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How The Fed Stops Market Corrections

  • Written by Syndicated Publisher No Comments Comments
    April 29, 2014

    I have been asked often why it seems the markets are continually able to ward off declines despite breaks of technical support levels? It is a good question.

    While I regularly discuss the broader macro-fundamental or economic backdrops, there is relatively little impact from these issues to the markets over the short term. Valuations, economic underpinnings, growth rates, etc. are VERY important to the returns investors should expect to receive over the next decade, but are of little use in short term analysis.

    John Hussman reminds us of this point his recent letter stating:

    “As a reminder of where capitalization-weighted valuations stand, the following chart shows the present ratio of market capitalization to GDP (shown on an inverted scale on the left, so richer valuations are lower on the chart). Actualsubsequent 10-year S&P 500 total returns are plotted in red (right scale). Any belief that present levels represent a “zone of reasonableness” is detached from the historical evidence. The entire market does not deserve to be viewed as a wide-moat Buffett-type stock where earnings can be relied on as a sufficient statistic of value.”

    Hussman-042814

    “All of this said, I would be remiss if I did not emphasize that valuation is not a timing tool. We have a strong expectation that stocks will achieve weak total returns over the coming decade, and negative total returns over horizons shorter than about 7 years. But as the investment horizon shortens to less than a few years, other factors become more important in determining market returns.”

    In the short term all that really matters is price, trend and deviation. However, even those that employ technical analysis have been confounded by the markets over the past couple of years. As the markets have committed repeated “bearish” technical violations, such events have not led to deeper corrections as would have been expected but with price spikes instead. The chart below shows the market since the beginning of 2012 and how each dip, instead of leading to a bigger correction, was met with buying as “shorts”were squeezed into an equity ramp.

    SP500-Dips-042814

    However, the media quickly attributes this activity to investors “buying the dip” due to “better than expected” economic or fundamental data. But is that really the case?  As we stated above, while “news” provides emotional context, the underlying economic and fundamental data changes occur extremel slow. It is from this basis that many individuals have pointed to the Federal Reserve as the primary supporter of asset prices in recent years. Despite weak economic or fundamental news, geopolitical intrigue or excessive investor “exuberance,” markets have surged higher.

    Is it “actually” the Federal Reserve’s actions that are supporting the financial markets? To answer this question I examined the weekly changes to the Fed’s balance sheet as compared to the S&P 500.

     Fed-Balance-Sheet-VS-SP500-042814

    As you can see, through the majority of 2012 the market struggled to advance as the changes to the Fed’s balance sheet limited overall balance sheet increases.  However, beginning in December of 2012, as the Federal Reserve fully implemented the current QE program, asset prices begin to surge.  Furthermore, as I have highlighted with vertical lines, market declines were halted as large rounds of asset purchases pushed liquidity into the financial system.

    explained previously how these “injections” lead to increases in asset prices stating:

    “The reason it matters to investors is that stock and bond prices have benefited greatly from QE and deficit spending. Not only has QE expanded M2, but a large portion of that M2 has found its way directly into stocks, pushing equity valuations higher and higher. The reason QE hasn’t produced significant economic growth is in part the fact that the money created on the front-end of this process has been invested in risk assets rather than flowing into the economy to stimulate GDP growth.”

    QE-how-it-works

    Importantly, these “bond purchase” days have been a boon to market participants who can effectively “game” the system with high-speed trading capabilities, utilization of leverage and access to massive amounts of information and intelligence. However, the average investor could have also outperformed the market, with much lower volatility, since the beginning of 2012 simply by investing ONLY on TUESDAYS when liquidity tends to hit the system.  The chart below shows the cumulative return of $1000 invested on only on Tuesday versus the remaining days fo the week.

    Fed-Balance-Sheet-Buy-Tuesdays-042814

     While I am certainly not suggesting that individuals should give up their current investment discipline and only invest on “Tuesday,” the evidence suggests that Federal Reserve interventions have been supportive of asset prices in the past.

    However, with the Federal Reserve now withdrawing that support, and will likely reduce asset purchases by another $10 billion this week, this leaves the market vulnerable to the actual underlying economic and fundamental underpinnings.  That story is much less exuberant.

    As John Hussman concluded:

    More importantly, the market has lost significant momentum, the stance of monetary policy is shifting to a less recklessly discretionary and more rules-based approach, and we’re observing increasing divergences in market internals. A loss of uniformity in market internals has historically been an important and subtle indication of rising risk aversion among investors.

    The worst market outcomes, hands down, occur in those environments where rich valuations are coupled with deterioration in market internals and a shift toward increasing risk aversion.

    The likelihood is poor that from current price levels, broad equity investments – even held for nearly a decade – will generate any positive investment return at all. Among the saddest notes I received in the 2000-2002 and 2007-2009 bear markets were from people who had short investment horizons (and were therefore “forced” sellers) and lamented “I wish I had listened.”

    For many investors, the confusion between macro economic and fundamental analysis and short term market returns leads to “emotionally based” decision making which rarely works out well.  This has been the bane of investors for decades as they continue to“buy high/sell low,” chase performance and ignore the fundamentals of market dynamics. The basic fundamental concepts of investing have not changed. This time is“only different” in terms of the catalyst but the outcome will remain the same leaving most investors “wishing they had listened.”

    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.

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