A Financial Love Triangle

Includes: SHY, SPY, TLT
by: Luke Nagell

The Fed, stocks and bonds are currently ensnared in a love triangle. More often than not, a love triangle ends poorly with one person feeling betrayed. One of the most famous love triangles played out in William Shakespeare's tragedy, Romeo and Juliet. I'll refresh your high school English class memory by providing a quick synopsis of the cliff notes you once skimmed. The plot is based around a love triangle between Romeo, Juliet, and Count Paris. Romeo and Juliet fell in love prior to a pre-arranged marriage by the families of Juliet and Paris. To avoid the marriage, Juliet fakes her death by taking a drug that induces her into a deep coma. Once Romeo finds out of her presumed death, he purchases a lethal drug and heads to her tomb to join her in the afterlife. Upon arrival, Romeo bumps into Paris and the confrontation ends with Romeo killing Paris followed by Romeo taking his own life with the drug. Hours later, Juliet awakens from her deep coma to find Romeo dead and as a result also takes her own life. Although the likely outcome of the financial love triangle will not be as tragic as Shakespeare's play, one party will inevitably feel betrayed.

Much like Romeo and Juliet's love, the love between the Fed and stocks is real. As companies benefit from excess liquidity, stock price appreciation, and a shrinking pension fund liability they are returning the love by hiring new employees. However, outside forces are testing how strong the relationship between the Fed and the private sector is. Since the height of the U.S. joblessness in February of 2010, the public sector (government) has lost 627,000 jobs while the private sector has added over 6 million. You can see from the table below, looking at the largest job loss periods in the U.S., the only other time the government sector did not contribute to the jobs recovery was in the 1940s after WWII ended. This was for good reason as troops came home and left the public sector for the private sector. Additionally, European woes continue to show just how fragile the jobs recovery is. After a roughly 14% decline in European stock indexes in May of last year, CEOs and mangers showed their concern by adding only 78,000 jobs in June compared to a monthly average of over 200,000 for the 12 months prior. Although the government sector continues to cut back and Europe continues to have an occasional flare up, one cannot bet against the historical stock returns during a jobs recovery period (last column in table below).

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From the table above, you can see that the most recent significant job loss and recovery occurred in the 1980s. The severity of job loss is vastly different but the stock market is tracking along a very similar path. The chart below illustrates $10,000 invested in the S&P 500 stock index at the height of layoffs in the 1982 and in 2010. Looking at the 1980s specifically, full job loss recovery occurred at month 11 and the unemployment rate fell below 7% for the first time in month 36. Even at 36 months, more than three times the length of any other jobs recovery period and we still have a long way to go before we recover all the jobs lost from 2008 to 2010. Assuming the government sector can remain at a neutral position, meaning no more layoffs or hiring, than it would take another 17 months for the private sector to fully recover the remaining 3 million jobs that were lost. This puts us at mid-2014 with a total of 53 months to fully recover just the jobs lost from the financial crisis. All of this leads one to believe that the Fed and stocks will still be head over heels for each other for at least another year and a half.

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The Fed has been putting on the face that it is deeply in love with bonds as well. At first, it was a more flirtatious relationship as the Fed began lowering short-term interest rates effectively to 0. However, their relationship really began to flourish as the Fed began buying Treasuries and mortgage backed securities in an attempt to lower long-term interest rates. Much like the failure of any relationship, the separation of the Fed from the bond market will come at a hefty cost. As more and more investors enter retirement and shift out of stocks and into presumably "safe" investments, they need to do so tactically. If longer term investors buy bonds (NYSEARCA:TLT) at these interest rate levels, at some point down the road they will feel betrayed, much like Paris felt. The Fed has made it very clear that it will not raise short-term interest rates until the unemployment rate falls to 6.5%. Furthermore, even as the Fed purchases longer term Treasuries, the yield curve is extremely steep relative to historical levels. Investors may have a small window of opportunity to receive some yield by moving out on the yield curve. However, investors should use extreme caution and shift towards a lower duration portfolio (NYSEARCA:SHY) as the unemployment rate continues its descent.

For good reason, many investors are becoming a little leery as the Dow reaches record highs on a daily basis. Further, comparing the current run-up in the S&P 500 (NYSEARCA:SPY) to the 1980s might bring some dark memories back for some investors. Black Monday occurred on October 19th, 1987 and was the largest one day stock market drop in history. However, even with this massive one day drop the S&P 500 ended the year positive and extended its positive streak to five years. Currently, we are also into our fifth straight year of positive territory and still have at least another year before all the jobs are fully recovered. Much like Romeo and Juliet showed their love by doing whatever it took to be together, the Fed has shown the same love for stocks. As for bonds, let's just hope investors don't feel too betrayed and that the death is slow and painless.

Disclosure: I am long TLT, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.