investors love what the Federal Reserve is doing even though more and more commentators want the Fed to start moving to higher interest rates.

The stock market remains near historic highs even though many indicators, like CAPE, point to the market being over-valued.

Even if the stock market is over-valued, the crucial question concerns the timing of a downward adjustment.

Investors love the Federal Reserve!

At least they love what the Federal Reserve has been doing and seemingly will be doing for the near future. That is, investors love interest rates at current levels.

The latest projection is that short-term interest rates will remain at historically low levels into 2015.

Janet Yellen, chairperson of the Board of Governors of the Federal Reserve System, reported to Congress on July 15 and July 16, "in June the Committee reiterated its expectation that the current target range for the federal funds rate likely will be appropriate for a considerable period after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal and provided that inflation expectations remain well anchored. In addition, we currently anticipate that even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the federal funds rate below levels that the Committee views as normal in the longer run."

The "asset purchase program ends" in October.

This has major implications for the stock market in the United States. For those that believe that one should not "fight the Fed" the feeling is that the stock market should continue to rise into 2015 as well. This forecast is given, despite many other things going on in the world. "Don't fight the Fed!"

Of course, this may not hold for the whole stock market. Ms. Yellen did suggest in her testimony to Congress last week that some smaller cap stocks might be a little over-valued or, in her words, "substantially stretched". The market noted this suggestion and did respond.

Others, however, think that the Federal Reserve really needs to pull back now from its "low" interest rate stance. For example, Larry Fink, CEO of the world's largest asset manager BlackRock, has suggested that the Federal Reserve really needs to start allowing short-term interest rates to rise. His point is, supported by many other analysts, is that the current policy stance of the Fed is having very little impact on economic growth and employment.

The problem for the stock market is that earnings have not kept up with the performance of the stock market. Looking once more at Robert Shiller's measure of the Cyclically Adjusted Price-Earnings Ratio, or, CAPE, one sees CAPE moving higher and higher. The July estimate for CAPE is 25.96 having risen almost steadily this year.

One year ago, CAPE was at 23.49 and two years ago in July 2012, CAPE stood at 20.99. This measure has risen by almost 25 percent over a two-year period whereas economic growth has risen by less than 5 percent and corporate earnings have not risen by much more.

The scary thing is that the mean of the CAPE statistics is around 17.00 and this series is based upon the idea that the series always reverts to the mean. Unfortunately, it makes no claim as to the timing of the movement back to the mean.

Thus, one can make the argument that the stock market is riding on the wave of Federal Reserve's largesse. And, it doesn't appear that corporate earnings will catch up with higher market prices given that almost everyone believes that the potential growth rate of the economy has fallen down to around 2.0 percent.

The bottom line seems to be: the American economy is not going to grow very rapidly in the near future; as a consequence, corporate earnings will also not grow very rapidly; and the primary reason that stock prices are so high is that there is so much liquidity around and this is supporting the very high stock prices.

So, what happens to this liquidity?

Well, the Federal Reserve has stated that the current round of quantitative easing will end in October. But, does this mean that the liquidity will go away?

The answer to this is no and the reason for this answer is that so much of the liquidity is still just sitting on balance sheets and not being fully used. The demand for the liquidity is very low and has been for that way for a long time. The economy is not growing, hence, there is not a lot of demand for money. This is one reason why the effective federal funds rate has remained below 10 basis points for such a long time. There is just not a demand for these funds.

Furthermore, the supply of fixed-income securities remains very low relative to funds available to invest in these issues. The 10-year Treasury bond has been trading around 2.50 percent. Yield spreads over this issue for Aaa and Baa bonds remain historically low as does the junk bond spread. Even though there seems to be more and more corporations issuing longer-term debt now to take advantage of the low interest rates, the supply of this debt seems to be low relative to the money available to invest in it.

The point is that the demand for funds seems to be so weak right now because of the weak economy and because of the absence of any real inflationary pressure that there is very little pressure…both in the short-end and the long-end…on interest rates to rise.

I believe this is why the Federal Reserve is so confident that (especially) short-term interest rates will remain low well into 2015. The Fed believes that it can stop quantitative easing in October and make use of the market for repurchase agreements along, possibly, with some outright sales of securities to test markets for reducing some of the liquidity that now exists there. It seems as if the Fed believes that it may be able to do this without putting too much upward pressure on short-term interest rates.

The key here is to watch what happens in the fixed-income market. What we need to look for is the presence of any demand pressure that might cause interest rates, both short-term and long-term interest rates to rise. This will change the situation for the Fed in that the Fed will not have any slack in which to play with its balance sheet.

To summarize: I believe that the statistics indicate that the stock market is over-valued but will continue to remain at relatively high levels as long as the financial markets continue to have sufficient liquidity to amply supply the market's demand for funds. This condition will be signaled by the absence of any significant demand-caused rise in short-term interest rates.

In other words, the Federal Reserve has some room to play with its balance sheet in the absence of demand pressure in the financial markets.

Once the demand pressure in the financial markets begins to build for short-term interest rates to rise, the Federal Reserve will be faced with the fact that it no longer can take any further actions that would adjust downwards its balance sheet without adding additional pressure to the increase in short-term interest rates.

When this happens, I expect that short-term interest rates will begin to rise relatively rapidly and this fact will spill over into the stock market and bring about a sizeable downward adjustment in stock prices. We must focus on markets and market behavior and not what officials at the Federal Reserve say.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.