- Instead of speculating on the timing of the next correction, we would like to paint a picture of a possible scenario that is likely to unfold after the correction.
- The 3 main weapons of choice have been to lower the price of money, increase the supply of money and generate wealth effect. But these are not likely to work.
- With the current Fed Funds rates at 0 and the Fed in no hurry to hike, this policy gun is empty.
- As the Japanese case study shows despite aggressive quantitative easing and government deficit spending, the Nikkei 225 has not budged.
- Once the investor confidence is dented, policy measures lose their sting.
The S&P 500 is up 195% since the lows of March 2009. This 5 year bull run has invited plenty of speculation not only on its length but also on the lack of a meaningful correction. Given the low level of market volatility at present and the investor predilection to buy any pullback in the market, there is little evidence to support the possibility of a correction any time soon. But this does not mean that we will not see one even though it is likely that this correction could be after another 20% rally in the S&P 500 and maybe delayed until later 2015. Instead of speculating on the timing of the correction, we would like to paint a picture of a possible scenario that is likely to unfold after the next correction, which is significantly different from what we have seen in the past corrections.
Here is a look at the 10 worst quarters for the S&P 500 since 1987 and the subsequent market moves, all of which point to the same underlying behavior. The trend in the markets has been to buyback the corrections aided by government as well as monetary policies.
Source: Yahoo Finance, MA Capital Management, LLC
The above table shows 5 main correction periods, starting from Black Monday to the most recent 2008 financial crisis. Even though the flash crash of Q2 2010 shows up as one of the top 10 largest quarterly drops in the S&P 500 we do not treat it as a correction as it was short lived and driven not by macro-economic conditions but by a technical glitch and/or trader error.
Both the internet bubble as well as the 2008 financial crisis had several sub-periods of market corrections. But the conclusion of every single main correction period listed above has resulted in a very large rally in the subsequent quarter, subsequent year as well as subsequent 5 years as highlighted above.
This is important to consider from an investor psychology perspective. Investors have become used to the inevitable bounce that follows these corrections and even welcome large market corrections, long as they can get out of the market before the onset of such. These large market corrections are viewed by retail investors, their advisors as well as large institutional investors (Warren Buffet) as opportunities to buy high quality assets at cheap prices and watch them soar in value over the subsequent years. The expectations of these investors are not unreasonable as markets in the past have been supported by government as well as monetary policies. The 3 main weapons of choice for the administrators in the past to tackle market downturns have been to lower the price of money, increase the supply of money and generate wealth effect.
While this has worked well in the past we would argue that, as far as the US is concerned, all the above mentioned guns are empty and will have little to no effect post the next correction/crisis.
1. Lower the Price of Money
This action falls under the purview of the Federal Reserve where the Fed lowers key interest rates like the O/N federal funds rate and the discount rate through its open market committee meetings. The idea behind lowering the price of money is to promote borrowing by companies as well as individuals in an effort to stoke spending and hiring.
In each of the previous crisis, as shown in the table above, the policy rates have been high enough before the correction, such that lowering of these rates has had a significant effect in lowering the price of money and thereby promoting economic growth. The chart below shows how the Fed Funds rates have fallen precipitously post the market correction as a result of Federal Reserve policy changes.
Currently, the Federal Funds rates are at about 0% and based on the Fed speak coming out of the Jackson Hole conference, the Fed is in no rush to hike interest rates and reload the gun. The Fed believes, and in our opinion rightly so, that the weak labor market and lack of wage growth is not supportive of a healthy economy. The way we look at it, the Fed is facing a paradox. If they hike too soon, it might derail the economic recovery and send the markets on a downward spiral but if they do not hike they will have no effective policy measures at their disposal when we do see a market correction.
Source: Yahoo Finance, MA Capital Management, LLC
2. Generate Wealth Effect
The other means at the Fed's disposal is to support specific asset classes in an effort to make holders of these assets feel wealthier in the hope that they will borrow and spend more which in turn may stoke economic growth. Examples of these actions have been quantitative easing in the US over the past 5 years. The main idea behind quantitative easing was to bring down not just the short end interest rates but also the long end interest rates, i.e. in the 5 year to 30 years sector. The main purpose behind lowering long term interest rates was to lower the borrowing costs for mortgages and long term financing by corporations. As another example and even a more direct one, China supported Hong Kong equity markets by purchasing not bonds but listed stocks during the 1998 Asian crisis.
There are 2 arguments against why further quantitative easing is likely to have little effect on the equity markets in the future. When the US embarked on the first round of quantitative easing, the long term bond yields in the US were around 5%. Now they are at 3% and despite the strong economic data have not risen. The incremental effect on the equity markets of quantitative easing has declined as the yields have dropped.
Source: Yahoo Finance
They key to quantitative easing is to engender confidence in investors and make them move their money out of savings accounts into equity markets. This psychological manipulation has diminishing rates of return as eventually investors want to see fundamental growth in the economy driving the markets instead of just capital flow. As can be seen from the above table, the returns of every subsequent quantitative easing diminished from QE1 to QE4.
The other argument why further quantitative easing will have little to no effect is by looking at the case study of Japan from 1990 to present. As Japan entered its recession in 1990 the Japanese stock market, Nikkei 225, started to drop precipitously. After cutting interest rates to 0, Bank of Japan (BOJ) embarked on its quantitative easing program in March 2001. The initial effect was very positive on the equity markets as the market rose nearly 100% over a course of 5 years. Therefore in 2006, the BOJ decided to reverse its quantitative easing policy. But given the persistent recession and a stalling equity market, BOJ decided to adopt a more aggressive asset purchase program again in October 2011. But this time around the quantitative easing has had no effect as the investor confidence had been irreparably damaged.
The charts below show how the Nikkei 225 has been stuck in a broad downward channel for the past 24 years despite the various aggressive quantitative easing measures adopted by the Bank of Japan. A similar episode is very likely to play out in the US if the Fed decides to tackle the next downturn with further quantitative easing.
Source: Yahoo Finance
Bank of Japan (BOJ) Holdings of Japanese Government Bonds
Source: Yahoo Finance
3. Increase Money Supply
Besides the 2 monetary policy measures described above, the other measure available to the legislators is to pick up the slack in private spending through increased government spending. This is done by spending on social programs like unemployment benefits, direct cash infusions into troubled economic sectors such as the bailouts of the banks in 2008, suspension or lowering of taxes and even mailing checks to each resident, as done by Japan in the late 1990s.
But each and every one of these actions at the end of the day tries to help the economy and the markets through increased deficit spending and thereby increased the federal budget deficit. Given the increased deficit accumulated by the US since the 2008 crisis, it is unlikely that the Congress will be amenable to passing large spending bills to support the equity markets post the next downturn. Additionally, the incremental benefit derived from government spending on the equity markets, post a confidence collapse, is questionable as can be seen from the Japanese case study.
Bank of Japan since 1990 has increased its budget deficit as a percentage of GDP from a surplus of 2% in 1990 to a deficit of -8% as of 2014. This once again has had no effect on the Nikkei 225 as shown in the above charts.
For investors who have become used to the inevitable bounce that follows deep corrections and pension funds that rely on an 8% annual return to meet their liabilities, this does not bode well. A change in mind set will have to occur, which will most likely be slow and painful, when investors realize that the next downturn in the S&P 500 will not be met by a rapid bounce despite all the measures the government is likely to adopt.