Thursday, September 18, 2014

The FOMC Decision and Financial Markets

by Pater Tenebrarum

No Surprises in Carbon Copy Statement

If anything, the FOMC statement was probably interpreted by Kremlinologists as less hawkish than expected (although the Fed already leaked that fact via the WSJ’s John Hilsenrath on Tuesday, spurring yet another surge in risk assets). The reduction in QE by a further $10 bn. to a mere $15 bn. per month was widely expected, but the feared “change in language” was conspicuous by its absence – in short, there were no hints as to a change in the envisaged time table for eventual rate hikes.

This provoked two hawkish dissents (actually, to call them “hawkish” is a bit of an exaggeration), by regional presidents Richard Fisher & Charles Plosser, i.e., the usual suspects who were never really on board with the Fed’s unconventional policies anyway. Their beef was precisely with the unchanged guidance on the timing of rate hikes. Readers can compare the changes relative to the July statement with the help of the WSJ’s trusty statement tracker.

Interestingly, a number of markets reacted as though the guidance had been changed – gold was down $12, the dollar index jumped to a new high for the move, treasuries weakened. The stock market is usually the last market to get the memo, and at first rallied with some verve, but gave back much of its gain as the initial euphoria faded – however, it still managed to close in positive territory (after all, nothing bad can possibly happen).

The Most Important Datum for Asset Prices

The most important datum for the asset bubble is the pace of money supply growth – everything else is secondary. As always, we caution that there exists no fixed level at which it can be regarded as insufficient to keep all the balls in the air, but generally speaking it is bad news for financial asset prices when it slows down at a time when asset prices are already very high.

In fact, given the narrowing of the rally – as Mish has noted, some 47% of all Nasdaq stocks are by now “technically” in a bear market, as well as more than 40% in the Russell 2000 – we can already tentatively conclude that the current growth rate of the money supply no longer suffices to lift all boats. Most of the stocks that are down by 20% or more from their highs are smaller capitalized firms, which normally tend to be more sensitive to developments in the domestic economy (so perhaps the market is actually trying to tell us something).

Add to that the coming surge in supply – not only the huge Alibaba IPO is in the pipeline, but many others as well – and the “more money chasing fewer stocks” equation certainly looks a lot less favorable than it used to. What remains to be seen is how long it will take for the portion of the market that is still well supported to reflect this changing backdrop.

During the mania of the late 90s, these divergences became so pronounced, that the entire value segment of the stock market was well mired in a bear market by the time the tech and big cap bubble peaked, as a result of which there were actually quite a few cheap stocks available, even as the SPX and the Nasdaq were trading at utterly insane multiples. This dispersion of valuations is definitely not a feature of the current market, which measured on a median basis is the most expensive market ever.

Given that it makes not much sense to buy based on valuations, it only makes sense if one a) believes that the artificial boost will continue forever unabated and b) the “grand experiment” central banks have engaged in will have no adverse consequences. This combination of beliefs has indeed been predominant for some time (hence the bizarre focus on a single sentence in the FOMC statement). It is a modern form of superstition.

1-TMS-2 w-o

US broad money supply TMS-2 (without memorandum items, which currently add approx. $ 90 bn. to the total). The huge bout of monetary inflation since 2008 is what has driven the echo bubble to its current extreme – click to enlarge.

2-TMS-2-w-o-growth
More important than the absolute level of the money-berg is the rate of change in its growth. “Tapering” of QE has been partly balanced by commercial banks creating more fiduciary media (i.e., stepping up their inflationary lending by creating deposits ex nihilo), which is why the growth rate has remained in a fairly tight range at a still brisk level this year. However, tapering may be beginning to take a toll, as the most recent y/y growth rate is at a multi-month low – click to enlarge.

Anecdotal Sentiment

How deeply ingrained the faith in the omnipotence of central bankers has become has been nicely demonstrated in a few recent WSJ articles. One of them reports on a fact we have recently discussed in these pages as well – it is entitled “Stock-Market Bears Turn Docile, Predict S&P 500 Gains”. If one looks at this headline closely, it almost sounds as though the term “bears” nowadays describes “docile” people forecasting more gains!

However, the topic is simply that the few remaining bears on Wall Street have by now capitulated (and they weren’t really all that bearish to begin with – two of them were looking for a 6% dip – no kidding). The article points to the possibility that the dearth of bears both in the professional and retail investor realm could be seen as a cause of concern, but this is immediately dismissed by pointing to “low interest rates” (in other words, central bank-induced market distortion). As John Hussman has recently argued, while low interest rates do account for a justifiable premium, it is far lower than is generally assumed.

Even more astonishing was however another article, in which the “potent directors fallacy” was on parade in all its glory (title: “A Scary World, But Investors Trust the Fed”). As we always point out, we firmly believe that this blind faith will eventually be put to a severe test. In our opinion, investors who after the events of the past 20 years have still not realized how utterly clueless the Fed is are in for a very rude wake-up call. An excerpt:

“Market fundamentals, from stock prices to interest rates and profit margins, are stretched. Europe is flirting with recession, the U.S. is expanding its Middle East bombing and Ukraine and Gaza are enduring uneasy truces.

And financial markets act as if everything is just fine. Investors widely believe the Federal Reserve and other central banks will do what it takes to keep economies and financial markets healthy.”

(emphasis added)

We would note to this that just because stocks are near record highs and junk bond yields are near record lows, these markets are by no means “healthy”. On the contrary, they are extremely distorted. So the highlighted sentence should actually read: “Investors seem to believe that central banks can keep markets distorted, without anything untoward ever happening to upset the apple cart”. In short, investors have apparently adopted a na├»ve faith in the miracles of central economic planning (as noted above, it is a kind of modern superstition).

Mind, we are not commenting here on how much longer this faith will persist – we don’t know, and it has already persisted far longer than we thought it would. The air does seem to get thinner with every passing day, but even so it is hard to be certain of when the wake-up call will arrive and what triggers will be involved. However, the article in the WSJ is literally dripping with platitudes and cliches, ranging from the well-worn “there is no alternative” (to buying overinflated assets in distorted markets) to “there is no inflation in sight” and of course the ubiquitous “the Fed has our backs” (paraphrasing).

These arguments are cited in the course of a wide-ranging dismissal of any concerns that may still be lingering in some obscure corners. At one point a fund manager is quoted as thinking that many professionals are actually aware of the market distortion and that it is making them a bit uneasy, but hey, if “there is no alternative”, what can you do? This attitude almost has shades of Japan in the late 1980s. Naturally, it is in many respects a very different situation, we are merely noting the parallels in the psychological backdrop (there was a similarly long list of cliches used to rationalize buying the Nikkei at the time).

Conclusion:

The Fed’s non-statement has provoked very uneven reactions in markets that all depend on the same thing: rapid money supply inflation. There are of course different leads and lags in evidence in these markets, as the traders who are active in different asset classes are often not the same people. These variations in leads and lags are a phenomenon that can be observed on a medium to longer term basis as well, as every individual market’s behavior partly depends on contingent circumstances. However, the more overvalued an asset class becomes, the more vulnerable it will be to unexpected developments. For the moment, everything still seems to be fine, but that is definitely not an immutable condition.

Addendum: Stocks vs. Unemployment Claims

In recent years, the stock market has exhibited a strong correlation with initial unemployment claims, i.e., it has ceased to be a leading indicator, but has rather become a coincident and sometimes even lagging indicator of the economy. We are not sure to what extent this is still applicable in the world of QE and ZIRP, but so far, the inverse correlation has held up well. Below is an updated chart:

3-Claims

Initial unemployment claims and the S&P 500 index. The blue lines are aligned with absolute highs and lows in claims, the red lines with highs and lows in the index. The final two lines are of course only “preliminary” ones that may still have to be shifted in the future. They only show the most recent highs/lows – click to enlarge.

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