The Federal Reserve's Titanic Stock Market

by: Lioncastle Research

Summary

The Federal Reserve's monetary policies have unintentionally brought an unsinkable attitude and sense of complacency to investors.

Investors should realize the level of risk associated with their portfolio has dramatically increased over the past eighteen months.

Unintended consequences associated with the Federal Reserve's zero interest rate policy include excessive risk taking, asset bubbles, and wealth inequality.

The number of investors fearing a severe market correction (or even a crash) conceivably parallels with the number of passengers aboard the Titanic who worried they might actually sink on their maiden voyage. When bombarded with never ending assurances that certain tragedy is impossible, human nature becomes defenseless from sinking into a false sense of complacency. For investors, artificially low interest rates created by the Federal Reserve's (the Fed) loose monetary policy undoubtedly have unintended consequences directly impacting every portfolio.

It's no secret the Fed has utilized a number of monetary tools directly intended to keep interest rates low. They have accomplished this primarily by maintaining a low Fed funds rate (zero interest rate policy - ZIRP) and purchasing U.S. Treasuries and mortgage backed securities. Ultimately, their goal has been to stimulate the economy by making money cheaper. In theory, debts are easier to payoff, consumers will spend more, and stock and real estate prices rise. Looking at our current environment, "Mission Accomplished"!

Unfortunately, this strategy (especially taken in scope and duration) has unintended consequences. Three significant outcomes negatively impacting investors include inappropriate risk taking, asset bubbles, and wealth inequality. Understanding these unintended consequences before they come to complete fruition will prove priceless when it comes to wealth preservation for today's investor.

Savings rates of less than a quarter percent and CD yields unable to maintain pace with inflation have forced investors to seek other options (or reach for yield). A growing number of portfolios traditionally centered on fixed income investments such as bond funds have been moving into the "lucrative" returns recently offered by stocks. While this reward has been recently enjoyed in the form of rising stock prices, the risks inherent with equities has quietly been forgotten. Historically, investors seeking lower volatility and greater capital preservation often seek fixed income as their tolerance for risk declines over time. In the end, this artificially low interest rate environment has driven low risk investors into profiles unsuitable for their investment goals and objectives. Should markets experience declines similar to 2008-09; investors hoping for even reasonable capital preservation will be devastated.

Unsuitable investments associated with inappropriate risk taking have certainly contributed to rising equity valuations and rising stock prices are good, right? In short, valuations should only be as good as their fundamentals. Unfortunately, low interest rates have also distorted fundamentals. The simple truth to rising stock prices lies in the fact there are more buyers than sellers. For example, if there are 10 buyers willing to buy 1000 shares of Apple at $95/share and only 3 sellers willing to sell 600 shares at $95/share, market makers are forced to raise the price to entice more sellers to satisfy the buyer's order. Matching buyers and sellers remains an extremely efficient way to value a stock. Theoretically, this efficiency relies on the fact buyers and sellers base their decision on company fundamentals and outlook. However, when you have a dramatic increase in buyers simply because they are reaching for yield outside of low interest fixed income investments, company fundamentals are no longer the driving force behind buyers and sellers. Ultimately, when valuations exceed fundamentals, asset bubbles are formed.

Finally, and perhaps the most alarming consequence from artificially maintained interest rates is the widening gap of wealth inequality. Low interest rates are only beneficial to those who can access the cheap credit and take advantage of the leverage. Rising stock and real estate prices directly benefit their owners (usually higher income individuals). Wealth inequality by itself is not necessarily negative or detrimental as long as it is not pervasive and the overall economy continues to expand and improve. As of July 2014, the current economic recovery since 2008-09 continues to be the slowest on record. Statistics also show the direct beneficiaries of the Federal Reserve's monetary policies have been the wealthy. A simple illustration supporting this claim is found in the demographics and behavior between multi-class shoppers.

In fact, most equity shares in America are owned by the wealthiest 10 percent. Again, this is not inherently a problem-wealthier individuals with more disposable income will obviously have greater ability to take ownership stakes in companies than those with lower incomes. By itself, it's not a call for class warfare. However, it does mean that when the Fed engages in loose money policies, it is providing a benefit to a very narrow segment of society at the expense of others (either through future inflation or through the cost of raising taxes to pay for increased federal debts). Take a look at how wide the income gap has grown:

The top 2,915 richest Americans earn more than the poorest 23,303,064 Americans combined. While there will always be wealth and income inequality in society, the magnitude of today's gap is unprecedented. To further exacerbate this growing gap, wage growth for the typical American has been virtually absent. If the median household income had kept pace with the economy since 1970, it would now be nearly $92,000, not $50,000. An economy that relies on the consumer for almost 75% of GDP will never reach escape velocity (even with the wealthy still consuming).

All of this might be acceptable to some if the Federal Reserve's monetary policies were actually helping the American economy recover. The reality is that quantitative easing has made it cheaper for the government to borrow (which it has to with current debt levels), has artificially propped up the housing and stock markets, and has dramatically manipulated the distribution of capital in financial markets. Overlooking the unintended consequences of pervasive monetary policies has seemingly blinded investors of all size. Hopefully, when markets begin to sink there will be enough "life boats" to handle the panic and desire to exit.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.