Investors Should Be More Focused On Data, Less Focused On Rumors Of Monetary Stimulus

Includes: SPY
by: Paul Nouri, CFP

Since the federal reserve began quantitative easing in 2009, every time the economic data in the U.S. pulls back, so do stocks. It is about that time that rumors are circulated and created, by investors and federal reserve officials, that more quantitative easing is on the way. As these rumors circulate, high beta stocks take off in anticipation of greater returns in the stock market. In the chart below, you can see the effect of the first program in March 2009, with a 100% gain from the bottom in the S&P 500 (NYSEARCA:SPY), 2010 brought a 30% gain from the bottom and 2011-2012 also brought a 30% gain from the bottom.

While the effect of quantitative easing on the stock market is simple to understand, investors should not assume that there is an indefinite relationship between when the federal reserve decides to ease and when stocks go up. Many financial indicators have changed for the worse wince the first quantitative easing program in 2009. First and most important, the amount of federal debt has increased nearly 50%. There are a bastion of investors and observers that do not see the debt as a significant issue to America's long term growth prospects. The easiest argument to make is that when the United States credit rating was downgraded in the summer of 2011, yields actually went down, implying that when people wanted safety, they still flocked to U.S. Treasuries. The thinking that this will always be the case, purely because it has been the case to date, is flawed. Markets are run on fear and greed. In the late 1990's, greed was running the market, sending stocks to previously unimaginable valuations. Currently though, fear is a greater factor. As can be seen in 2009, when there is a great deal of uncertainty, investors have no problem abandoning stocks. While bonds have had a great run in recent history, it is a one sided trade, much like internet stocks in the 1990's, housing from 2003-2007 and oil when it saw $150 per barrel. One of the reasons I think bonds are particularly dangerous at current levels is because most of the investors in bonds don't think twice about issuer safety when it comes to bonds. For this reason, economic and financial textbooks almost always site U.S. Treasuries as risk free.

United States Federal Debt Level (In Trillions of Dollars)

As with any organization, however, the more debt it owes, the more expensive it becomes to service the debt. Companies in the private sector usually issue debt to purchase productive assets, including equipment and companies. The bank loans them the money with the expectation that the assets they are purchasing will be at least as productive as they cost to purchase. When the government issues debt, it is primarily to make transfer payments and fund government programs. There is little to no productivity in this. As a result, while a company that borrows money hopes to earn enough money over time to pay down the debt, the government never has this expectation. The only way that the government can pay down the debt is to tax its citizens more. Since January of 2008, the government has added $50,000 in debt per family in the United States. If we take out the families living in poverty (over 9%) this number is closer to $56,500 per family. In total, each family owes $136,000, while the median household net worth is approximately $80,000. Last year, as the markets were tanking, I put the argument forward to my clients that while the debt levels were high, if you took the net worth of the wealthy, and figured that if it came to it, they could pay a higher share to bail everyone out, the debt was more manageable than met the eye.

However, it is more than the current level of debt that bothers most people. It is the trajectory that is frightening. If there was some reasonable effort by lawmakers to bring down the deficit over the next five years, with a permanent tax plan in place, whether investors liked it or not, there would be some level of certainty. As a result of the federal reserve's easy money policy, while government debt outstanding is up 70% since 2008, interest payments are flat. The chart below illustrates an average interest rate above 5%. If/when interest rates return to their historical norm, interest payments will balloon by nearly half a trillion dollars per year or $4,000 per family for government interest or about 8% of the median income per family.

Historical Fed Funds Rate

As the federal reserve has initiated its easing programs, it has cited uncomfortably high unemployment as one of the primary justifications. That's unfortunate, because for the trillions of dollars the federal reserve has created, it has lowered the unemployment rate 0.1%.

U.S. Unemployment Rate

Another key reason for easy money policy is to make home purchases more affordable. New home sales are down since the federal reserve started its easing programs.

One chart that is significantly higher is gasoline. But since most people don't own gasoline as an asset, this actually took money out of the average family budget.

U.S. Gasonline Price, Monthly

Now that we've established that quantitative easing is not the holy grail for a vibrant economy, we can look at how the real economy has been trending of late. When the year started, weekly claims fell noticeably from 380,000 per week to 363,000 per week in the first 4 months of the year. However, since then, claims have been back on the rise. Many people attribute this discrepancy to the unseasonably warm winter we had. Additionally, the unemployment rate ticked up for the first time this year in May.

FRED Graph

While car sales have been seen as a source of strength for the economy during the recovery the past few years, in 2012 the trend has been lower.

Even though car sales and other durable goods orders have declined this year, as you can see below, inventories are up.

While the last three periods of quantitative easing have resulted in stock market gains, investors should be cautious and lighten long positions on rallies based on expectations of quantitative easing. It's uncertain how long investors will be willing to bid up stocks on the basis of quantitative easing without positive indicators in the economy to support it.

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