On November 3rd, the Wall Street Journal inked an article titled, "Labor Market Inches Forward." The piece covered the Labor Department's new unemployment figures print, the market's reaction (SPY) (DIA), and the potential impact on the presidential election. All of this was fairly nondescript, with the exception of the article's jarring conclusion:
"For some investors, the recent stream of positive economic news has become a matter of concern for stocks. [...] an improving economy could encourage the Federal Reserve to lighten up on its stimulus."
And courtesy of MarketWatch:
"Positive economic reports bring stock selloffs resulting from investor concern that the Fed will decide against further monetary stimulus."
Investors are concerned that improvement in the real economy will be bad for stock markets because the market's artificial life jacket will disappear. Let that sink in. For market participants, looking at the past years has become an exercise of staring through fog - the anomalies of financial crisis, historic fiscal stimulus, and esoteric Federal Reserve easing operations render the past five years unfit for comparison. At the same time the dramatic uncertainties that hang over the market - vitriolic partisanship over the fiscal cliff in America, a morbid sovereign debt crisis and recessionary climate across Europe, an opaque slowdown and regime change in China - have left the future utterly unpredictable. If the market could be viewed on a timeline, the two ends have been cut off, leaving just the present. Through this strange combination of amnesia and myopia, investors have managed to make the present irrational.
The phrase "catch-22" comes from Joseph Heller's satirical novel of the same name. Today it is taken most often taken to mean a certain sort of self-contradictory and circular paradox. In Heller's book, a World War 2 pilot by the name of Yossarian desperately concocts ideas to secure his release from service.
"There was only one catch and that was Catch-22, which specified that a concern for one's safety in the face of dangers that were real and immediate was the process of a rational mind. Orr was crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn't, but if he were sane he had to fly them. If he flew them he was crazy and didn't have to; but if he didn't want to he was sane and had to."
Today, the market faces a catch-22 of its own. If the market's underlying fundamentals improve in the coming months, it necessitates no further quantitative easing and must deflate to its real value. If the market deteriorates, it will look hopelessly for further relief from the Federal Reserve. Regardless of the direction it takes, the market suffers from a paradox at the highest level, leaving little room for a coherent bullish thesis and much for a bearish one. If the economy continues on its path of uninspiring recovery (which is a questionable assumption to grant today), gains will only cannibalize the artificial buoy the market enjoyed as a result of quantitative easing.
The Spectre of Quantitative Easing
Combined with its continued zero interest rate policy, the Federal Reserve has purchased $2.3 trillion in assets since December 2008. In so doing it has decreased the quantity of safe assets such as Treasuries available to the market, leading to lower available rates of return, and ultimately crowding investors into investments that carry more risk, such as equities and commodities. The market's subsequent run-up has partly achieved the Fed's aim of generating recovery through increased consumer spending on the back of higher stock prices (this circularity in an escapable reality of unconventional monetary policy). Apart from their direct economic impact, these actions have undeniably propelled stock markets (a chart of 10 year treasury yields and the S&P 500 is below). Nonetheless, a vocal minority has stated that easing has had little, if anything, to do with the market's climb, which they maintain has been precipitated mainly by a rebound in earnings. The true economic impact of QE is impossible to ascertain fully, but the stock market moves on expectations, and every new QE announcement has led to sizeable short-run market upswings.
If an observer unfamiliar with the state of the American economy was shown the graph above, he would probably come away with a very positive perspective on the state of things. This is not the case. As the WSJ wrote in September, "The Federal Reserve, frustrated by persistently high U.S. unemployment and the torpid recovery, launched an aggressive program to spur the economy through open-ended commitments to buy mortgage-backed securities." This third round of quantitative easing centers around purchases of $40 billion in mortgage-backed securities a month until the labor market improves, a commitment to a Federal Funds Rate of 0% through 2015, and a dampened continuation of Operation Twist.
The problem with the market's opiatic infatuation with easing is that the program's efficacy is behind it. The federal funds rate has rested at its absolute bottom of 0% since the beginning of 2009. By its nature as a nominal rate, it can go no lower. The Reserve's recent announcement that it will maintain that rate through 2015 is the most it can do for the market through conventional means. The large scale asset purchases the Reserve has engaged in (QE1, QE2, and now QE3) represent unconventional monetary policy. As rates on safe assets have bottomed to historic lows, the efficacy of these unconventional mechanisms has also declined - academic consensus is that the second round was roughly half as effective as the first. And the third round's defibrillation of the market has been decidedly anemic. To put it a more obvious way, there is a reason that the Federal Reserve's third iteration of easing did not follow in the footsteps of the previous two rounds, instead focusing on the housing market.
Easing in a Broader Context
In the current environment of a perpetual lame duck Congress, the Federal Reserve led by Ben Bernanke has become the apple of the market's eye. But only so much can be done, and as Barclays notes,
"for equities to extend the monetary policy easing anticipatory rally either the economic or public policy outlook would need to improve. We believe a long-term period of sustainable equity market multiple expansion requires monetary policy normalization, which is unlikely until key public policy concerns - tax and debt sustainability via entitlement reform -are settled."
To return to some state of market stability, the Federal Reserve's unconventional policies need to taper off. Yet any chance of a broad recovery and timely exit from the market has evaporated, as 60% of companies missed revenue expectations in Q3 and earnings growth will most likely decelerate into 2013. At the same time, for all the initial conciliatory press releases by the two parties regarding the fiscal cliff, Obama and Boehner's positions on tax cuts are irreconciliable. Many cannot begin to imagine a rehash of last year's debt ceiling debacle. But politicians calculate politically, not economically. With the election having passed, the Republicans have no incentive to reach resolution, which would tally as a victory for Democrats. As uncertainty builds, the market will strain under political brinkmanship once again. Some sort of patch work will emerge in the final moments as pressure mounts on Capitol Hill, and the can will be happily kicked down the road. But in the current political climate, I will eat glass if any sort of Grand Bargain comes.
The market is just now beginning to absorb the potential consequences of the fiscal cliff. And nothing points to its combined state of amnesia and myopia more. Compare the current abnormally high reading of the Baker Bloom Davis Index, a measure of economic policy uncertainty, to the market's expectation of future short-term volatility, the (VIX):
The S&P 500's implied volatility expectations have risen slightly in the past weeks, but remain far below rational assessment of future risks. During the debt ceiling quagmire last year, the S&P 500 took a 20% haircut in under a month. Today, investors are just as skittish. A correction of 10-20% seems likely by the end of the year for the S&P. At the same time, bearish investor sentiment and weak corporate results place an upward ceiling on the index. The market is caught in a double bind of needing both recovery and further liquidity by way of easing, but it will only be able to receive one. The uncertainty it now faces will only accelerate the market's realization of this reality.