Since the Great Recession’s inception, whenever the stock market dropped like a steel anvil or the U.S. economy showed signs of weakness, the Federal Reserve acted to inspire investor confidence. For example, in November of 2008, when the Fed announced its first quantitative easing (QE1) program to buy mortgage-backed securities (MBS), stocks rocketed 10% in two weeks. The enthusiasm wore off quickly. In March of 2009, the central bank of the United States “doubled down” on the MBS dollar amount and simultaneously expanded its reach with a decision to acquire $300 billion of longer-term Treasury bonds. The 1-year program correlated with stock market gains of 70%.
Could the Fed have stopped there? At the end of the first quarter in 2010? The Fed could have. However, when the S&P 500 lost 16% over the next few months, committee members began hinting at a second tidal wave of bond buying (QE2). From summertime rumor through QE2 completion in the second quarter of 2011, the S&P 500 pole vaulted approximately 29%.
Might the monetary policy authorities have decided, at that juncture, to let financial markets operate without additional interference? At the conclusion of the second quarter of 2011? They might have. Perhaps unfortunately, the S&P 500 responded unfavorably to the end of another Federal Reserve program and the absence of a European bank bailout. A 19% price collapse over a brief span of time compelled the Fed to invoke “Operation Twist” – a program to push borrowing costs even lower through using the proceeds of short-dated Treasury bond maturities to acquire intermediate- and long-dated maturities. The Federal Reserve also orchestrated dollar liquidity swap arrangements that aided European financial institutions with raising capital. Not surprisingly, the Fed-inspired activities helped push U.S. stocks 27% off of the 2011 bottom.
“Operation Twist” was scheduled to end in the second quarter of 2012. What could possibly go wrong? This time, investors did not even wait for another Fed program to end, sending stocks down nearly 10% over 8 weeks in April-May. The Fed did not wait either. They extended “Operation Twist” through year-end 2012. And there was more. In an effort to break the cycle of start-stop stimulus dates, and to stimulate a U.S. economy that showed definitive signs of deceleration, the Fed served up hints of its largest quantitative easing experiment yet. The third round of asset purchases (QE3) was not only larger than its predecessors at $85 billion per month, it was open-ended in nature; that is, it came without a formal termination date. Over the next three years, the S&P 500 catapulted roughly 57% with little resistance.
Since the last asset purchase by the Fed in mid-December of 2014, however, investors have not been able to rely on the Fed to “ride to the rescue.” On the contrary. Investors have lived with the persistent headwind of overnight lending rate tightening. Granted, the Fed did everything it could to prepare financial markets for an exceptionally slow path to rate normalization. Monetary policy leaders even pushed its first move – a 0.25% increase in the Fed Funds rate – out from the first quarter of 2015 to the 4th quarter of 2015. Nevertheless, once market participants began to fear that the Fed would cease serving as a backstop for falling equity prices, return OF capital supplanted return ON capital.
Unless the Fed reverses course back toward zero percent rate policy, and perhaps another round of QE, overexposed investors are likely to sell the bounces. Consider the overexposed participants who leveraged their portfolios on margin. Those who bought stock on margin have leveraged themselves 2:1, having borrowed money to acquire twice as many shares of stock than they would have been able to do otherwise. And while that increased demand for stock shares pushed prices higher on the way up, the need to deleverage accelerates price declines on the way down.
How out of whack did margin debt become over the last few years? Margin debt peaks went hand in hand with the stock market tops in 2000 and 2007. Similarly, the margin debt pinnacle in April of 2015 is not far from the nominal high for the S&P 500 in May of 2015.
Keep in mind, prominent members of the Federal Reserve like Richard Fisher, have acknowledged front-loading an enormous stock rally to create a wealth effect. What Mr. Fisher did not acknowledge, however, are the back-end issues associated with wealth effect intentions. For instance, stocks that move to exorbitant valuation levels offer less hope for future returns. In the same vein, one should be able to anticipate a wealth effect reversal when a front-loading Federal Reserve subsequently removes its support for ever-increasing equity prices.
Don’t be fooled by CNBC’s focus on China or the ticker tape on crude oil. China’s slowing economy may be relevant to U.S. corporate revenue and profitability, but it’s the Fed’s perceived unwillingness to “save stocks” from the volatile sell-off that exacerbates the panic. Oil depreciation may be signaling global recessionary pressures and domestic manufacturer retrenchment. Again, however, it is the direction of the Fed’s rate normalization path, albeit gradual, that has poked the grisly bear in its eyes.
Perhaps ironically, the Fed ignored its own projections on economic deceleration in the final quarter of 2015. It raised its benchmark overnight interest rate by 25 basis points to between 0.25 percent and 0.50 percent, even as the Atlanta Fed’s “GDP Now” currently projects 0.6% 4th quarter economic growth. That’s well below the 2.0% annualized growth in the six-and-a-half year economic recovery, where 2.0% had been deemed too anemic for the Fed to fully remove itself from the QE/zero percent rate game.
In sum, the U.S. stock market is likely to see little more than bounces and rallies in a bearish downtrend, until and unless the Fed reverses course. In the past, “bad news was good news” because poor economic data solidified ongoing central bank involvement. “Good news was good news” because, well, that meant things were getting better. Today, on the other hand, “good news is bad news” because it might encourage the Fed to tighten rates more quickly. And bad news? That’s the worst of both worlds for risk assets because the Fed is not currently expressing a willingness to head back toward quantitative easing or zero percent rate policy.
There have been some safer havens over the last six months, ever since the August-September meltdown for stocks. PowerShares DB U.S. Dollar Bullish (UUP), iShares 7-10 Year Treasury (IEF), Pimco 20+ Year Zero Coupon (TLT), SPDR Gold Trust (GLD), CurrencyShares Japanese Yen Trust (FXY) and iShares S&P National Muni (MUB) have all gained ground over the last six months. In fact, most of the asset classes in the FTSE Multi-Asset Stock Hedge Index (MASH) – zero-coupon bonds, munis, longer-term treasuries, the yen, the greenback, gold – have appreciated in value. The SPDR S&P 500 (SPY) has not been quite as fortunate.
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