Since the Great Recession, each time that the U.S. economy bogged down, the U.S. Federal Reserve began printing additional electronic dollar credits to acquire billions in assets (a.k.a. “quantitative easing” or “QE”). And the efforts were primarily responsible for pushing interest rates lower, as well as stock and real estate prices higher.
Take a look at the blue line in the chart below. It represents the electronic money printing activity of central banks across the world. Not only did stocks surge ahead at every U.S.-inspired QE juncture (e.g., QE1, QE2, QE3, etc.), but globally coordinated QE activity actually accelerated in 2016 and 2017. (See the orange oval.)
More than anything else, including the prospect for U.S. tax reform, stock price appreciation has been a function of central bank monetary credits ending up in riskier assets (e.g., stocks, bonds, etc.). On the other hand, global QE is set to decelerate dramatically in 2018. For example, our Fed is stopping the reinvestment of electronic money credits into new asset purchases and the institution plans on eliminating $420 billion from its balance sheet. Similarly, the European Central Bank (ECB) is slowing down its acquisition of below-investment-grade corporate bonds in its tapering process; they’re going to be removing $500 billion in “accommodation.”
The removal of nearly $1 trillion in asset price support in 2018 is hardly insignificant. Over the last nine years, stock price appreciation has been robust when the slope of the blue line above has steepened. In contrast, stocks have tended to struggle in periods when the slope of the blue line flattened.
Researchers at Bank of America have elaborated on the analysis. They identified each market shock since the start of 2013. In so doing, they found that central banks like the Fed intervened to protect markets in every instance up until the Brexit vote. Ironically enough, since the Brexit vote in July of 2016, investors have conditioned themselves to expect the central bank backstop (a.k.a. “Fed put”) and to buy every market dip.
The current buy-the-dip mentality has been remarkable. In spite of irrationally effervescent valuations, the MSCI All-Country World Index has risen every month for 12 consecutive months. The string of monthly gains has never happened before in the history of the global stock benchmark.
Many believe that Republican-led tax reform is a phenomenal positive for bull market continuation stateside. Indeed, there’s little doubt that stock investors have been buying the proverbial rumor since the November 2016 election. The question is, should people consider selling the actual news of passage?
Granted, greater profits at public companies will make their way into dividends, mergers and buybacks. Yet there’s little evidence to suggest that the domestic economy will improve dramatically.
Take a look at the graph below. At least one bit of research shows that real GDP per capita does not grow at a faster clip when associated with higher or lower federal tax revenue (as a percentage of GDP). Tax reform might be inconsequential. In other words, even if tax reform produces a lot of stimulus out of the gate, it may not be a sustainable force.
What’s more, in the last six economic expansions, the initial GDP growth rate tended to be very similar to the growth rate down the road. In essence, there’s little evidence to suggest that the slowest domestic expansion on record (2009-2017) is going to catapult from its anemic 2%-2.5% average to a permanently higher plateau of 3%-3.5% for a sustained period. For a quarter or two? Sure. For another 5-10 years without a recession? Not a chance.
One thing’s for certain: The Treasury bond market does not support notion that tax reform will light the domestic economy on fire. Immediately following the November 2016 election, the difference between 10-year Treasury bonds and 2 Year Treasury bonds spiked from 1% to 1.35%. The implication at that time? Tax reform should stimulate economic growth beyond post-Great-Recession levels.
Now consider the yield curve chart below. Since the inception of the year, however, the spread between intermediate maturities (10 years) and short maturities (2 years) has been whittled down to a mere 0.53%. If the bond market believed in the longer-term viability of current tax reform efficacy, the spread would stay elevated or widen, rather than compress.
The fact that the Federal Reserve is raising its overnight lending rate and seeing little reaction from the yields of intermediate and longer-term bonds is an indication that bond investors do not believe in the strength of the economic outlook going forward. In truth, the spread between key Treasury bond rates sits at a decade low. Should the spread turn negative, a phenomenon known as “yield curve inversion,” fears of recession would creep into everyday conversation.
“But Gary,” you argue. “You just don’t get the enormously positive impact of corporate tax cuts.” Well, we may have to agree to disagree.
Consider an effective tax rate for public corporations at 25% (statutory rate 35%). Now let’s bring the statutory bracket down to 20% per the bill in Congress. And let’s let the effective rate move 10% lower than the statutory sticker price, or 10% effective. (Not sure the effective will actually be this low, but let’s run with it.) The upshot for after-tax cash flow would work out to a 20% boost (.90/.75=20%).
And how much has the S&P 500 risen since the November election? 25%-plus? It follows that most of the tax benefits have already been priced into the market at a time when market overvaluation rivals 1929 and 2000.
Bottom line? With the central banks reining in the easy money and tax reform largely priced into stock price appreciation, you might want to have a risk reduction plan at the ready. As I discuss frequently, my exit strategy involves the monthly close on the 10-month simple moving average. You should use it in some capacity. Not only did it help me sidestep the bulk of stock losses in the tech bubble (2000-2002) and the financial crisis (2008-2009), but it has outperformed buy-n-hold with less risk for 90 years.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.