Do You Believe In The Fed?

by: Scout Finance

Summary

The Fed hasn't been able to push the market up since December 2014.

The profit cycle has peaked.

The population trends are a headwind for long term GDP growth.

The business cycle is nearing its end as it is already longer than the average expansion and indicators such as industrial production are rolling over. Investors who want to challenge this thesis say two things: "What is the catalyst which will drive the market lower?" and "How can you fight the Fed?" Both these questions get at the same issue. The catalyst is the ending of belief in central bankers' ability to alter economic cycles. The Dallas Federal Reserve President Richard Fisher claimed to front run the market in 2009 as I mentioned in my last post, but it's important to realize that the market would have rallied anyway because the cycle bottomed. The point I was making in the last post was the Fed is attempting to move the market higher. This is significant because it alters their policy decision making. Just because the Fed is trying to get the market higher, doesn't mean it can do so for eternity.

You may be thinking that the Fed is trying to unwind its policies which may negatively impact the market, but if you remember the market last year actually seemed to be begging the Fed to raise rates. To give an analogy, the Fed is like a parent of the market. The Fed has been giving its child ice cream every day for months. The child has gained a lot weight and is very unhealthy. The child realized that it might be a good time to have broccoli for dinner one night. It quickly spit out the broccoli and demanded ice cream again in 2016. This is why the Fed can't listen to the markets to make policy. It will wind up where it is at now. Namely, it will end up with zero interest rates for eternity, until the market child dies of obesity at a premature age.

The point that I made about the Fed raising rates to appeal to the market is important. The Fed has been trying to push the market up since 2009, but as you can see from the chart in below the market hasn't rallied since December 2014. This along with the data on the economy leads me to believe the market is giving up on the Fed.

I believe the market is giving up on the Fed and the Fed is running out of policy actions to take. It already threw a lot at the market in February and March to stop the latest correction. At this point the Fed can only lower its open mouth policy from raising rates 50 basis points to cutting 25 basis points. After that it can either go to negative rates, pursue helicopter money, or another round of QE. QE pushed the market higher, but it is having a diminishing effect as even Fed governors question its merit. Negative rates in Japan aren't boosting its economy either. The Fed is over confident in its abilities to alter the business cycle, but it can't do this forever.

The chart below shows the profit margin cycle peaking. It also shows the estimates for future profit margins going lower. Stocks trade on their future prospects, so this negative trend can cause stock prices to fall. You can overlap the equity market with the profit margin cycle perfectly. If profit margins continue to fall, the market will fall regardless of where the Fed sets interest rates.

If you take a step back beyond the business cycle, the Fed looks even less important. The chart below shows the population growth rate. The U.S. population is aging which means lower growth in the future. The Fed cannot change this reality.

My conclusion is the Fed looks important to the near term stock market performance, but is less powerful in the medium and long term. It cannot improve the future negative trends to come as the business cycle rolls over and the slowing population growth becomes a headwind to GDP growth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.