Over the week since we sent out our last Market Commentary, the investing landscape changed rather dramatically. From last week’s highs to this week’s lows, the S&P 500 dropped nearly 6%. Emerging market equities fared worse, with the MSCI Emerging Markets index dropping 8.5%. Investors also dumped bonds, as the yield on the 10-year Treasury bond increased nearly 50 basis points from last week’s low to this week’s intra-day high. And the price of gold continues to plummet, now having dropped more than 10% over the past week.
Indeed, for one week it seemed that investors wanted to sell any and all assets they owned. This represented a stark departure from the patterns we had experienced over the four years since the stock market bottomed in March, 2009. While we certainly had “corrections” in stock prices over this four-year period, the sale of stocks was generally accompanied by the widespread purchase other assets (such as Treasuries and/or Gold). The media parlance for these stock market corrections had been “risk off”, as investors shed riskier assets in favor of “safer” ones. But as we are seeing now (and as we have repeatedly warned our readers), longer-term Treasury bonds may not be as safe as many had thought.
The impetus for all this selling was the Fed’s rhetoric last week, which suggested to some that the central bank is ready to “taper” its asset purchases. For our part, we are not so convinced. We do believe that the Fed is very encouraged by the recovery in the housing market. We have long held the opinion that the Fed is laser-focused on housing. However, other sectors of the economy do not appear to be recovering nearly as fast as they should. While the unemployment rate is down to 7.6% from a high of 10.0% (October, 2009), the labor participation rate continues to suggest that jobs are very hard to find. Moreover, growth in average incomes remains anemic for those lucky enough to have jobs. And finally, recent gauges of inflation suggest that the economy is experiencing disinflation rather than the 2%+ inflation rate that Fed governors would like to see. All this evidence suggests to me that the Fed has a ways to go in meeting its dual mandate of maximum employment and stable prices. In other words, the Fed is not yet close to ending its monetary support.
This is not to say that we agree with what the Fed has done through its endless program of Quantitative Easing (QE). Our view has been that the Fed, through QE, is intentionally targeting asset prices in an effort to create jobs and economic activity through a Reagan-esque “trickle-down” maneuver. Bernanke has actually admitted this – repeatedly. But while higher stock and housing prices may have helped put a floor under the economy for now, the longer-term ancillary effects are likely to be problematic. The Fed risks creating new asset bubbles, the likes of which led directly to the last two recessions. In addition, the Fed’s actions are exacerbating the widening in the wealth gap, which creates long-term problems of its own. Finally, some economists believe that ultra-low interest rates – a direct result of QE – are actually impeding the economic recovery as interest earned on financial assets reduces disposable income for many consumers.
The good news is that we believe that Bernanke & Co. have become more aware of these risks as the criticism over QE has mounted. While the Fed Chairman has commented that he believes stock prices are reasonable based on Price-to-Earnings ratios, he cannot be so shallow as to ignore the fact that profit margins are running at all-time highs. So rather than a fundamental upgrade in how the Fed views the economic recovery, we think that Bernanke’s change in rhetoric last week represented an effort to cool the meteoric rise in stock prices.
But let’s assume that the Fed has actually decided that the economy is strong enough to take its foot off the accelerator. One of two scenarios might unfold under this assumption. The first scenario is that the Fed is correct and underlying economic growth is indeed accelerating with the help of a stronger housing sector. The Fed would remove much of the stimulus that has supported asset prices, but this support would likely be replaced by organic demand rather than artificial monetary support. Under this scenario, stocks might swoon initially until investors realize that a strengthening economy will result in strong earnings growth for corporate America.
The second scenario is that the Fed is wrong and the recovery has not accelerated. Under this scenario, the tapering of asset purchases by the Fed would cause interest rates to rise even though economic growth remains anemic. If this happens, the Fed is likely to quickly reverse its decision to taper. After all, hasn’t Bernanke said all along that the course of future monetary policy will be dependent upon the incoming economic data?. The rebound in equities over the past two days likely represents a recognition by investors that the Fed will remain engaged until the economy is strong enough to stand on its own two feet. We don’t believe we have reached that point. The Bernanke “put” is alive and well, despite the fact that he would like to somehow cool the enthusiasm for stocks in the near term.