Tuesday, December 3, 2013

Bernanke/Yellen To Drive Stocks 30% Higher

by Lance Roberts

That's right, despite all of the recent "bubble talk," it is entirely possible that stocks could rise 30% higher from here.  However, it is not because valuations are cheap because as I discussed in my recent analysis of Q3 earnings stocks are trading near 19x trailing earnings.

"Understanding this it is easy to understand the flaw in using "forward" estimates as a valuation tool.  The use of forward, operating estimates, is only beneficial to Wall Street analysts who need to create a "valuation" story when none really exists.  Overly optimistic assumptions about the future spurs faulty analysis in the present as sliding earnings leads to sharp valuation increases. The chart below shows the progression of forward P/E estimates since the beginning of 2012.  Currently, with the S&P 500 valued at 18.89x reported earnings, it is hard to justify that the market is undervalued."

The primary reason that stocks are likely to climb 30% higher from current levels, over the next 24-months, is because that is what happens during the "mania" phase of a bull market cycle.  This is something that Richard Russell recently defined as:

"The third or speculative phase of a bull market is characterized by a wild and wooly and ever-increasing entrance by the retail public. This phase is characterized by hot tips, hype and pure greed."

As I stated previously it is probably too early to say that we are deep within "bubble" territory because simply too many people are talking about.  It is reminiscent of Alan Greenspan in 1996 uttering the words "irrational exuberance."  The fear of irrational exuberance was eventually quelled by a belief that "this time was indeed different" due to the "new era" of technology.  Ever higher levels of valuations were justified through "forward earnings expectations" and modified "valuation analysis" that, as always throughout history, ultimately failed to materialize.

Currently, individual investors are once again piling into equities under the belief, once again, that this time is different.  In 1999, it was the "tech boom,"  followed in 2007 by the "real estate/credit boom."  Today, it is the inherent belief that the "Fed's accommodative policy"  trumps all other issues.   "Don't Fight The Fed" has become the retail investor's call to arms as shown by the chart of money flows into retail equity mutual funds by ICI.  (Note:  Only the first two weeks of November are included which are already as great as the full month of October)


The support provided by the Federal Reserve has given investors a false sense of complacency regarding the risks of chasing yield in the financial markets.  However, that has always been the hallmark of the late stages of bull market cycles.

"The Beatings Will Continue Until Morale Improves"

Ben Bernanke has been very clear in his communications that the Federal Reserve will continue with its "ultra-accommodative monetary policies" until there are significant signs of improvement in the economic data.  One of his key phrases has been:

“When, ultimately, asset purchases do slow, it will likely be because the economy has progressed sufficiently for the Committee to rely more heavily on its rate policies,”

The term "ultimately" is the key phrase in this regard as it implies that there current stance could remain in place for quite some time to come.  This is especially the case when you consider that the Fed's biggest fear is actually getting worse; deflation.

"The [inflation] index is clearly warning of rising deflationary pressures in the economy, which has recently been seen in many of the manufacturing reports that have shown downward pricing pressures both on prices paid and received, there is no 'exit' currently for the Federal Reserve to reduce its monetary supports.  The real concern is that with the index at just 5.11%, which is well below the long term average of 11.62%, that the economy is far to weak to handle much of an exogenous shock.

The risk, as discussed recently with relation to Japan, is that the Fed is now caught within a 'liquidity trap.'  The Fed cannot effectively withdraw from monetary interventions and raise interest rates to more productive levels without pushing the economy back into a recession. The overriding deflationary drag on the economy is forcing the Federal Reserve to remain ultra-accommodative to support the current level of economic activity. What is interesting is that mainstream economists and analysts keep predicting stronger levels of economic growth while all economic indications are indicating just the opposite.

Despite the Fed's recent communications that they are planning to "taper" the current monetary program by the end of this year - the index is suggesting that their interventions, in one form or another, are unlikely to end anytime soon as the threat of 'deflation' remains the Fed's primary concern."


Of course, it is not just Bernanke that maintains this stance but also his replacement Janet Yellen who has already indicated that she very much supports, and will maintain, Bernanke's current monetary policy regime.  As I stated recently in "Yellen Promises More," the lack of "economic success" will likely mean that the Fed remains engaged in its ongoing QE programs for much longer than currently expected.  The real surprise in 2014 could very well be an increase in size and scope of the current quantitative easing programs if interest rates remain elevated, deflationary pressures continue to increase and economic growth stalls. The injection of more liquidity could very well drive asset prices to the irrational extremes of a true market bubble.  However, if that occurs, the majority of market analysts and economists will not be talking about a "bubble" in asset prices but why "this time is truly different."

Jeremy Grantham of GMO, via ZeroHedge, more eloquently discussed this idea:

"My personal guess is that the U.S. market, especially the non-blue chips, will work its way higher, perhaps by 20% to 30% in the next year or, more likely, two years, with the rest of the world including emerging market equities covering even more ground in at least a partial catch-up. And then we will have the third in the series of serious market busts since 1999 and presumably Greenspan, Bernanke, Yellen, et al. will rest happy, for surely they must expect something like this outcome given their experience. And we the people, of course, will get what we deserve. We acclaimed the original perpetrator of this ill-fated plan – Greenspan – to be the great Maestro, in a general orgy of boot licking. His faithful acolyte, Bernanke, was reappointed by a democratic president and generally lauded for doing (I admit) a perfectly serviceable job of rallying the troops in a crash that absolutely would not have occurred without the dangerous experiments in deregulation and no regulation (of the subprime instruments, for example) of his and his predecessor’s policy. At this rate, one day we will praise Yellen (or a similar successor) for helping out adequately in the wreckage of the next utterly unnecessary financial and asset class failure. Deregulation was eventually a disappointment even to Greenspan, shocked at the bad behavior of financial leaders who, incomprehensibly to him, were not even attempting to maximize long-term risk-adjusted profits. Indeed, instead of the 'price discovery' so central to modern economic theory we had 'greed discovery.'"

The following chart, which I have used many times in the past, supports this idea of a continued liquidity driven market melt-up.  It is simply an extrapolation of the correlation between the S&P 500 index and the Federal Reserve's balance sheet.


At the current rate of balance sheet expansion, and assuming that correlations remain, the markets could well rise to 2329 by the end of 2015.  This would also mean the Fed's balance sheet would have also expanded beyond $6 Trillion.  This would likely imply that the Fed would own more than 50% of the treasury market.

The problem with this analysis is that it assumes that everything else remains status quo.  The reality is that some exogenous shock will come along that causes a more severe reversion in the markets as current extensions become more extreme.   As Grantham noted:

"What can go wrong for the market? There is a slow and for me rather sinister slowing down of economic growth, most obviously in Europe but also globally, that could at worst overwhelm even the Fed. The general lack of fiscal stimulus globally and the almost precipitous decline in the U.S. Federal deficit in particular do not help."

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