Can Stocks Rally Without The Fed's Punchbowl?

by: Bret Jensen

Summary

Since the Federal Reserve ended its quantitative easing programs in October of 2014, equities have been stuck in the mud.

A correction that swept energy into a bear market early in 2015 has now spread to other sectors of the market including small caps, biotech and transports.

Although our central bank will likely soon back off its projected four quarter point interest rate hikes in 2016 forecast, no additional easing looks to be in the cards.

This leaves investors with the proverbial $64,000 question. At current levels, can stocks rally without the Fed's punchbowl?

The rough start to the year for investors looks like it will continue this week. On Friday the NASDAQ posted its lowest close since October 2014 and the index looks to be heading significantly lower in trading Monday. As I noted in a previous article, even the so call FANG (Facebook, Amazon, Netflix, Google) stocks which were one of the few areas of substantial areas of outperformance in the market in 2015 are wilting under this onslaught.

I just finished a book entitled "Kennedy's Revenge: The Election of 2016". It is a fast moving page turner that centers around a conspiracy angle on the real reason for the creation of the Federal Reserve, its nefarious real purposes and its hidden impacts on society. It is one of the few non-fiction works I have read in recent years and it was a nice break from just watching the downward action of the market so far in 2016.

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More importantly it reminded me of the Fed's impact (the non conspiracy kind) on the markets and why equities seem unable to do much without a push from the central bank. I don't think it is any coincidence that the NASDAQ is trading at the same level as it did when the Federal Reserve finally ended its third and last quantitative easing program back in October of 2014. These efforts quintupled the Fed's balance sheet to more than $4 trillion.

"QE" pumped massive liquidity into the credit markets. However, the quantifiable impact on both the domestic economy and the markets has always been the subject of an intense and evolving debate. I don't want get into impacts on the economy or whether the QE efforts after TARP were the right course of action for the economy.

However, it has become quite apparent in hindsight that domestic equities have been stuck in the mud since the Fed ended its largesse roughly five quarters ago. One should also note that the declines in energy and commodities accelerated soon after our central bank ended the last of its quantitative easing programs during the fourth quarter of 2014. This weakness soon spread to the small cap sector which posted decent losses in 2015.

Soon thereafter the transports, biotech, Japan, China, and Europe also descended into official bear market territory in late 2015 or early 2016. Recently even the FANG (Facebook, Amazon, Netflix, Google) stocks have broken down with both Amazon (NASDAQ:AMZN) and Netflix (NASDAQ:NFLX) falling some 15% just last week. Again this was one of the few areas of significant outperformance in the market in 2015, and this is the latest high beta area of the market that has started to fall apart.

My regular readers know that I have not been the biggest fan of the Federal Reserve over the years. The central bank has consistently been one of the primary factors with its liquidity measures behind the inflating of bubbles (Internet boom in late 90s, housing bubble before financial crisis) over the past 15 years or so. It has also consistently been overly optimistic about its growth assumptions about the domestic economy throughout this post war recovery. The central bank has consistently put out initial forecasts at the beginning of a year calling for growth of three percent or better for GDP. Actual GDP growth has come in almost every year at a full one percent below those levels.

In hindsight, our central bank would have better served by hiking rates in the second half of 2014 when domestic economic activity was much more robust and global growth levels were higher as well. Now it is in a position where it has publicly forecast it plans to hike interest rates by a quarter point four times in 2016. The Fed is committed to raising interest rates while both the central banks of Europe and Japan are engaging in their quantitative easing efforts. This highlights the disconnect between the world's central banks. It also is a key reason while the dollar keeps strengthening.

I think the Federal Reserve will have to come to its senses in the very near future as it is obvious the global economy is in terrible shape. The huge amount of capital flight out of China means a currency devaluation with the Yuan (more on that in my Thursday instablog post to real-time followers) is probably going to happen sometime in the first half of the year. This will be a tailwind for more appreciation in the greenback.

It is hard to believe given the current rate of deterioration in the markets that the Fed will not back off its current stance on interest rates in an obvious way before the month of February is out. This will probably be the point that equities slow or reverse their decline. However, without additional easing measures which I don't think is in the offing at least in 2016 at this point; it is hard to see a sustained rally until prospects for global growth improved markedly. Until that happens and without the benefit of the Fed's "punchbowl", flat might be the new up for the markets.

When the Fed does back off its current four rate hike in 2016 projections this should be supportive of stocks and sectors with high dividend yields especially those with cheap valuations. The market has already turned from one focused on growth like it was in 2015 to one rewarding value stocks, which have held much better during this onslaught we have seen in the markets to begin 2016.

I continue to be positive on high yielding large cap growth plays that have cheap valuations after the bear market in the biotech sector. These include Amgen (NASDAQ:AMGN) and AbbVie (NYSE:ABBV) which I have continued to add to in the recent downturn. The high dividend yield is just one of five reasons I believe big biotech, which is selling at valuations not seen since 2011; is a sector long term investors want to buy here.

As I recently outlined, some of the lodging real estate investment trusts (REITs) look very enticing here. I continue to pick up a few shares on dips in Chatham Lodging Trust (NYSE:CLDT) and Diamondrock Hospitality (NYSE:DRH). Both REITs yield between six and seven percent, are cheap and have solid growth prospects outside a significant domestic recession. This is a possibility I put a low likelihood on despite less than perfect forecasts and policies from the Federal Reserve.

Disclosure: I am/we are long ABBV, AMGN, CLDT, DRH.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.