This QE Bower My Prison

by: Eric Parnell, CFA


The Federal Reserve’s persistently aggressive monetary policy has had a paralyzing effect for many investors over the last several years.

Repeated monetary stimulus programs have distorted capital markets in such a way that it has imprisoned many investors to a bower of heightened risk control and uncharacteristically short-term thinking.

But as Fed asset purchases end, the confined investor has reason for gladness, for they can continue to participate in today’s upside while also preparing to capitalize on downside risk.

The Federal Reserve's persistently aggressive monetary policy has had a paralyzing effect for many investors over the last several years. Like a skillet of boiling hot milk being emptied on one's foot, repeated monetary stimulus programs, including three rounds of quantitative easing, two rounds of Operation Twist and the quintupling of the Fed's balance sheet, has distorted capital markets in such a way that it has imprisoned many investors to a bower of heightened risk control and uncharacteristically short-term thinking amid the expectation that the negative spillover effects from such unprecedented policies will eventually come home to roost in a significant way. But as we enter the twilight of the Fed's supposed final round of quantitative easing, the confined investor has reason for gladness, for they can continue to delight in the splendor of today's market while also knowing that nature never deserts the wise and pure in the end.

Well, they are gone, and here must I remain,

This lime-tree bower my prison! I have lost

Beauties and feelings, such as would have been

Most sweet to my remembrance even when age

Had dimm'd mine eyes to blindness! They, meanwhile,

Friends, whom I never more may meet again,

On springy heath, along the hill-top edge,

Wander in gladness, and wind down, perchance,

To that still roaring dell, of which I told

--This Lime Tree Bower My Prison, Samuel Taylor Coleridge

Many investors have gone to frolic in the grandeur of today's capital markets. With stocks trading at fresh all-time highs, they fully embrace the notion that the financial system has been properly revived and that the sustainable health of the global economy has been fully restored. Emboldened by these beliefs, they have returned their focus to the traditional fundamental metrics that have historically driven the behavior of capital markets with the assumption that they are untainted by the extraordinary policy environment that surrounds them. As for any lingering imbalances, these will simply resolve themselves over time, as the sustainable economic recovery finally takes hold under the guidance and wisdom of experienced policy makers.

I only hope that these friends are right. But as I sit in this QE bower my prison, I worry deeply about the road that lies ahead for capital markets and the investors that participate in them. I have never been of the opinion that artificially inflating asset prices was a proper or healthy way of trying to revive sustainable economic growth. Recent history has shown that falsely high asset prices, as witnessed with technology stocks in the late 1990s and housing in the past decade, ultimately led to disastrous outcomes that have required ever greater restorative actions in their wake. Yet policy makers, including the Federal Reserve, have continued to persist in their attempts to defy the natural economic cycle and pursue similar policies by this time artificially inflating stock prices under the unfounded belief that the associated wealth effect might lead to a measurably and sustainable stimulative effect on economic growth. It is with this very point that I am most dismayed. For one might have had the chance to argue that the explosion of the national debt and the quintupling of the Fed's balance sheet were worth the expense had the U.S. economy at least achieved escape velocity so many years later. Instead, we are still left with an economy that continues to sputter sluggishly along despite so much treasure continuing to be deployed and a stock market that is now at historically peak valuations across a number of measures that include earnings per share that remain well above trend, and profit margins well above historical averages. Fool me once, shame on you. Fool me twice, shame on me. Fool me thrice?

Thus, I have lost beauties and feelings in recent years associated with participating in a more normally functioning investment marketplace. Instead of considering opportunities with a multi-year, if not multi-decade, time horizon in mind, investment decisions in the hyper stimulative aftermath of the financial crisis must now also be considered through much shorter time horizons and the additional lenses of various qualitative risk controls. This includes the recognition that at any given point in time, the unpredictable human decision making process by any key global policy maker, whether it is words uttered in a speech or an unexpectedly abrupt policy shift, could have the shock effect of destabilizing financial markets at any given moment in time. After all, it was the capriciousness of human decision making that resulted in the decision to allow Lehman Brothers to fail in September 2008 and sent markets reeling as recently as late spring 2013, with then Fed Chairman Ben Bernanke's speech on tapering coming at the same time that Chinese policy makers began taking a tough line on their own shadow banking system. This is just one example of the many additional risks that must now be factored into the investment decision making process, for the next major decline in inflated asset values may not see a similar recovery as we have in the recent past. After all, exactly what treasure will policy makers deploy to stabilize markets in the aftermath of the next crisis if it were to indeed come to pass? Perhaps a stronger and more robust global economic growth trajectory would help alleviate such concerns. But alas and alack.

A delight

Comes sudden on my heart, and I am glad

As I myself were there! Nor in this bower,

This little lime-tree bower, have I not mark'd

Much that has sooth'd me.

--This Lime Tree Bower My Prison, Samuel Taylor Coleridge

Fortunately, those investors that feel confined to the bower of seemingly endless central bank stimulus have good reasons to delight, as they may find themselves the most rewarded and enlightened in the end.

First, one should not forgo the opportunity to meaningfully participate in today's still glorious financial markets. We as investors do not get to chose the markets in which we want to participate. Instead, we must participate in the markets that are set before us. And these have been strong performing markets across a number of asset classes, including stocks that warrant a considerable degree of participation. This does not mean that those concerned investors should simply throw caution to the wind and abandon their instincts toward risk control. On the contrary, investors that can embrace the fact that great opportunities are still abundant today while not abandoning their risk controlled framework stand to benefit just as much if not more from what the market has to offer today.

Second, and perhaps more importantly, by maintaining a keen awareness to the downside risks facing today's markets and monitoring various events closely as they unfold, those confined investors are also preparing themselves for an even more profound total returns opportunity once today's aging bull market finally arrives at its climax and a new bear market has finally begun to roam the countryside. After all, rising stock prices is only just one of many ways to achieve strongly positive investment results in capital markets. And in many ways, the higher the bull market rises, the more pronounced the opportunity set will be on the other side once stocks finally reverse and begin heading lower. For regardless of the strength of your convictions in today's environment, bull markets do not last forever and this one is already running at the third longest in history.

Thus, the investor that may feel imprisoned by Fed policy actually has good reason to feel soothed today.

Through the late twilight: and though now the bat

Wheels silent by, and not a swallow twitters,

Yet still the solitary humble-bee

Sings in the bean-flower! Henceforth I shall know

That Nature ne'er deserts the wise and pure

--This Lime Tree Bower My Prison, Samuel Taylor Coleridge

Looking ahead, we are now in the late twilight of ultra aggressively stimulative Fed policy. Yes, zero interest rate policy is likely to remain intact at least through early 2015, but the asset purchase programs that have been so supportive to rising stock prices since the outbreak of the financial crisis are set to come to an end over the next two months. Thus, it is reasonable to consider the potential effect, if any, across global capital markets once these stimulus programs finally draw to a close.

The dependence of the U.S. stock market (NYSEARCA:SPY) on repeated rounds of quantitative easing from the Federal Reserve has been meaningful. In short, when the Fed has been actively engaged in a stimulus program, stocks have soared. And when the Fed has stood down from stimulus, stocks have meandered at best and struggled mightily at worst. As a result, the correlation between U.S. stock prices and the expansion of the Fed's balance sheet has been extremely high since the first Treasury purchase was made as part of QE1 back in March 2009. This raises an important question. What will propel stocks to further gains much less support them at today's prices given already elevated valuations once the support of Fed stimulus is finally gone? Perhaps so much liquidity has leaked into the financial system at this point that further Fed asset purchases no longer matters and the market will show the resilience to keep pushing upward on its own. Only time will tell at this point. But it is a development that warrants close attention in the months ahead.

What is a bit worrisome in this regard is that dividend growth stocks (NYSEARCA:SDY) have followed the broader market on this Fed asset purchase fueled ride higher. Why this is disconcerting is that many investors have abandoned lower risk alternatives and have migrated to the dividend growth stock space in recent years under the allure of impressive returns in recent years and buoyed by the notion that these somehow represent lower risk alternatives relative to the broader market. Perhaps this is true on the margin for selected stocks in the dividend growth universe, but these are still equities that are accompanied by the commensurate risk that comes with being a common stock. And they are not at all "bond equivalents" as some might suggest.

When standing back from the tree that is the U.S. stock market as measured by the S&P 500 Index and looking at the forest of capital markets, a critical point that often goes overlooked is that even if the Fed continued their asset purchase program, the forces of Fed policy are not boundless. In fact, nearly all other major asset classes around the world have now ceased to benefit from a price inflation perspective from central bank stimulus. In some cases, this implied support ended a long time ago.

The small cap (NYSEARCA:IWM) segment of the U.S. stock market had been sharing the joys of Fed stimulus up until the start of 2014. Since that time, it has increasingly deviated. Whether small caps can catch up with the broader trend remains to be seen, but if this segment of the market starts to truly run out of gas from a Fed stimulus standpoint, large caps may not be far behind.

The further one drifts away from U.S. large cap stocks, the more we see that most asset classes have reached a point of exhaustion with Fed stimulus long ago. For example, REITs (NYSEARCA:VNQ) broke away from the Fed balance sheet trend over a year ago in early 2013.

The same can be said of high yield bonds (NYSEARCA:HYG), which are historically highly correlated with U.S. small cap stocks, but have fallen off of the Fed stimulus path with the launch of QE3 at the beginning of 2013. And this drop off has occurred despite the ongoing thirst for yield from income starved investors.

Developed international (NYSEARCA:EFA) and emerging market stocks (NYSEARCA:EEM) deviated several years earlier, effectively breaking from the trend with the end of QE2 back in the summer of 2011.

And for all of the talk about the beneficial effects of stimulus on U.S. stock prices, we can see in China (NYSEARCA:FXI) that not all central bank stimuli have a beneficial effect on stock prices, for the People's Bank of China has not been shy at all about providing aggressive monetary policy support in recent years, yet Chinese stocks have been grinding sideways for roughly four years since late 2010.

For those looking toward the metals complex for confirmation of an uptick in inflation and accelerating global economic activity thanks to the expansion of the Fed's balance sheet, they are likely to be gravely disappointed. Industrial commodities such as copper (NYSEARCA:JJC) and oil (NYSEARCA:OIL) have been flat to negative since the beginning of 2011, completely deviating from their correlation with the Fed's balance sheet in the process.

And gold (NYSEARCA:GLD), which had been a Fed balance sheet expansion darling, as would be reasonably expected in a more normal market environment, has not only stopped rising with the increase in the Fed's assets, but actually reversed and headed lower since the start of 2013.

Interestingly, the only major asset class that never had a strong correlation to the expansion of the Fed's balance sheet over the last five plus years is the one category that the Fed's program was allegedly supposed to help most, which is U.S. Treasuries (NYSEARCA:TLT). In fact, the two are effectively uncorrelated at +0.03. But if history is any guide, the end of QE will be a welcome development for Treasuries, not a negative one. That is, of course, circumstances simultaneously arise where market participants in a foreign nation are being compelled to liquidate their Treasury holdings en masse to raise cash at the same time that U.S. policy makers are seeking to stand down from further stimulus, then all bets are off (this, of course, is what took place last spring with China).

One of the key takeaways from all of these charts is the following. At some point, all asset classes have stopped responding to Fed stimulus. U.S. stocks are the only remaining major category that is still showing signs of continuously benefiting, and even U.S. small caps are showing signs of starting to fall off the pace. This, of course, raises the following important question - will stocks catch down to all of the rest of the asset classes that broke away from the Fed's balance sheet trend long ago? If so, what is the magnitude and duration of the potential downside in stocks that we might see before this adjustment process is complete. Such are the additional risks that investors must consider in today's market place. For it is much better to find oneself in the bower than wandering out in the countryside when a storm suddenly arrives.

Bottom Line

We as investors should all rejoice in today's markets. And this is true whether you are someone that has full conviction in the rally or if you are someone that is deeply skeptical about the sustainability of the economic and market recovery, as today's market offers the grandeur of fresh new highs along with the ongoing opportunity to capitalize regardless of whether stocks or any other asset class is rising to new highs or if the market has broken to the downside.

But in the late twilight of the Fed's asset purchase stimulus program and potentially the aging bull in stocks, investors would be well served to at least prepare for a potential downside correction if not the onset of a new bear market at some point in the near future by closely evaluating their risk control measures and readiness to capitalize when the time finally comes.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: The author is long TLT.

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.

Additional disclosure: I am long stocks via the SPLV and XLU as well as selected names including a number of dividend growth stocks. I also hold a meaningful allocation to cash at the present time.