The stock market pulled back last week and we are now in the midst of a mild correction, down all of 3% from the all time highs set just a couple of weeks ago. It has been an extremely orderly retreat so far with the volatility index barely budging from its recent lows. The natural question is whether this is the start of a bigger correction, the start of a bear market or merely another buying opportunity in a bull run that is getting long in the tooth by historic standards. There were 33 bull markets from 1900 to the beginning of this one in March 2009 with an average length of 2.1 years so this one is already on borrowed time. How much longer will it last?
Well, I can’t tell you for sure but if you’ve been reading these weekly musings for even a few weeks you know I’m in the bear camp. The market may well go higher from here and prove me wrong – it wouldn’t be the first time and surely not the last – but to me the risks far outweigh the potential rewards from these levels. The US economy is still weak and while there are signs of life in Europe – and maybe even China – the global growth outlook is not comforting. Earnings and revenues at US companies are flat-lining and valuations are either average, high or ridiculous depending on what method one uses and what index one chooses. The market run up in the first half of the year was based on an expectation that the economy and earnings would improve in the second half of the year but this is the second half and it isn’t happening. Earnings expectations are now being revised down for the third quarter and fourth quarter mark downs seem likely to follow.
Those expectations of a better second half were, I think, to some degree driven by a belief in the efficacy of Quantitative Easing. If that is true, the release last week of research from the San Francisco Fed on the effectiveness of Large Scale Asset Purchases (or QE as it is popularly known) is bad news for the bulls. The paper’s conclusion is that QE2 added a mere 0.13% to growth in the quarter it was implemented and that the effect waned rapidly afterwards. That is consistent, by the way, with what I’ve said from the beginning about the potential gains from any wealth effect. Economists have been studying these effects for decades and this paper merely confirms what we already knew – wealth effects are weak at best, especially when based on stock market gains.
What the paper did say that was important is that without the Fed’s forward guidance with respect to interest rates, QE would have had an even smaller effect. Without jawboning, the paper reckons that economic growth would have increased by only 0.04% or as we call it here, a rounding error. While I find it amusing that these economists believe they can isolate an effect with such accuracy, the implications for the market may be profound. Bernanke has said from the beginning that QE was contingent on the rewards outweighing the risks and now his own researchers have shown the benefits to be, at best, minimal. If that isn’t a great big flashing warning that QE’s days are numbered, I don’t know what is.
One thing I’m certain of when it comes to QE is that it has fostered a belief by a lot of investors that as long as the Fed does it, buying stocks is free money to be had by those bold enough to take it. It is impossible to know how many people are buying stocks on the mistaken, cave man like belief that QE good, me buy stocks, but my guess is that it is a pretty large number. We do know that there are enough of them so confident in QE that margin debt sits near all time highs. We know that there are enough of them to have the small cap Russell 2000 index trading at 48 times trailing earnings. And we know that the Fed merely talking about tapering their purchases from Large Scale to Pretty Big Scale is enough to send these folks online in search of a sell button.
If we remove the cave man cohort from the market and stocks have to trade on just the observable fundamentals, I suspect that would be enough to push the market into bear market territory. What multiple should we put on a market with little or no earnings growth? I don’t know but it wouldn’t take much of a markdown to make a serious dent in a portfolio. If you knock the P/E down from the current 19 to a more normal 15, that would by most definitions be enough to produce a bear market decline of 20%. Interest rates and expectations also play a role – and a bigger one than QE if you believe the SF Fed – so I wouldn’t expect much more than that unless interest rates continue rising or earnings go into an outright decline. If either of those unhappy outcomes become reality, a much larger decline is likely.
And what about interest rates? Will rates continue to spike every time it seems more likely the Fed will taper? I suppose that could happen but there are larger forces at work in the bond market than the Fed. China and Japan have both reduced their holdings of Treasuries and if emerging markets continue to struggle, more sales from more countries seems likely. There is a natural limit to how high rates can go though. Debt levels in the US are still very high – actually debt levels are high just about anywhere on the globe – and it won’t take much of a hike to put the US economy back on the skids. In fact, we may already be seeing that in the housing market which seems to have stalled on a mere 100 basis point hike in the 10 Year Treasury rate.
The one thing that might push interest rates even higher would be an outbreak of inflation that is totally unexpected right now. Could that happen? I am watching the US dollar closely right now and it is on the verge of breaking down. A lower dollar is the very definition of inflation in my book so a breakdown against other currencies and/or gold is not good news for bond holders. However, what the market cares about is the impact on consumer inflation and even if the dollar falls, I’m not sure it would show up in the CPI any time soon. Oil and other commodity prices have been perking up lately but I don’t see how companies could push that through to consumers at this point. The economy just isn’t strong enough. It would take a near complete collapse of the dollar to push up consumer prices and I just don’t see that in the cards right now.
At best we are entering a period of high uncertainty. Despite the Fed’s transparency fetish, we have no idea what policy might be in the near future. Will they taper? If so, how much and what? Will they slow down purchasing Treasuries, Agencies or mortgages? Of maybe greater concern is that we don’t know who will be making these decisions. Larry Summers? Janet Yellen? Somebody else? Add in the coming budget battles and uncertainty may reach a breaking point very quickly.
I think we are near the beginning of the end for QE and it’s market distorting effects. The Fed has made some promises about what would push them to end their grand monetary experiment but at some point reality may intrude. QE has been ineffective at its stated purpose of raising economic growth and I find it hard to believe that the Fed will continue a policy that isn’t working just because some stock speculators might get a margin call. Bernanke has said repeatedly that the Fed will take into account the risks of QE as well as the rewards. Well, those risks are mounting. We’ve seen the return of so called covenant lite bond issuance, investors are chasing yield in leveraged loans, junk bond sales are up almost 25% from last year, sales of payment in kind notes are rising again and of course, stocks are hitting all time highs. The risks of QE and extended periods of low interest rates are primarily in their effects on asset prices and speculation – bubbles. Right now, the risks are pretty evident and the rewards are elusive. Will Bernanke and the Fed just ignore the evidence? QE is coming to an end whether the cave men like it or not.
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