Follow The Yellen Brick Road, But Watch Out For Lions And Tigers And Bears (Oh, My!)

by: Altitrade Partners

Summary

The Federal Reserve begins the implementation of a policy change to end QE3 next month.

Investors believe that since this move was telegraphed well-ahead of time that market behavior will be calm and collected.

When too many investors hold the same opinion, consensus thinking is often proven wrong.

In the classic movie "The Wizard of Oz" Dorothy Gale steps out of her tornado swept home into a lovely world of colored fantasy. Everything she encounters is beautiful and charming; from the little chubby-faced munchkins to Glenda the good witch of the north.

However, it isn't long before the appearance of the wicked witch of the west, who threatens to destroy Dorothy (and Toto too) if she doesn't hand over the ruby slippers which had belonged to the wicked witches' sister from the east who was killed when the Gale farmhouse fell upon her.

When Dorothy inquires of Glenda how to get back home to Kansas, she is told to seek out the Wizard of Oz, who resides in the Emerald City. The munchkins point her on her way by telling her to "follow the yellow brick road".

It seems to us that many of today's stock market investors are like Dorothy. Investors are being swept into a fantasy world of eye-popping stock prices, price-popping IPOs, all with potential bubble-popping consequences. They too are following a road which will seemingly lead them to a place of great wealth and prosperity. They are on, what we call, the Yellen brick road.

Janet Yellen like the "great and powerful" Wizard of Oz is operating behind a curtain of mystery, shrouded in a clandestine cloud of monetary mechanisms; manipulating the economy with levers and pulleys of all kinds. However, like the great and powerful "Wizard" she will ultimately be shown to have little real powers in bringing about a successful resolution to today's economic and fiscal problems.

The Federal Reserve has embarked on their own journey of Quantitative Easing for six years now, and despite all of the gradations of policy change, along with tweak this and tweak that, they have made very little progress in helping to generate sustainable pecuniary growth for the United States economy.

Their Zero-Interest Rate Policy (ZIRP), designed to push savers and investors into higher risk, higher yielding investments, was thought to be the way to create a substantial wealth effect, and thereby boost the economy.

The idea was that if your stock portfolio goes up, and the value of your home goes up, you will feel wealthier and more likely to spend additional money on goods and services. This fueling of overall consumer spending, which accounts for 2/3rds of the U.S. economy, would then lead to higher corporate profits, which would, in turn, result in additional capital spending and hiring of workers by those same corporations. The problem is that it just has not played out according to the Federal Reserve's script.

We have likened the actions of the Federal Reserve to someone filling up a water bucket with holes punched all around it. The more it leaks, the more you have to continue to pour in liquid to maintain the same level of water. One thing that we can say for sure is that the Fed has a tremendous understanding of liquidity.

A more troubling problem facing the Federal Reserve Board (NYSE:FRB) is what to do if the twin bubbles of housing and the stock market pop. With interest rates already so low, there will be very little they will be able to do to help support prices (unless they want to start purchasing stock futures and housing inventory).

We have often said that you cannot suspend the laws of economics any more than you can suspend the laws of gravity. What goes up must eventually come back down to its historical mean. For more on this subject, please see one of our earlier articles on regression to the mean.

What Janet Yellen and the Federal Reserve do understand is that the linchpin to the U.S. economy is jobs. Plain and simple. But keeping interest rates low for a "considerable time" is not the key to job creation. If it was we would have seen it already.

Many who have been unemployed, remain so. In fact, the majority of those who have been without a job for the past 6-12 month are not even bothering to look for a job anymore. They are discouraged and disheartened. Employers are not willing to hire someone who has been out of the active workforce for any meaningful length of time. If you are among the older population in the workforce (say 50 plus) your chances of finding someone who will hire you declines considerably if you have been unemployed for over a year.

Jobs generate income for workers, but they also generate income for the government through the levying of taxes on earned income. Without jobs, not only do individuals have a hard time paying their bills, but so does the government. The amount of debt that the federal government owes is mind-boggling. As of today, the national debt exceeds $17.7 trillion.

How in the world can we, as a nation, expect pay that back without strong, sustainable economic growth? If you want to see how much the interest costs consume out of the U.S. budget, just take a look at this chart from the Congressional Budget Office (CBO).

The problem is that nothing of substance or significance has been done to address the economic issue of job creation. Try as they might, by keeping interest rates low, there is nothing that the Federal Reserve can do to create jobs.

Janet Yellen should be very worried, and quite frankly she looks it. The Fed has boxed itself into a corner. They have to be concerned about the historical price of the U.S. equity markets. In fact, just yesterday it was revealed that all of the leaders of the G-20, meeting in Cairns, Australia were concerned about stock market valuations, and potential market bubbles.

We found it to be very troubling when Fed Chairwoman Yellen commented on the stock market back in June, by stating that she isn't particularly concerned about stock prices at current levels.

Ms. Yellen said she and her committee look at several different metrics to gauge stock valuations relative to earnings and dividends on an historical basis. When asked whether the market is trading outside of those norms, she responded: "I still don't see that for equity prices broadly," while adding she currently doesn't see bubble-like conditions in the market. Not only was she insincere, in our view, but we believe that she was inaccurate as well.

Two of the more popular metrics used for gauging the valuation of the markets are the Shiller Cyclically- Adjusted Price-Earnings Ratio (CAPE), and the Warren Buffett Valuation Indicator, which measures total market cap to Gross Domestic Product (NYSEMKT:GDP).

Let's take a look at where those two valuation methods are currently.

The Shiller CAPE is currently at a reading of 26.5 , which is 59.6% higher than the historical mean of 16.6.

There have only been three other periods in stock market history when the CAPE was higher than it is today; September 1, 1929 when it was at 32.54, December 1, 1999 when it registered an all-time record reading of 44.19 and September 1, 2007 when it stood at 26.73.

The Buffett indicator, as it is known, is currently at 127.2, meaning that the total market cap of U.S. equities is 127.2 percent of the U.S. economic output as measured by Gross Domestic Product . This number is more than two standard deviations above its historical mean of 68.6 going back to 1950.

Here's another look at market cap to GDP, this time using the Dow Jones Industrial Average as the equity benchmark.

So what is it that so many others see that Janet Yellen does not? We find her observations either disingenuous or intentionally misleading. Could Ms. Yellen just be plain worried about the upcoming tapering in October and what effect that may have on equity prices?

The Fed knows what happened the last two times they changed course on QE policy. When they completed QE1 the market, as measured by the S&P 500, dipped some 9.0 percent. When they finished QE2 the market declined by 11.65%, even after the Fed hinted about the end of QE2 well ahead of time to soften the blow. Here are a couple of charts that show the S&P 500 Index plotted against the QE moves by the Federal Reserve Board.

Perhaps the thinking by the Federal Reserve Board is that by saying valuations are not overdone, the impending swoon that the markets may encounter once QE3 ends might be mitigated by the Fed's assurances that we are not in bubble territory. Either way, we don't believe that the Chair of the Federal Reserve Board should be making prognostications about the stock market.

In conclusion, the last six years of Federal Reserve policy have not produced the kind of economic growth that they had hoped for. What they have produced, instead, is an echo-bubble in the housing market and another valuation bubble in equity prices.

Investors who are on the Yellen brick road might be hoping for some kind of Oz-like wizardry to transition from the last six years of Fed intervention to an economic state of tranquility and steady, albeit slow, growth. Hope is not an investment strategy and wishful thinking is dangerous, especially in the financial markets.

To expect the markets to remain calm and collected during one of the most critical changes in interest rate policy ever undertaken by the Federal Reserve is like Dorothy expecting to go skipping down the yellow brick road without a care in the world. When in reality lurking in the forest and woods along the way we know that there are hidden dangers in the guise of lions and tigers and BEARS.

Additional Disclaimer: The opinions expressed herein are exclusively those of Altitrade Partners. We do not provide investment advice, and do not offer buy and sell recommendations on any securities mentioned in our reports. For additional information, including our full disclaimer, we invite you to visit Altitrade Partners

Disclosure: The author is long SPXS.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.