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Fed Taper And Market Direction

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    August 18, 2013

    There has been quite a bit of discussion as of late on the expectations of the Federal Reserve beginning to “taper” or “reduce” their current monetary intervention program as early as September.  Just recently Fox Business quoted Dennis Lockhart, President of the Federal Reserve Bank of Atlanta and a non-voting member of the Fed, stating:

    “To translate ‘tapering’ into ‘downward adjustment: I think we are approaching a period in which it could be considered…we are approaching a period in which it can be seriously considered based upon sort of the momentum of the economy — which is not great but is nonetheless is moving forward — and based upon accreting confidence in the economy.”

    He followed those statements up in August by stating, as reported by Zero Hedge:


    The importance of these comments is that it is currently the primary support of the “bull case” for stock ownership.  The belief is simply that the pace of economic growth, which is expected to recover strongly by the end of 2013, will offset the drag from lower rates of monetary intervention.  Furthermore, it is believed that this stronger economic growth will continue to foster the “great rotation” from the safety of bonds into the stock market which will further advance the current “bull market cycle.”

    The real question is whether any of these expectations will come into existence and what the market reaction will actually be?  Let’s break down the statement into its individual concepts.

    Economic Growth Set To Expand In The Second Half

    This has been a statement that has been floated by the Federal Reserve each year for the past three years.  Each quarter the Federal Reserve produces its estimates for economic growth, employment and inflation which I have discussed in detail in the past but most recently in “Fed’s Economic Projections: Myth vs Reality” in which I stated:

    “When it comes to the economy the Fed has consistently overstated economic strength. Take a look at the chart and table. In January of 2011 the Fed was predicting GDP growth for 2012 at 3.95%. Actual real GDP (inflation adjusted) was 2.2% or a negative 44% difference. The estimate at that time for 2013 was almost 4% versus current estimates of 2.3% currently.

    We have been stating repeatedly over the last 2 years that we are in for a low growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when an economy requires more than $5 of debt to provide $1 of economic growth – the engine of prosperity is broken.”

    The chart below shows the declining trends of the Fed’s mistaken economic growth views versus reality.


    With the economy currently growing at 1.4% (average of first two quarters as reported so far for 2013) it will take growth in the 3rd and 4th quarters of 3.6% to achieve the Fed’s current goal of 2.5% for the year.  The table below lists the quarterly real growth rates of the economy since 2009:

    Q2:2009 = -.42%
    Q3:2009 = 1.27%
    Q4:2009 = 3.82% 
    Q1:2010 = 1.58%
    Q2:2010 = 3.85%
    Q3:2010 = 2.75%
    Q4:2010 = 2.78%
    Q1:2011 = -1.30%
    Q2:2011 = 3.15%
    Q3:2011= 1.36%
    Q4:2011 = 4.78%
    Q1:2012 = 3.66%
    Q2:2012 = 1.20%
    Q3:2012 = 2.76%
    Q4:2012 = 0.15%
    Q1:2013 = 1.14%
    Q2:2013= 1.66%

    First, there has only been one period of two consecutive quarters of economic growth greater than 3.6%.  That period was an anomaly due to the pent-up demand generated by the Japanese manufacturing shut-down from the earthquake/tsunami, the debt-ceiling debate, a plunge in energy prices and the warmest winter in 65 years.  That combination of events is unlikely to happen again during the remainder of this year.  The only other three instances of greater than 3% economic growth can be attributed to the pull-forward of demand caused by the Fed’s monetary interventions.

    The reality is that the sequester spending cuts, higher tax rates, and further potential negative economic impacts from policy decisions made during the upcoming budget and debt ceiling debate are likely to keep economic growth somewhat suppressed through the end of this year.  2014, and particularly 2015, will also see likely curtailments of growth caused by the very large increases in healthcare costs, taxes and other expenses related to the onset of the Affordable Care Act.

    While I am not suggesting that the economy is set to plunge into the next recession – it is also hard to fathom a significant pickup in growth given the underlying variables.

    Valuations Are Cheap

    If I am correct, and the economy continues to “struggle along” rather than picking up steam, then the erosion of corporate revenues and profitability will continue.  This brings the“valuations are cheap” argument into focus.  With corporate earnings already at historically high levels, and expectations are that they will continue to advance over the next couple of years, any misstep could become an issue.  This was addressed recently by Scott Minerd of Guggenheim Partners:

    “The S&P 500 index has increased by over 34% since the beginning of 2011, of which 28% has come from multiple expansion. During the same period, growth in corporate earnings has slowed. The trailing 12-month earnings for S&P 500 companies rose 2.4% in 2012 and another 2.5% for the first seven months of this year, registering the slowest earnings growth in non-recession years since 1998. Without renewed earnings growth, a continued rally in stocks driven by multiple expansion may be not sustainable.”

    As Doug Kass noted in a recent article:

    “It is important to recognize that most investors and strategists have made little change in their economic and S&P forecasts for earnings in 2013-2014, yet they have comfortably accepted the rise in valuation from under 14x to over 16x this year [using forward operating estimates] and have almost universally stepped up their S&P price targets. This P/E expansion has occurred despite China growth issues/questions, a (market-unfriendly) trajectory of higher interest rates, evidence of a growing ineffectiveness of quantitative easing, the heavy weight of upcoming decisions in Washington, D.C., and disappointing bottom- and top-line second-quarter 2013 results (and guidance).”

    Valuations, while historically a horrible market timing indicator, are terribly important to the long term expected returns from portfolios.  The higher the valuation at the time of entry – the lower the future return of the portfolio.  I recently quoted John Hussman in “Are We Retracing A Market Peak?” in which he pointed out that:

    “Needless to say, my concerns about this strenuously overvalued, overbought, over bullish, rising-yield syndrome have not been useful or relevant in recent months, as the market has advanced to further highs. As a result of that advance, our estimates of 10-year prospective S&P 500 nominal total returns have deteriorated further – from 3.8% annually in January to just 2.8% today.

    Valuations do matter and they matter very much.  In the short term it may seem that the markets can defy gravity and fundamentals due to price momentum, investor exuberance and monetary flows.  However, in the long term, periods of excess valuation, and particularly those driven primarily by price increases, have not been kind to investors.

    Rising Interest Rates Won’t Matter

    Along with the ideas of stronger economic growth and the “great rotation” is the assumption that the accompanying rise in interest rates will not be a negative impact.  This is an issue that I fear is grossly misunderstood.   Interest rates are the lifeblood of the economy.   As interest rates rise the cost of borrowing increases which reduces overall corporate profitability.  Rises in borrowing costs also negatively impacts the housing market as investors are effectively priced out of home ownership causing prices to fall.  Debt service costs rise on variable rate debt and corporate projects become less favorable.

    As shown in the chart below rising interest rates slow economic growth.


    It is important to notice that historically it does not take massive increases in interest rates to sharply impact economic growth.   With economic growth already slow the recent rise in interest rates is likely to have a greater impact to growth than currently expected.  Furthermore, if firms are unable to borrow cheaply enough to fund stock buybacks (which boosts EPS) and pay dividends (investors have been “chasing yield”) which have been a key supports of the rise in stock prices; a sharp rise would have a very negative implication on the financial markets.  History suggests that sharp increases in interest rates are not favorable for future stock market returns.


    Furthermore, as stated above, with economic growth already weak the question of interest rates becomes much more important.  If historically low interest rates couldn’t spark an economic recovery – what will higher rates do?

    What Will Really Happen If The Fed “Tapers”

    While I certainly cannot predict the future, nor can anyone else for that matter, the weight of historical evidence would certainly suggests that if the Fed begins to reduce its monetary support that the consequences are certainly less than favorable given the current state of the economy.  The chart below shows the very high correlation between the expansion of the Fed’s balance sheet and the financial markets.


    The reduction in the size of purchases is certainly not the same as ceasing purchases as was witnessed at the end of the previous two programs which led to fairly sharp declines in asset prices.  However, the lower rates of flow certainly suggests a slowing in the rate of elevation of asset prices.

    Doug Kass summed this up well:

    “If you don’t think the market is the beneficiary of quantitative easing and you think tapering is nonevent, consider that the Fed has printed $600 billion of new money this year. This has generated only a 1.5% increase in GDP or $300 billion this year. But thus far in 2013, there has been a 20% rise in the value of U.S. stocks — that is a rise of $3.5 trillion (on a base of $20 trillion total market value). So, a change of policy (i.e., tapering), is more significant and impactful than most argue.

    The ‘taper is not tightening’ argument is semantics because less asset purchases equals less accommodation. Moreover, it is now the markets that have tightened policy over the last two months, as the Fed has begun to lose control of rates. (Note: The yield on the 10-year U.S. note resides at 2.66% this morning, only a few basis points from the recent high yield. In my judgment we are close to the line in the sand, where rates will adversely impact economic activity.)”

    As a money manager I am currently invested in the markets because the markets are rising and I must participate or suffer career risk.  However, it would be completely naive to dismiss the risks that are currently present and rising.  Market and economic cycles do not, and cannot, last forever.  While it is never expected, as “this time is always different,” it is the eventual “reversion to the mean” that leaves investors devastated as the reality of the underlying fundamentals collides with fantasy.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live
    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.