by Lance Roberts
All eyes are on the Federal Reverse announcement as the market will quickly parse Bernanke's statements for clues on a reduction of the $85 billion monthly bond buying program that has sent stocks to all-time highs in recent months. As I stated back in February the advance to these new highs was certainly expected as the Fed flooded the financial markets with excess liquidity. The chart below shows the high correlation between the Federal Reserve's balance sheet and the financial markets.
The question is simply this: What happens if the Fed does announce a slowing of their bond buying program?
In theory this is binary answer: "No Taper" - stocks go up. "Taper" - stocks go down. Reality, however, may be more of a singularity for three reasons: overbought conditions, fundamentals and economics.
Overbought Conditions:
There is one truth about the markets, despite Federal Reserve interventions, that remains true: "Stocks do not go in a straight line."
During unfaltering advances in the market investors begin to migrate towards the belief that the stock market will continue its current trajectory indefinitely into the future. This is particularly true near market tops when almost every pundit, analysts and investor is touting why now is the time to "jump in". Of course, history is replete with examples of the disaster that followed such advice.
As we discussed at length in our recent weekly missive "An Initial Sell Signal Approaches" prices can only move so far away from their long term average before "gravity" sucks prices back. The chart below shows the S&P Index on a weekly basis (which smooths out day to day volatility) with a set of Bollinger bands representing 3-standard deviations from the mean.
[Geek Note: In statistics and probability theory, standard deviation shows how much variation or dispersion exists from the average (mean), or expected value. In a normal distribution of data, as shown by the bell curve below, ONE standard deviation from the mean encompasses 68.2% of all data in the distribution (in our case price movement). TWO deviations account for 95.4% of all potential price movement while THREE deviations account for 99.8%. There when prices reach two and three standard deviations above or below their mean the majority of the probable price movement has been achieved.]
With the market trading at 3-standard deviations above the 50-week moving average history suggest that a correction of some magnitude is forthcoming regardless of the Federal Reserve's interventions. This extreme deviation from the long term average combined with record levels of margin debt has the market primed but currently lacking a catalyst to ignite a selling panic.
Fundamentals:
The fundamental underpinnings of the market are also showing signs of strain. While the Federal Reserve interventions, and near zero-interest rate policy, has forced investors to "chase yield" in the financial markets - the current rise in asset prices comes at a time when corporate earnings are hitting a record and showing signs of deterioration as shown in the chart below.
The problem with the peak in earnings is that it negatively impacts the "valuation" story of stocks. If the mainstream analysts are right, and bond yields are set to rise substantially, the valuation story (earnings yield versus interest yield) becomes much less compelling. Ultimately, the weakness that is showing up in the fundamental story will translate into a repricing of "risk" in the markets.
Economics:
Behind the scenes of earnings and price momentum is the economic story. In the long run the markets respond to the strength, weakness, in economic growth. While the market charged ahead in hopes of strengthening economic underpinnings - the problem has been that it has yet to be the case. With the economy "muddling" along at less that a 2% real annual rate - the pickup in employment, above mere population growth, wages and demand have been weak.
The chart below shows real, inflation adjusted, GDP turned into an economic indicator. When the annual growth rate has historically fallen below 2% the economy was either in, or about to be in, a recession. The only time in history that this has not been the case was in 2011 when the economy fell below the 2% threshold for 4 straight quarters. Of course, the bailout of the economy through liquidity programs kept the economy from sliding lower.
The economy is currently pushing a third straight quarter of sub-2% growth with the Federal Reserve discussing taking away a major support for the economy. The extraction of liquidity from the system will stem the forward pull of future consumption, which has come at the expense of higher credit balances and lower personal savings rates for consumers, leading to weaker rates of economic growth.
With corporate earnings dependent on consumer spending (70% of GDP) the gap between economic realities and financial fantasy will likely be filled sooner, if the economy continues to weaken.
The weak economic story, combined with weakening fundamentals and extreme price overvaluation will ultimately lead to a correction of some magnitude in the market. This will occur regardless of whether the Federal Reserve "tapers" their intervention program or not. This leaves investors at the whims of a highly leveraged market that has become much more volatile in recent years. Investors have piled into some of the riskiest assets in the market in their quest for income as their faith has been placed in the Fed that they will prevent a market meltdown. Maybe that is the case, however, history suggests that such blind faith in the markets has rarely worked out well in the long run.
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