Pro-Cyclical Monetary Policy And The Dormant Bear

| About: SPDR S&P (SPY)


Long topping formation not unusual at end of long bull market.

Confidence in Fed policy, low rates, and stabilizing macro indicators keeping equities afloat.

Don't rely on traditional leading economic indicators to time the next recession.

Since last summer, a significant portion of the investing community has gotten the message that the "jig is up"…or at least should be up. For the first time since 2009, we have witnessed back-to-back cascading drops in equities (in both August 2015 and January 2016). The selling had felt much more like a "proverbial race to the exits" than a typical bull-market profit-taking correction. However, the magnitude of the bounce-back rallies in October and February/March surprised many investors. This is seen by the huge swings in investor sentiment over past six months (see below), increased option market activity, and our informal observations of CNBC Talking Heads (the census of whom gave the "brace yourselves, this will get worse" message during each cascading drop).

All of this should not be surprising. In technical parlance, this is termed a "topping pattern". The longer and the more ingrained a bull market becomes, the longer and more complex the top tends to be. In this missive, we'll first try to make sense of the ostensible "reasons" the market has rallied back from these cascading drops, then in the second part look at some charts that help visualize what is happening.

Why The Markets Keep Rallying Back

The recent bull market has been very unusual by historical standards. Assuming a May 2015 peak on the S&P 500, this past bull market would not the longest on record (the 1987-2000 bull holds this crown, outstripping the recent bull by 39 months). Nor would the current bull have posted the greatest gains. What makes the recent bull unusual is the accompanying economic environment. We have not exactly been in a booming economy, with firms making money hand-over-fist, as would describe the environment in prior, comparable bull markets. While the first part of the bull market (in 2009) was a snap-back normalization from "end-of-the-world" scenarios, the second part of the bull (2010-2012) saw legitimate margin expansion of firms (although aided by still inappropriately low interest rates) to justify stock price advances. The third part of the recent bull has admittedly (even inveterate bulls would agree) be driven by non-fundamental factors. One major factor making today's topping pattern so complex is a persistent belief in the efficacy of Federal Reserve policy. What really differentiates today's bull market top from the 2000 and 2007 market tops (see chart below) is the use of "pro-cyclical monetary policy". Indeed, in the prior two cycles, monetary policy was run in a "normal", counter-cyclical fashion. In this lies the key disparity with today's cycle: for the first time in history, the Federal Reserve is running pro-cyclical monetary policy, thereby confounding value investors and forward-looking, thoughtful investors who have (rightly) opted for prudence in their investments. Lord Keynes would turn over in his grave. The term"boom and bust" should come to mind (flash back to 1970's-1980's). The fundamental difference between our investment outlook at WMA and the average long-term bullish investor outlook is that the latter believes that central banks in general (and the Federal Reserve in particular) will be able to manage the "bust" (yes, there is also a Janet Yellen joke here). After over 300 years of Central Banking, we are understandably very skeptical to the idea that today's central bankers have "discovered" the cure to economic recessions and talisman offering permanent prosperity in equity markets.

One main reason for the two recent snap-back rallies is the Fed's "reassuring" discourse during the sell-offs. For example, since the December FOMC meeting markets have known that rates increases will be at "gradual, measured pace". The "gradual" and "cautious" spiel from the Fed is old news that investors should have fully discounted by now. However, instead of paying less and less attention to Fed copy-and-paste speeches and communiqués," investors seem to get more and more excited about each mention of the word "gradual". And typically investor excitement is what starts to really separate asset prices from asset values. Traders are splitting hairs over nomenclature. A rally predicated on nothing should do nothing. In sum, as long as the majority of investors believe that (1) the Fed will continue to run pro-cyclical monetary policy and (2) that they will be successful, the market will continue the current topping formation. However, the longer the Day of Reckoning is put off, the greater the bust will be once central banks lose control of the markets.

A second, persistent reason for the recent equity rallies is the still positive spread between the S&P 500 dividend yield (2.10%) and the U.S. 10-Year note yield (1.80%). As long as investors feel that the Fed will back-stop equities, investors will continue to choose higher yielding stocks with the potential for capital gains. We expect this divergence to actually widen…due to T-Note rates falling towards the average of other G7 developed nations (currently at 0.77%). Paradoxically, in this case, equities may collapse from a widening positive spread between S&P 500 dividend yields and Treasury yields, as investors "unlock" the value in Treasurys.

A final reason for the snap-back equity rallies is the belief that the U.S. economic is not going into recession. On this point, the macro data does not indicate an impending recession. The ISM PMI, which had been slowing since November 2014, has been moving towards expansion since January 2016. In terms of other indicators (we ignore employment as it is a notoriously lagging indicator), the more reliable leading economic indicators (LEIs) are KO this cycle due to pro-cyclical monetary policy. Notably, we can't count on a contraction of money supply or an inversion on the yield curve to signal recession. The stock market may be the best LEI of the economy this cycle. We will therefore be in an expansion until the financial markets decide we are no longer in expansion.

In the next section, we pulled out three charts that are consistent with an on-going topping formation in equities.

Market Tops Don't Turn On a Dime

We went back and looked at the prior two major market tops in 2000 and 2007 and compared them with the tentative top made in May 2015 (based on the S&P 500 index)(NYSEARCA:SPY). In both prior cases, it was not until 225 days after the market high point that the index "released" and turned into a full-fledged bear market. Admittedly, current path of the S&P 500 (in green) is much stronger this cycle, perhaps due to the persistent belief (mentioned above) that Federal Reserve policy can still become more accommodative. The difference between the red/blue curves and the green curve is the use of counter-cyclical monetary policy in the former cases and pro-cyclical monetary policy in the latter case.

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Déjà Vu All Over Again

Next, we updated our overlay of the double-dip S&P 500 bounce last fall with the double-dip bounce in January/February 2016. Yes, it is simplistic and naïve. But so is the average investor. Will markets really repeat the trend we just experienced? It is our forecast.

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The Mercurial Investor

Finally we show the wild swings in our WMA Sentiment Indicator. Large swings in sentiment are typical at market tops, as investors are usually confused and have a hard time abandoning their recent beliefs (memory bias). To this end, the 25 point swings in sentiment in and out of optimism and pessimism should not be reassuring.

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We will be arriving at a period of poor seasonality for major averages in several weeks which argues for lightening up on April market strength. While it makes sense to give the market the benefit on the doubt for a retest of last summer's highs on the S&P 500, do not hesitate to hit the exits on any deterioration in our Trend Indicator. Today the downside risk is just too great.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.