Monday, October 28, 2013 - Markets Are All About the Fed

10282013 Script

Markets Are All About the Fed

by Sinclair Noe

DOW – 1 = 15,568
SPX + 2 = 1762
NAS – 3 = 3940
10 YR YLD + .01 = 2.51%
OIL + .69 = 98.54
GOLD + .30 = 1354.20
SILV - .09 = 22.61

The Federal Open Market Committee, the FOMC, is the Fed's policy making arm; they will meet on Tuesday and Wednesday to determine possible changes or adjustments to monetary policy. The broad consensus right now is that nothing will change. The government shutdown and a mixed batch of economic data convinced many the Fed would delay any move to begin trimming its stimulus into next year.

The longer the Fed keeps its policy loose, the longer US yields will stay low, making the dollar less attractive. The dollar index was just a smidge higher today, but still trading very close to a 9 month low just under 79, reached on Friday, while the euro has been trading near 2 year highs. As long as the Fed's easy money policy remains in effect it provides abundant liquidity for Wall Street. Last week the S&P 500 hit records and many global stock markets were also near record highs. The MSCI world equity index has been moving higher for 4 consecutive sessions and is near records of January 2008. The Fed's easy money policy has served to support gold and other metals markets. After all the recent bullish movement, you might think the Fed's dovish policy stance has been well priced into the markets. Maybe.

If you want to see the graphic definition of an uptrend, just look at the S&P 500 chart over the past year. With the exception of a few minor whipsaws, the chart is a good progression of higher highs and higher lows depicting a gain of more than 400 points. It hit record highs, at least on a nominal basis, but if you look at the index in inflation adjusted terms, the high was in August 2000, and the purchasing power of a dollar invested in the S&P 500 is still more than 12% below the August 2000 level; and to get to a new high, we would need to top 2000 on the index. The price to earnings back in 2000 were much higher than today, meaning relative valuations today are more justifiable, but that doesn't tell us whether or not we'll advance to a new high in this cycle. There are some positive, almost bullish considerations: Corporate balance sheets are in excellent shape, which could prompt elevated returns for shareholders; shareholder-friendly M&A driven by still low borrowing costs could add another boost to the market rally.

And there is still cash on the sidelines. Plenty of people burned back in 2008 have been parked in cash reserves, but every now and then the market temptation becomes too great. The rotation from cash to stocks typically takes longer than most people imagine, and just about the time that cash comes back into the markets, we might expect yet another rotation; after all, earnings have a lot of work to catch up to valuations, and there are still strong fiscal headwinds. Plus, it's been about 6 years since the start of the last recession and about 4 years since the recovery (if we can call it a recovery), and these things tend to repeat with regularity; it's called a business cycle.

Today, we had economic reports showing manufacturing output inching slightly higher in September, while contracts to buy previously owned homes posted the biggest drop in more than 3 years. Manufacturing production edged up 0.1% last month after advancing 0.5% in August. The National Association of Realtors said its Pending Homes Sales index, based on contracts signed last month, dropped 5.6% to the lowest level since December. The decline was the largest since May 2010.

The index, which leads home resales by a month or two, has now dropped for four straight months. Realtors believe home resales, which dropped in September, peaked in July and August. The reports come on the heels of data last week showing a gauge of business spending tumbled in September. That data, combined with a disappointing reading on hiring released earlier this month, has offered a dull picture of economic activity.

Rates on 30-year fixed rate mortgages rose to an average of 4.49 percent in September from an average of 3.54 percent in May, according to Freddie Mac. But a surprise decision by the central bank in mid-September not to cut its purchases and soft economic data have pulled rates lower since then. With politicians in Washington still to agree on a budget, uncertainty over fiscal policy may also continue to hinder growth

Over the next couple of days we'll see reports on producer prices and consumer prices, retail sales and home prices, the ISM manufacturing report and more. It probably won't matter. The Fed's keeping the digital printing press running and the economic data is not compelling enough to change the QE, not yet, likely not this year.

Quantitative Easing, the Fed's $85 billion a month debt purchase program has has caused significant inflation (even if the inflation isn't reported in the official economic reports) and made national debt soar (even if much of that debt now rests on the Fed's balance sheets); it has made the bond markets fragile and volatile. The value of bonds look nice on balance sheets but unless one plans to cash them in like growth play stocks, their worth as income producers has been lousy. Income investors look for “risk-free returns” but QE creates a "return-free risk" scenario. If you are heavily weighted in fixed income, it is with a grip white-knuckled by the real, perhaps inevitable fact that at some point QE will end or simply fail to keep yields low and asset values high. And the whole idea of income investing is a stable buy and hold approach that makes it difficult to pare gains, just as it is painful to accept losses. Classical measures of value have been destroyed. It is very difficult to find true price discovery or a reasonable degree of certainty about these markets except that they are artificial and fragile, and increasingly vulnerable to exogenous influences. Just as the Fed force-feeds liquidity to the equity markets, it also provides the essential sustenance for the bond markets, and this seems the major lift, maybe the only justification for rising markets.

In this context, if you "buy the market" you're betting on continuing QE and an absence of crises that have lingering effects. While QE is likely to continue so long as policy-makers prefer to keep the markets climbing for whatever reasons happen to suit them, and remember policy-makers change from time to time, we still have geopolitical, and economic, and fiscal, and political crises ready to explode. So if you simply develop an allocation, buy and mainly forget about it, the chances for painful surprises are high.

And the longer the markets rally without a pullback, the more delicious that uptrend chart looks, the more the warning signs point toward the latter stages of a bull market. There is for instance the narrowing of the rally to a handful of 'story stocks' that trade at ever more absurd valuations and seem to be able to inexorably rise into the stratosphere, discounting a glorious future that may or may not arrive. Similarly, the pace of IPOs has vastly increased. Whereas IPOs were in 'slumber mode' for much of 2009-2012, issuance has really taken off this year and is at the highest level since 2007. Not only that, but many stocks are once again soaring by up to 100% on their first trading day, which is strongly reminiscent of the insanity that reigned in 1999 to early 2000.

And as we look at earnings, don't forget the buyback effect, which helps earnings per share to increase even as revenues slip. In fact, since corporate leverage is often increased in order to finance buybacks, shareholders in many cases will ultimately end up worse off. In the short term everybody loves the effects of buybacks of course, but be warned: buybacks tend to peak when stock prices are near a peak.

And one more consideration is margin debt, which provides leverage to increase profits in a bull market but is worse than salt on a wound in a bear downturn. NYSE margin debt has soared to a new record high, exceeding $400 billion for the first time ever. The risk-reward situation in the market is dangerously skewed toward risk. Investors are skating on ever thinner ice. Once the risk becomes manifest, forced selling will exacerbate the decline in prices. The stock market keeps levitating on the promise of more money printing. It remains possible that the advance will enter a blow-off stage or a panic buying type advance during which prices rise almost vertically, increasing considerably in a very short time. That would be a clear indicator to take profits and run, but there is no guarantee of a parabolic chart pattern; a 'blow-off' doesn't have to happen. Whether or not it happens misses the point, which is that risk has increased enormously.