From 666 To 2,800 In 10 Years - Is The Stock Market A Discounting Mechanism Once Again?

by: Lawrence Fuller

The S&P 500 bottomed at 666 10 years ago today.

The Fed then decided to use the stock market as a catalyst to meet its objectives.

As a result, the market lost its ability to serve as a discounting mechanism.

As the Fed withdraws stimulus, expect the market to revert to a discounting mechanism once again.

Fundamentals should start to matter in a world where bad news is no longer good news.

It has been a decade since the S&P 500 (SPY) bottomed at the infamous level of 666 on March 9, 2009. I remember that day vividly, because it was the late Mark Haines, my favorite news anchor of all time, who called the market bottom the very next day. Shortly thereafter, on March 18, the Federal Reserve announced it would buy $300 billion of Treasury securities and $750 billion of agency debt and mortgage-backed securities in what would be its first of several quantitative easing (QE) programs. Chairman Bernanke had already lowered short-term interest rates from 5.25% to near zero over the prior 18-month period. From that point forward, our financial markets would have a monetary tailwind unlike anything we had ever experienced.

With the implementation of QE1, the stock market no longer served as the discounting mechanism it had been in years past. To a certain extent, it was the end of our free market system. Prior to this monetary intervention, investors would interpret movements in the broad market as indications of what was likely to transpire in the real economy. In other words, changes in stock market valuation would serve as a leading indicator to either positive or negative geopolitical and economic developments. This is why the stock market is a component of the Conference Board's Leading Economic Index.

The Fed largely neutralized the stock market's ability to forecast when it decided to use it as a catalyst to achieve its objectives. By lowering short-term interest rates to near zero and then purchasing huge quantities of the highest-quality, fixed-income securities, it forced investors to reach for yield in increasingly higher-risk securities. Lowering the cost of money and increasing the quantity of credit led to explosive demand for financial assets. That phenomenon, which has defined the past decade, is global. The European Central Bank, Bank of England and Bank of Japan have all followed similar programs.

Source: Federal Reserve

The Fed's balance sheet peaked at approximately $4.5 trillion in 2015, and it began to shrink in earnest at the beginning of 2018 when the Fed stopped reinvesting maturing securities. As of yesterday, it was down to $3.969 trillion. Note below that as liquidity has been withdrawn from the financial system, the stock market has experienced several fits and starts, like an angry drunk who is sobering up. The S&P 500 is basically unchanged over the past 14 months.

Chairman Powell clearly agitated the market when he indicated in December that the Fed's quantitative tightening program, which is now reducing the balance sheet by $50 billion per month, would continue on "auto-pilot" for the foreseeable future. Following a near bear-market decline in the stock market, he reversed course in early January by saying that the Fed would not hesitate to adjust its current policy based on incoming data. Like an alcoholic reinvigorated with a new bottle of bourbon, the stock market has been off to the races ever since.

While data about tariffs, trade, earnings and rates of economic growth swirl in the background, serving as either mini tailwinds or headwinds, depending on the day, liquidity is the number one factor impacting the markets. So long as liquidity is being drained from the financial system, I think it will be very difficult for the stock market to achieve new highs. As indicated by the most recent report on the Fed's balance sheet, the pace of quantitative tightening continues unabated.

This doesn't mean that the stock market can't make significant moves upward over the course of several weeks or months. The rally year-to-date is evidence of that fact, as was the rally from April to October of last year. Yet the fact remains that as liquidity is withdrawn, and the cost of credit increases, the stock market will gradually revert to being the discounting mechanism it was before the financial crisis 10 years ago.

What this should mean is that fundamental developments will have more sway over market prices than they have in a very long time. Bad news will no longer be good news, as it has been in the expectation that more monetary stimulus was in the offing. The timing really couldn't be any worse for this development because the fundamental headwinds are starting to mount.

A trade deal with China is of paramount importance to investors. It is very difficult to determine what the outcome will be, but it seems to me that the market has rallied year-to-date in anticipation of a very favorable outcome. Therefore, a positive outcome may already be priced into the market.

Investors also seem to be looking beyond the first year-over-year decline in corporate earnings since 2016, as market values have risen while estimates have come down. Analysts are projecting a decline in earnings of 3.2% for the first quarter. Note that this divergence is primarily due to Powell's suggestion that the pace of quantitative tightening may slow later this year and that trade deal discussions are making "fantastic" progress.

Expectations are for growth of 0.3% in the second quarter, 1.9% in the third, and an increase of 8.5% in the fourth. This would result in earnings growth of 4.2% for 2019, but I think fourth-quarter estimates are a big stretch. In fact, as Morgan Stanley pointed out last month, over the past 15 years, the average spread between any given quarter's year-over-year earnings growth and the average of the prior three quarters was 0.3%. How are we going to realize 7.5%? I think this is a number Wall Street has created to produce a growth rate for the calendar year that supports current valuations and doesn't alarm the consensus of investors.

Investment Strategy Implication

The stock market is at a critical juncture. If a trade deal is reached that leads to an acceleration in the rate of global growth, it could lift earnings expectations. Yet I don't think this will override the continued withdrawal of liquidity from the financial system. So long as the Fed continues to drain liquidity, the broad market looks to be in the process of making a long-term top. As a result, I am positioned defensively in expectation of a retest of the December low in coming months. If the fundamentals change, then I will change with them.

What defense means for me is that I am below my target exposure for stocks in my model portfolio, but still slightly above my core allocation. I have also hedged that exposure. As the S&P 500 breached its 200-day moving average and approached overhead resistance at the 2,800 level, which it has tested four times over the past five months, the technical picture began to deteriorate.

Instead of focusing my hedge on the S&P 500, I looked to the only major index that had not been able to breach its 200-day moving average. The Russell 2000 Index (IWM) is by far the weakest of the major indices.

Its relative weakness suggests that it will be the worst-performing index in a broad-market decline. As such, I used the triple-inverse ETF of this index (TZA) for my hedge. I purchased two bull call spreads, as shown below, with an expiration of January 2020 to insure against a decline in the value of my long positions. This option strategy involves purchasing a call at one strike price and selling a call at a higher strike price that both expire at the same time. This caps my gains, but it also reduces my cost for the insurance. I don't need to see the market retest its December lows to realize gains from this hedging strategy.

This is a relatively inexpensive form of portfolio insurance, and if I lose the insurance, it means that I am hopefully recovering far more than I am losing from the gains that are accruing in other segments of my portfolio.

The Portfolio Architect is a Marketplace service designed to optimize portfolio returns through a disciplined portfolio construction and management process that focuses on risk management. If you would like to see how I have put my investment strategy to work in model portfolios for stocks, bonds and commodities, then please consider a 2-week free trial of The Portfolio Architect.

Disclosure: I am/we are long TZA CALL OPTIONS. 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.

Additional disclosure: The Portfolio Architect is published as an information service. Lawrence Fuller, the publisher, is also the Managing Director of Fuller Asset Management, a Registered Investment Advisor, which is unaffiliated with this Marketplace service. While this service includes opinions about buying, selling and holding a wide range of securities, the publisher is not acting as an investment adviser or providing advice or recommendations to any particular subscriber. Any investment recommended should be made only after consulting with your investment advisor or completing your own due diligence. There are risks involved with investing including loss of principal. Mr. Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals or the strategies discussed by will be met.