The Stock Market, The Economy And The Federal Reserve

by: John M. Mason

Summary

The Federal Reserve is considering a move in its policy rate of interest in December, and the stock market, highly dependent upon Federal Reserve actions, seems to be on hold.

The top-performing subsectors of the stock market seem to be related to mining and commodities and are are also seen as beneficiaries of Federal Reserve support.

Last year's interest rate move by the Fed resulted in a two-month decline in stock prices, but this rate move was not followed up on and stocks bounced back.

The stock market over the past seven years has been the handiwork of the Federal Reserve system. The Federal Reserve wanted to create a wealth effect by underwriting a rising stock market prices, and it has done so.

The stock market seems to be the child of monetary policy.

And, if one looks at a measure like Robert Shiller's Cyclically Adjusted Price Earnings index (CAPE), the stock market seems to be overpriced given the corporate earnings performance. In October, the CAPE is at 26.54, significantly above its historical mean.

The earnings season has not produced a significant improvement in corporate profits, and the economy seems to still be locked in its modest growth path. It appears as if stock market performance will receive very little help in the future from either economic growth or from corporate earnings.

Thus, what is there to expect from the stock market?

Well, let's look to see what investors seem to be doing with their money and see how this relates to what is going on in the economy.

First, the stock market as a whole has grown year over year, only modestly. The Dow Jones Industrial Average has risen by just 2.8 percent in the last year and the S&P 500 index has risen by 3.2 percent.

As for the leading sectors behind this market rise, according to Barron's Market Laboratory, has been Technology, although this sector has only one subsector in the top ten performers and only three in the top twenty.

The Technology sector itself rose by 14.32 percent year over year, and the top subsector performer was the Internet area, which rose by 24.86 percent. The Internet subsector was the seventh best subsector performer on the list. The Semiconductor subsector and Software and Computer Services came in eleventh and seventeenth, respectively.

The second best performing sector, however, really dominates the highest-performing subsectors. The Basic Materials subsector only grew by 9.84 percent year over year, but produced six of the top ten performing subsectors on the list.

The Gold mining area took the top spot with an 83.02 percent year-over-year performance. This was followed by Coal at 80.41 percent, Mining at 64.93 percent, Steel at 29.42 percent, Basic Resources at 24.67 percent, and Platinum and Precious Metals at 22.57 percent.

This sector is primarily made up of commodities, and commodities is one of the major beneficiaries of Federal Reserve policy, particularly in the mining area.

Prices have generally been risen in the commodities area over the past year. One example is the S&P GSCI index, which has increased by 5.2 percent. Individual areas within commodities have grown much faster than this.

The commodities area continues to be a space that benefits from Federal Reserve largesse, and if there are some Fed-created asset bubbles currently in existence, basic commodities are included as one possible bubble area.

If this is the case, then the market is getting a "double benefit" from the Federal Reserve, as the Basic Materials area of the stock market seems to be doing exceptionally well on the expectation that commodity prices will continue to be a good place to place your money in the near future.

One concern facing the stock market in the near term is the possibility that the Federal Reserve might raise its policy rate of interest at its December meeting.

Already there is some indication that the Fed is removing excess reserves from the banking system in an effort to prepare commercial banks for such an increase. The Fed removed reserves from the banking system last Fall before it raised its rate at the December 2015 meeting.

Reviewing the statistics, it appears that this reduction in excess reserves began in the middle of September. Since this movement began, the stock market has basically been flat.

On Friday, September 16, the end of the week when the Fed appears to have overseen the beginning of the decline, the DJIA was at 18,124. The S&P 500 was at 2,139. On Friday, October 21, the DJIA was at 18,146 and the S&P 500 was at 2,141.

It appears as if investors are "on hold" right now, waiting to see what the Federal Reserve is going to do.

In terms of the economy as a whole, the focus of the stock market on technology and basic materials does not seem to indicate that investors believe there will be much bounce to the economy in the future.

The Industrial sector has shown some life, as it has been the third best performing sector year over year. However, the subsectors that are doing the best are not what you would connect with the business capital expenditures that would get the economy moving at a faster pace.

The Gross Domestic Product statistics back this up this conclusion.

Might there be a wealth effect coming from the consumer sector, something the original Federal Reserve stimulus hoped to achieve?

Doesn't really look like there is one on the way, if investors are correct. There are four consumer sector areas that are in the top twenty best performers, but these include such areas as Gambling, Brewers, and Toys. These areas don't appear to me to be ones to build faster economic growth on.

So, as far as the economy goes, the performance of the stock market does not make one too optimistic.

Money can still be made in the stock market based on Federal Reserve support for stock prices. But, don't expect that the high-performing sectors will be those that are connected with innovation or solid expenditures on physical capital. Seems as if the most profitable areas will be the ones connected with some kind of asset bubble occurring, like in the commodities area.

As far as the possible increase in the Fed's policy rate of interest?

Last year, the DJIA closed at 17,369 on the day before the Federal Reserve meeting started - the one at which the Fed's policy rate was raised.

On February 11, 2016, the DJIA closed at 15,660, the post-raise bottom. By the end of February, the Dow was at 16,514, and by the end of March, it was at 17,685.

The Fed backed off any further increases to the present time, and the Dow is back up to 18,146.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.