I’ve been laid up the last week after a minor surgical procedure and while I haven’t been that productive at getting any actual work done, it has given me a lot of time to watch CNBC and Bloomberg. The portfolio managers, strategists and assorted market soothsayers stream across my screen, talking about markets the way they always have, as if this is just a normal market like all the others we’ve experienced over the last few decades (as if those were “normal” markets for that matter). They talk about earnings and economic growth and what the Fed may or may not do, pretending to analyze a market for which there is no parallel. It seems as if they don’t want to acknowledge that we are living through extraordinary times because they are afraid it might break the spell that has been cast over stock market punters this year.
And these are indeed extraordinary times. Just consider that the stock market is making new highs while the Fed continues to purchase $85 billion per month in bonds and mortgage securities. Just so we’re clear, the policy of QE is a radical, experimental policy. It isn’t normal and if the Fed is still doing it, it means that there is something radically wrong with our economy. And yet, stocks have recently been rising on bad economic news because it means a continuation of radical monetary policy. If QE works as it seems to, that might make some sense. QE “works” by forcing investors to bid up the current price of risky assets. The Fed assumes that those who benefit from this policy will spend some of their new found wealth and create a virtuous circle of more spending and production. Unfortunately, the second part of that equation doesn’t seem to be working so all QE is really accomplishing is to reduce future returns of risky assets. In simpler terms, it is pulling forward future returns to the present. And stock market players seem to believe this is a good thing.
I do hope the folks buying on bad news understand there is a limit to this operation. Since interest rates on the things the Fed is buying can’t fall below zero, the spread between future expected returns of risky assets and risk free assets will close over time. At some point, investors will no longer be willing to take on additional risk if the additional potential reward is too small. How close are we to that point? Probably not as close I think and surely not as far away as the average Wall Street strategist believes. The S&P 500 has a dividend yield of about 2% and earnings are growing at less than 5% per year. 10 Year Treasury Notes yield about 2.75%. Are you being properly compensated for the risks of owning stocks? Not unless you believe, as so many on Wall Street seem to, that earnings growth is about to accelerate dramatically.
So what about the prospects for earnings acceleration? It would seem, with margins already at all time highs, that an acceleration in earnings is dependent on an acceleration in global economic growth (since we’re talking about the S&P 500). The US economy grew at a 2.8% rate last quarter but that was primarily due to inventory building and a reduction in trade. The jobs report last Friday was cheered as good news, coming in much better than expected on the headline, but it was also a report that showed 720,000 people leaving the workforce (and no, those weren’t government workers affected by the shutdown). The participation rate is now down to 62.8%, a number last seen when Jimmy Carter was President. There are structural reasons for the continued drop (retiring baby boomers), there are policy reasons (easier eligibility for disability and welfare programs) and there is the fact that the economy just isn’t producing that many good jobs. But even if you assume that all of the drop is due to baby boomers retiring, this is a gigantic headwind for the economy as a whole; in other words, it is a pretty extraordinary situation.
In Europe, the ECB cut interest rates last week and that was taken by the markets as the obvious negative that it is. There has been quite a lot of talk about a European recovery this year but all that has really happened is that it has gone from awful and getting worse to just awful. That is a necessary step in any recovery but it isn’t recovery – yet – as the ECB acknowledged last week. The ECB hasn’t been as aggressive as the Fed in its policy choices but it has taken some, yes, extraordinary steps over the last few years. The rest of the world is largely dependent on demand from Europe and the US so if those two aren’t doing well, the rest of the world is not likely to be either. China has recently seen some improved data but if you want to talk about extraordinary and extreme, China is the place to be. Unless you want to consider Japan where they have done QE so many times they don’t even number them anymore. It isn’t just the US where conditions are far from “normal”.
Meanwhile, back in the US, we’ve decided (well at least some of us decided) that now would be a good time to restructure 18% of the US economy. I and many others warned that the ACA was poorly designed and economically idiotic but for now, as the President is fond of saying, it is the law of the land and we’ll just have to adjust. Some of what is becoming known now, such as the cancellation of a lot of individual policies, were features, not bugs, and should have been anticipated by anyone who took the time to dig into any of the details. But there will be unintended consequences too and we are starting to see some of that emerge as well. Venture investing in the medical device industry is on pace to drop over $2 billion this year and is down about 40% since 2007. Even that shouldn’t have been that surprising with the tax on medical devices – if you want less of something, tax it – but I’m sure it wasn’t something the designers expected or wanted. Lastly, as again I and a lot of others warned, ACA will not reduce the cost of health care. In fact, it will increase it and while that might be good for some health care companies, it won’t be good for the economy as a whole.
The point, once again, is that this is not a normal investing environment. We are still, five years after the crisis, operating under an extreme set of circumstances. Monetary policy is far, far from normal and the Fed is struggling to just get back to the policies that produced the last crisis (low interest rates for a very long time). That is not normal and to invest as if it is, is a bit crazy. Fiscal policy is also a mess and with the extreme factions of both parties holding the cards, it isn’t going to get better anytime soon. Regulatory policy is not getting any better either with both the ACA and Dodd-Frank still being installed with all the lobbyists bells and whistles intact. Both are poorly designed efforts that merely pile more regulations on top of two already heavily regulated industries. And they will both have (are having) negative, unintended consequences. We may need extraordinary policies to get the economy growing at a respectable pace again, but right now we have it where we don’t need it (monetary) and don’t have it where we do (fiscal and regulatory).
Extraordinary times, extraordinary measures, extraordinary markets. How it all ends, nobody knows but these are not normal times and you shouldn’t invest as if they were.
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