Following steady gains for most of the year, stocks are experiencing a bit of a sell-off today. The major market indices are down over 1% as the “risk trade” comes off, at least temporarily. As expected, we are seeing the heaviest selling among the more cyclical sectors – Energy, Materials, and Financials – that have run up the most in recent months. So are we seeing the final throes of the 100%+ run since the lows of March, 2009, or is this just a healthy pullback for a bull market that remains in tact? While we cannot definitively say, the selling does provide evidence to support two of our concerns about recent investor exuberance. First, the stock market has become heavily dependent on easy money from the Fed. And second, the problems in Europe have not yet been solved.
A quick glance at recent bond market action in Europe shows that investors are yet again becoming jittery. Most of the recent press has focused on Spain, which is a much bigger economy than either Greece or Portugal. An auction of Spanish government debt last night was met with disappointing demand, and yields rose. Investors are dissatisfied with the country’s budget plan for 2012, which was released on March 30 and calls for spending cuts insufficient to meet previous deficit targets (5.3% of GDP). It did not help that Prime Minister Mariano Rajoy said publicly today that “Spain is facing an economic situation of extreme difficulty, I repeat, of extreme difficulty, and anyone who doesn’t understand that is fooling themselves.” As the chart below shows, yields on European debt have been rising in recent weeks, with yields on Spanish debt now close to highs for the year.
Back home in the US, yesterday we received the minutes from the Fed’s most recent meeting. The minutes revealed that fewer Fed members are now calling for additional monetary easing in the form of “QE3″. The reduction in support for additional action reflects the improvement in economic data since the last Fed meeting, including strong gains in payrolls, gains in manufacturing, and improved confidence among both investors and job creators. It is obviously ironic that better economic data is met with a sell-off in stocks. However, this is the situation the Fed has created. Encouragingly, several Fed members already recognize the problems created by this extended period of easy money. Richmond Fed President Jeffrey Lacker said today that “The logical time to raise interest rates is going to be sometime next year.”
In last week’s market commentary, we tried to show how addicted the market has become to ever-increasing amounts of cheap liquidity from the Fed. For many months we have been warning that Fed policy has created the risk of asset bubbles and moral hazard, especially in the stock market. In our view, it couldn’t be more clear that traders have been investing based more on prognostications of future Fed intervention than on pure fundamentals. This needs to change before we can finally put the financial crisis and Great Recession behind us. Yesterday’s Fed minutes were, perhaps, the first step.
So, without question, the waters remain choppy. We are hopeful that today’s market action is simply a reaction to the reality that the Fed will stand pat for now rather than engage in QE3 (for which some probability had been baked into share prices until yesterday). In any event, and despite the hole the Fed has dug and the continued problems in Europe, we continue to believe that high-quality, defensive stocks remain attractive in this environment. In fact, there is enough long-term value to be realized among large-cap, blue chip multi-national companies that one need not get aggressive and swing for the fences. While the hare may be first out of the gates, the tortoise is likely to win this race.