Unwinding the Unwindable
“Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.”
- Howard Marks
It was not a boring end to 2019 for the Aspera family. We had to put our Stress Management Guru, Bella, to sleep after 14 years of loyal service. As much as I’d like to blame the Federal Reserve for this, the fault instead lies with the ravages of old age. It’s lonelier in the office these days, and I miss her ability to remain calm and centered regardless of what the markets are doing, where gold is trading, or who the U.S. is assassinating in the Middle East.
On a happier note, our Junior Research Analyst won her elementary school spelling bee. She represented her class three years in a row and improved each year. I have clearly improved my gene pool as the best I could muster in elementary school was a single school-wide appearance that met with an ignominious end on the word bicenntenial…bysentennial… bissentennial…whatever. She was not exactly excited about prepping for the school bee, and she wasn’t thrilled to learn that the reward for her victory is the opportunity to study a much larger and more challenging list of words for the upcoming regional bee. Nevertheless, she was treated to an arts supply shopping spree, and she has been promoted to Senior Junior Analyst and Chief Editor. So, although the content of these missives may seem nonsensical or downright asinine at times, you can at least rest assured that they’ve been adequately spellchecked.
Unwinding The Unwindable
The investing and economic landscape has been no less eventful, and we can blame the Federal Reserve this time. One of our long-held core beliefs has been that the Federal Reserve would never be able to completely unwind its post-2009 stimulus. Financial markets have become dependent on stimulus, and the “need” for even more stimulus would grow with every ensuing downturn. The Fed had promised that Quantitative Easing (QE) and 0% interest rates were merely a temporary response to the 2009 crisis, but temporary turned into 6 years. The Fed finally attempted to remove the juice by very gradually raising short-term interest rates beginning in early 2016. At the beginning of 2018, they also began the process of unwinding some of the QE. The financial markets didn’t implode during this “normalization” simply because other global central banks were still more than offsetting the Fed. It wasn’t a coincidence that the U.S. stock market and various credit markets suffered their first major pullback just after central bank stimulus dried up globally in the back half of 2018.
Fed Chairman Powell reacted to that late-2018 scare just like every Fed Chair since Paul Volker. He balled himself in a designated “safe space” at headquarters and started rocking gently to the pan flute version of Bob Marley’s “Everything’s Gonna Be Alright.” Then he promptly reversed monetary policy. He began with the standard rhetoric in January of last year, stating that the Fed “will be patient.” This was sophisticated economic code for “We have no idea what’s happening, but we need to project confidence and SAY SOMETHING to stop the stock market from falling before Trump starts mean-tweeting us again!” This was escalated in March when the Fed announced that Quantitative Tightening (QT) would be ending in September despite assurances a few months earlier that it was on autopilot. At the end of July, the Fed followed through and cut the Federal Funds rate. In addition, they announced that QT was going to end even earlier now. The two charts below tell the story. The top chart shows that it took the Fed 3 years to raise the Fed Funds rate from 0% to just under 2.50% and 4 months to lower it back to 1.50%. The bottom chart shows that the Fed added (printed) $3.60 trillion in assets (QE) to its balance sheet following the last crisis but was only able to remove $0.75 trillion.
Not only did the Fed make little headway in reducing its balance sheet, they didn’t even pause to high-five each other before cranking up the printing presses again (“Here We Go Again!” on the bottom chart). This time the culprit was the seizing up in September of what’s known as the repo market. This is very short-term lending between financial institutions. The details of why exactly that market seized up are still being debated. The ultimate cause is less important than the fact that the fragility of our financial markets was once again laid bare, and the Fed once again affirmed that it would soil itself every time the markets whimpered. The Fed has repeatedly stressed that this latest balance sheet increase is not QE, but the $400 billion they pumped into the system these past 4 months sure has a strong QE stink about it.
It should be increasingly clear to everyone by now that there is no escape for the central banks. They’ve blown huge bubbles, encouraged massive debt growth, and fostered the creation and sustenance of chronically money-losing businesses. The economy can’t sustain much higher interest rates without suffering a devastating recession, and the financial markets can’t stand on their own merit. Any attempts to raise interest rates or reduce their balance sheet will fail. The practical follow-on is the issue of how the financial markets would react to the realization that more stimulus was coming. Stock investors have been trained for a decade to react in a Pavlovian fashion to any stimulus from the Fed, so the latest rally in the stock market is far from surprising. The counterargument is that the last two market collapses occurred despite aggressive easing by the Fed.
But is this latest stock market boost the beginning of a new bull market or the final blow-off rally of the bubble? The stock market is more overvalued today than in 2000 or 2007, with the overvaluation rivalling that of 1929. The “market” is being driven higher by fewer and fewer companies, with the largest 5 companies in the S&P 500 accounting for an all-time high 18% of the total index value. This concentration is now greater than the 2000 peak. At the same time, 40% of U.S. listed companies lost money over the past year. These aren’t signs of a healthy, well-supported bull market. Ultimately, you either believe that this madness will meet the same demise as every bubble in the history of homo sapiens, or you believe that some way, somehow this time it really is different and the laws of economics, finance, and psychology have been sufficiently and permanently altered in a fashion that henceforth prevents bear markets. Of course, it’s a bubble, and of course it will end. The heavier the partying, the worse the hangover. The only real question is when, and this is impossible to pinpoint as bubbles are marked by a mass temporary insanity which precludes rational analysis. Your guess on timing truly is as good as mine (better for the less rational among you). Fortunately, despite the overall stock market being very unattractive, there are some narrow yet tremendous pockets of opportunities within the market.
Ken, CFA, CFP, MBA, Wannabe Wailer
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.