Does Another Cruel Summer Lie Ahead For Stocks?

by: Eric Parnell, CFA

The stock market has made one thing abundantly clear in the early days of the second quarter: It still cannot stand on its own at current levels without the continued support of additional stimulus from the U.S. Federal Reserve. And with the latest Fed stimulus program set to end in June, it may be shaping up to be another cruel summer for stocks.

It all began on April 3 with the release of the latest Fed minutes from the March Open Market Committee meeting. Although nothing was included or discussed that we haven't already heard from the Fed many times before over the last several years, the market decided that the key take away from the latest minutes was that no further quantitative easing would be coming from the Fed any time soon. Stocks (SPY) immediately recoiled on the news, sliding lower for the remainder of the holiday shortened trading week. Then came the disappointing employment numbers on Friday and the uneasy response by investors once the stock market reopened early this past week. All of the sudden, the additional Fed stimulus that so many had concluded was off the table merely one week earlier was all of the sudden back on once again.

This highlights a key point about today's market and the continued lack of discipline. I have long been critical of the Fed's inclination to sometimes be reactive in applying additional stimulus in recent years. But Fed policy makers are not so mercurial as to move from a stance of no further stimulus one week to preparing to launch a new round the next week all based on a single data point in the employment report that, like so many individual economic data points, is subject to error and revision. Furthermore, the Fed did not take the possibility of additional stimulus off the table in their most recent minutes, and Ms. Yellen did not necessarily put it back on the table in her recent policy speech this past Wednesday either. A close inspection of both the recent minutes and the transcript of her speech show that the Fed's message has basically stayed the same all along. It is the market's interpretation of the Fed's intentions that has been all over the place.

Unfortunately, we operate in a market today that has become so heavily dependent on the Fed and any mention of its next policy moves. The addiction to Fed policy has become so pronounced that economic and market fundamentals are often completely ignored on any given trading day in deference to the latest musings of the FOMC speaker du jour. And investors have become worryingly quick to plead for more Fed stimulii if the market is down for even a moment. This last Tuesday, for example, stocks had plunged lower for five straight trading days to levels last seen - wait for it - less than a month ago in March. Shudder the thought that the stock market ever go down any more even for a few days. Yet investors were clamoring that more Fed support would be needed. Such desperate dependence is not healthy.

So given the apparent importance of the Fed to investors, it is worthwhile to stand back and truly assess what their next move, if any, is likely to be in the coming months. This is not an assessment that should change with the latest economic data point. Instead, it should be a broader view that tries to get inside the head of Fed policy makers including Chairman Bernanke. After all, they like the rest of us are human and put their pants on one leg at a time.

One point should be made abundantly clear before going any further in predicting the Fed. Operation Twist is a Fed stimulus program very similar to the past rounds of quantitative easing in QE1 and QE2. It is effectively QE3 by everything but name. The only difference is that under Operation Twist the Fed is exchanging cash equivalents in the form of Short-Term U.S. Treasuries with the banks instead of cash as they did with QE1 and QE2. But in the end it still amounts to a $400 billion stimulus program that is set to run through the end of June 2012. I have noticed that the media has become more aware of this point in recent weeks, but it is still lost on the many that are still speculating about the timing of QE3.

This initial fact raises an important point. While the stock market has been long overdue to correct, it is unlikely to do so in any meaningful or sustainable way as long as Operation Twist remains in effect. If anything, we are likely to see the stock market grind back and forth in a sideways pattern for the next few months until this program comes to an end in June. The performance of the stock market during this same time last year leading up to the end of QE2 in June 2011 is instructive as to what we might expect in the next couple of months.

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Thus, the Fed is not likely to launch any new stimulus program until the beginning of July at the earliest. And here are a few things we know about the Fed in contemplating whether they might launch another round of stimulus.

First, Bernanke is devoted to his beliefs about applying aggressive stimulus. Given his background and expertise on the Great Depression, it seems that he simply refuses to be remembered as the person that allowed the economy fall into Great Depression 2 because he did not provide sufficient monetary policy support. Thus, when in doubt, the Chairman is likely to err on the side of more stimulii. And this option is NEVER off the table.

Second, the Fed is keenly aware of the daily moves in the stock market. They clearly see this as a daily weathervane on the economy and the public perception of whether underlying economic conditions are improving or deteriorating. Thus, they are not likely to stand by for long without responding to any sharp stock market decline.

Third, the Fed like so many investors in the marketplace are now well aware of how the stock market responds the moment the crutch of monetary stimulus is removed. Just as we experienced in April 2010 and July 2011, the stock market will hold for roughly three weeks after the end of a Fed stimulus program before cascading sharply lower. If possible, I believe they would like to work to avoid the same shock occurring a third time around in July 2012 once Operation Twist comes to an end.

All of these factors suggest that the Fed may be inclined to stand ready to launch another stimulus program at the beginning of July once Operation Twist comes to an end in early June. Oh, if it were only that simple.

The Fed faces a series of dilemmas in applying such an immediate policy prescription.

First, stock prices are not the only thing that rises with Fed stimulus. So do oil prices. In fact, oil prices like Fed stimulus just as much if not more so than stocks. This creates a dilemma for the Fed. If they provide additional stimulus to support stock prices, they will also be fueling a continued rise in oil prices. This, of course, is highly inflationary. And given the fact than roughly 50% of Americans own stock, but nearly 100% of us have to get in our cars and drive to work, school and the grocery store on a daily basis, it raises questions as to whether any wealth effect benefit from rising stock prices would be increasingly overwhelmed by the added tax of higher oil and gasoline prices. And how much higher can stocks levitate from current levels anyway.

Second, the Fed is under increasing political scrutiny over their policy actions. The victory lap following the Fed's successful QE1 program is now a distant memory. Instead, many in Congress are becoming increasingly vocal in their criticism that the Fed may now be putting the economy at increased long-term risk by its continued stimulus programs. And with a presidential election looming around the corner in the next six months, such scrutiny is only likely to intensify. Thus, the Fed must act carefully with any future policy decisions.

Third, the Fed is facing increasing pressure to demonstrate that their policy responses are actually providing the desired effect. Sure, stock prices are rising. And it appears that with Operation Twist that they have finally figured out how to keep bond yields low while juicing the stock market. But not everyone owns stocks, as retirees and savers in this country continue to be punished by FDIC insured interest rates that are essentially zero. Also, the justification for these ongoing stimulus programs was to keep borrowing rates low in order to support a rebound in the housing market. But three years on, housing continues to languish in many parts of the country. And getting a low interest rate on a mortgage is certainly not the deterrent that is thwarting any housing recovery at this stage.

So putting this all together, what does this suggest about the most likely course for the Fed in the summer once Operation Twist comes to an end? It leads to the following conclusions.

The Fed will need a clear reason to enact further policy. And this is unlikely to materialize in a profound way in the coming weeks prior to Operation Twist ending in June. Thus, the Fed will likely need the economic data to continue to weaken along with the sharp stock market correction that will likely arrive post stimulus in July to justify any further policy response. And oil prices will also need to come down along with stocks to enable the Fed to comfortably take further action. And even this timing may be tricky given that the presidential election will be less than three months away by the time everything presumably unfolds to give the Fed clearance to act. But if conditions get sufficiently bleak as they did in early August 2011, the Fed will likely have the justification to move with further monetary support.

This required outcome implies that the stock market may be facing a cruel summer. After a period of chopping back and forth through the end of Operation Twist in June, a sharp correction would likely follow in mid to late July once the economy is forced to go it alone once again, as growth is still woefully insufficient to support stock prices anywhere near currently elevated levels. Having stocks quickly fall into the 1000 to 1200 range on the S&P 500 would likely provide sufficient clearance for the Fed to then act with more stimulus.

And how are they likely to act? Despite all of the talk about QE3, it remains the less likely outcome. QE3 comes with direct and visually evident balance sheet expansion that is now well known to juice stock and commodity prices while also causing bond yields to rise. It is also politically much more controversial. The more likely outcome would be the balance sheet neutral but enlongating Operation Twist 2, with the focus this time on exchanging Short-Term U.S. Treasuries for Mortgage Backed Securities. But this strategy comes with its own complications. Most notably, the Fed only has a finite inventory of Short-Term U.S. Treasuries to exchange for these longer dated assets that are making up an ever growing percentage of the Fed's balance sheet. This is a potential constraint in future policy action that will be worth monitoring as events unfold.

So what then is a suitable investment approach given the uncertainties associated with these Fed driven markets. An ideal strategy is to remain hedged. If the Fed was not influencing the market, I would be assertively allocating to those categories that are negatively correlated to stocks. But since the Fed is actively involved, it remains worthwhile to hold an allocation to stocks that is proportional to other asset classes. This includes holdings in those areas of the market that are of higher quality and have trailed in the recent stimulus induced rally over the last several months including consumer staples like General Mills (GIS), HJ Heinz (HNZ) and Tootsie Roll (TR) as well as utilities such as WGL Holdings (WGL). Maintaining a position in high yield bonds (HYG) may have appeal at least in the short-term given their high correlation to the stock market with lower price volatility. Beyond stocks, the potential for continued global monetary stimulus activity remains supportive of precious metals including gold (GLD) and silver (SLV). And the fact that the next stimulus program is likely to focus on MBS makes gives appeal to owning a position in agency MBS (MBB). And for those looking for a high quality way to short the stock market with lower risk and income, long-term U.S. Treasuries (TLT) continue to provide a reliable offset during stock market pullbacks.

The springtime will bring much in the way of information as to what we can expect from the Fed in the coming months. And it may ultimately lead to another cruel summer for stocks. Stay tuned.

Disclosure: I am long GIS, GLD, HNZ, HYG, MBB, SLV, TLT, TR, WGL.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.