Multiple Puts

The stock market’s strong rebound from Monday’s thumping shows, once again, that there is a sizeable queue of investors waiting to take advantage of any meaningful market pullbacks. But this week’s volatility also shows, yet again, why efforts to time the markets by getting in and out are an exercise in futility. Who could have foreseen that the major market indices would drop 2.5%-3.5% on Monday of this week? And if you were able to predict the sell-off, would you also have been wise enough to get back in and benefit from the rebound over the past two days? And what’s going to happen tomorrow?
Having said all that, we think there is a pattern that has been established by policymakers. The Fed, the Trump administration and Congress appear to be increasingly willing to employ their various tools, or levers, to limit the damage in volatile markets. In market parlance, we refer to these levers as “puts.” The “Fed put” has been a staple of this market recovery since the market lows of March, 2009. Whenever the Fed perceived that downside market volatility threatened the economic expansion, the central bank stepped in to reassure investors that interest rates would remain low for as long as necessary. In doing so, the Fed put a floor under stock prices. In the instances when the Fed felt it was finally safe to disengage and raise interest rates, as with the “taper tantrum” and more recently in late 2018, the markets effectively forced the Fed to walk back its previous commitments to normalize policy (i.e., raise interest rates). And each time the Fed reversed course, it reinforced the belief that the central bank would be a reliable ally in limiting investor losses.
There are other “levers” that have emerged over the past couple of years that enable policymakers to effectively manipulate the markets into submission.
  1. Fiscal policy is the most obvious policy lever that has been employed. Tax cuts and spending increases clearly led to an acceleration in economic growth in 2018, thereby providing hope for investors that earnings growth would continue at a robust pace. Looking ahead, we may not get additional tax cuts, but the administration and Congress appear to have reached a broad agreement about the need for a $2 trillion infrastructure spending bill. A spending bill this large would support job growth, economic growth and stock prices, and so increased public commentary about the eventual passage of such a bill can and has been used to support the markets.
  2. The trade negotiations with China have obviously caused a significant amount of volatility. But each time it looks like the negotiations may fall apart, we receive reassurance from the administration that a deal is within sight. We also typically hear how the US continues to gain leverage in the negotiations, how China will be forced to make a deal due to their flailing economy, and how the ultimate deal will be very favorable to the United States. These comments are designed to soothe a nervous investor base, and they’ve been very effective on multiple occasions.
  3. Elections are coming up next year. While stocks tend to underperform in election years, we think there is reason that this year could be different. The Trump administration will be running on its economic accomplishments, and so we will hear, ad nauseam, about how the strong the current economy is. On the Democratic side, we are likely to hear at least some support for Modern Monetary Theory, which is a (baseless) school of thought that advocates for vastly increased public spending (on things like Medicare-for-All , a Green New Deal, and free college) to support economic growth with few meaningful consequences. At the very least Democrats are likely to advocate for increased investment spending designed to reduce economic inequality. It seems to me that commentary like this, from both sides, could help keep the animal spirits alive through the elections.
  4. A final factor that comes to mind is the Twitter factor. Never before has a president had the capability to speak directly to the people as frequently and comprehensively as President Trump does today. If there is one thing that is fairly easy to predict, it is that the President’s Twitter followers are going to hear about any and all good economic news that crosses the wires. It is also true that investors have come to anticipate tweets offering market support during times of downside volatility. This is no small factor. I’ve spoken to many professional investors and traders who have become increasingly gun-shy about placing trades, at times, for fear of the next inevitable tweet. It is also true that algorithmic traders make trading decisions based on a single word within a tweet. This is a new era, and it is no longer enough to be right. You have to be right and be able to anticipate how tweets and other noise could affect investment outcomes.
Whether or not these levers of support, or puts, are a good thing for the intermediate- to long-term health of the markets and economy is a completely different question altogether. We tend to think that the less interference in the markets, the better. When investors become emboldened by factors other than economic and corporate earnings strength, it usually doesn’t end well. Our consistent views have been the following: 1) eight years of artificially low interest rates have compounded the problem of too much debt, pulled forward demand, created frothy asset prices, and exacerbated the problem of economic inequality; 2) the positive benefits of the tax cuts and government spending increases will likely be fleeting as they don’t address the long-term problem of weak labor productivity while also causing a surge in deficits and exacerbating the problem of economic inequality; 3) greater restrictions on immigration will exacerbate the problems created by a wave of baby-boomer retirements; and 4) efforts to change China’s unfair trade practices are worthwhile, but tariffs are unproductive and high trade deficits are normally a sign of economic vitality.
I will end with a quote from Martin Barnes, who was a guest on this week’s FarrCast. Please check it out! FarrCast
“The core problem is that monetary policy is ill-equipped to deal with the forces that have held back economic growth. A combination of demographics, high debt and slower productivity growth have limited the U.S. economy’s potential. Thus, I have a lot of sympathy for Larry Summer’s secular stagnation thesis. Yes, that implies that the real equilibrium interest rate is very low and, therefore, that monetary policy needs to be accommodative. But it also implies that force-feeding the system with easy money is more likely to lead to asset bubbles and financial distortions than to increased consumer price inflation.”

– Martin Barnes, BCA Research