Rein In the Fed

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Would you borrow from your children to solve personal financial problems if you had no realistic way ever to repay them? If you knew it would leave them financially weakened and less able to live as well as you do now? We as a society are doing exactly that to our children as we allow the Federal Reserve and politicians of both parties to borrow from tomorrow to bail us out of past overindebtedness and to live more comfortably today.

Few see this as a moral issue. Without question, it is! Americans are happy to accept political and monetary largesse with scarcely a thought about the negative impact it will inevitably have on subsequent generations. Centuries of history argue convincingly that debt levels, even well below ours today, have almost invariably been punished by extended periods of sluggish economic growth, often accompanied by significant securities market losses. Those consequences will be felt most egregiously in coming decades.

Current legislators could take a major positive step by reining in the Federal Reserve Board. Through its first 95 years, the Fed acquired a balance sheet of a bit more than $800 billion. To bail the U.S. out of the 2007-09 Financial Crisis, the Fed abandoned all financial discipline and exploded its balance sheet to about $4.5 trillion through a series of money printing episodes. In its more recent attempts at “normalization”, the Fed has raised interest rates from the zero bound and gradually reduced the balance sheet by nearly $1 trillion. Investors, however, have rebelled against the withdrawal of monetary ease with sharp stock market selloffs. And the Fed has apparently conceded defeat, trading “patience” for preemptory easing. That concession makes Wall Street happy, and makes it convincingly clear that the Fed has indeed adopted a third mandate in addition to its Congress-dictated duo of maintaining a stable currency and maximizing employment. Inflation of 2% per year now masquerades as stability. And maximizing employment provides cover for virtually any Fed action to manage the economy. It makes no sense to invest any small group of primarily academics and regulators with the power to exercise massive influence on the domestic and, in turn, world economy. Rarely, if ever, does the Fed have even a single member who has ever successfully run a major corporation, much less has the credentials to guide the world’s largest economy. The Fed’s assumed third mandate leads them to make decisions far beyond their areas of experience and competence.

Allowing the Fed to wield the power it now has is also creating massive stock market distortions. So much market reaction flows from Fed proclamations that analysts spend an inordinate amount of time attempting to interpret the slightest variations in language or attitude of Fed voting members. For many strategists this deciphering has become even more important than the analysis of underlying fundamental conditions. That dynamic becomes blatantly obvious when we see markets surge on an announcement of disappointing economic news, as the prospect for more stimulus increases.

The single most effective antidote to the recent circus of political attacks on the Fed, a 180 degree Fed policy turn and investment strategists’ guessing game about upcoming Fed easing would be to establish a transparent rule-based system to determine monetary policy. Such a system would almost certainly be preferable to the frequently flawed Chair-led decisions heavily influenced by personal perceptions and biases. The arguments against relying on a rule-based system typically involve pointing out how such a system would likely have led to an arguably unacceptable monetary position in one or more instances– as if the existing system itself has not placed the country in an extremely dangerous position. If a rule-based system appears imperfect, improve the rules. Clearly, each voting member of the Fed relies on his or her own set of rules in making monetary decisions. Those rules are not, however, publicly known, so we are left to speculate on how voters, especially the Chair, will make their decisions. The securities markets would be far better served if analysts knew the rules on which monetary decisions would be based. Strategists could then abandon the psychological analysis of voting members and their probable decision-making patterns and return to an analysis of how the data align.

Notwithstanding the best of intentions, the Fed in recent years has bet America’s future on a flawed (now failed) experimental monetary policy. Until we speak up loudly, we remain at risk of continued experiments further decimating the future economic prospects of our nation and coming generations.

Congress needs to step up now to rein in Fed power.


Will Fading Forecasts Change Investors’ Behavior?

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Our July Quarterly Commentary, released last week, highlighted that U.S. corporate earnings peaked in 2018’s third quarter. GDP data announced Friday indicated that second quarter corporate profits posted their largest annual decline in several years. Q2 marked the third consecutive quarterly decline, off 7% from year ago levels. In the annual GDP revisions, operating profits were lowered by significant amounts for both 2017 and 2018. According to the GDP data, there has been no growth in U.S. operating profits for the past five years. Remarkably, the S&P 500 has advanced by over 50% during the same time period. The Fed’s newly created money has obviously found its way into stocks and bonds, not into the economy, ostensibly the target of the Fed monetary policy.

Economic and corporate profit growth have been similarly sluggish in most of Europe, but European stocks have shown a far more logical relationship to the weak underlying fundamental conditions. Stocks surged when the European Central Bank (ECB) initiated its Quantitative Easing (QE) policy in early 2015, but, unlike in the United States, stock prices subsequently reflected weak economic conditions rather than central bank stimulus. The Stoxx 600, a broad European index, is 6% lower today than in April 2015.

The Fed, ECB and other major central banks are now expected to employ looser monetary policies beginning this week. Even factoring in that expectation, the vast majority of economists anticipate both 2019 and 2020 to show weaker economic growth than 2018. Last Thursday, Reuters announced the results of its poll of over 500 economists taken this month. The growth outlook for nearly 90% of almost 50 world economies was either downgraded or left unchanged for both this year and next. In answer to a separate question, over 70% of about 250 economists now anticipate a deeper global downturn than they previously expected.

If these economic forecasts prove accurate, the question facing investors is whether stock prices will nonetheless advance because of central bank stimulus, as they have for years in the U.S., or decline in concert with fading economic conditions, as has been the case in most of the rest of the world.


Quarterly Commentary 2nd Quarter 2019

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“Is the market going up just because of the Fed?” – asked of an investment strategist by a CNBC announcer. “No, the economy is incredibly strong.” This interchange took place immediately following the strategist’s prediction that the Fed will lower short-term interest rates in July by 25 basis points, possibly by 50. Even if illogical, Wall Street is at least consistent. Strategists regularly paint a rosy picture of the economy and prospects for the stock market. At the same time, they lobby the Fed for lower rates, typically employed only to prevent a faltering economy from falling into recession.

Very clearly, both the domestic and world economies are slowing. The World Bank, International Monetary Fund and Federal Reserve all forecast 2019 and 2020 to be weaker than 2018. The Fed’s long-term U.S. GDP growth forecast is a meager 1.9% per year. Similarly, corporate earnings, both here and abroad, are losing altitude. Ned Davis Research points out that profits for all domestic corporations peaked in 2018’s third quarter at $2,321 billion, falling to $2,311 billion in the fourth quarter and $2,252 billion in this year’s first quarter. FactSet is currently estimating that S&P 500 earnings will decline year over year in both the second and third quarters. In my 50 year investment career, I can’t remember another instance in which stock prices remained near historic highs with domestic and world economies growing very slowly and weakening and corporate earnings declining on both a sequential and year over year basis. Wall Street, nonetheless, remains bullish.

For several years, stock price advances have very clearly followed bullish comments and policy changes by central bankers around the world. Over the past several weeks, it has become even more apparent that markets are responding to the likelihood of the Fed employing more monetary stimulus rather than to fundamental strength or weakness. Bad economic news has become good for equity prices. In recent weeks, relatively rare positive economic news has typically led to stock market declines, whereas stocks have risen aggressively on days following downbeat announcements. Investors clearly prefer weak conditions that raise the likelihood of additional Federal Reserve assistance. While not a healthy or ultimately sustainable state of affairs, it has been the path to stock market advances for the better part of the past decade.

Governments around the world began the greatest ever episode of money creation to rescue their respective economies from the Financial Crisis and Great Recession. In the last two years, most central banks have expressed their intentions to “normalize” interest rates and to reduce their bloated balance sheets, the result of the unprecedented money creation process.

Despite the best of intentions, 2018’s negative market reactions demonstrated that investors were not ready for “normalization”. Virtually all major world equity markets provided negative total returns in 2018, several by double digits. As central banks tried to reduce their balance sheets, interest rates rose and bonds also produced negative total returns. Consequently, central bankers have given up “normalization” and have returned to the abnormal conditions that have rewarded investors for the past decade. That has led to powerful bounce-backs by both stocks and bonds so far in 2019. While several major U.S. stock market indexes are close to all-time highs, the main contributors have been a relatively small number of very large companies selling at extremely high price-to-earnings multiples. The average stock’s progress has been far less impressive. The New York Stock Exchange Composite Index, which includes all stocks traded on that exchange, is still below where it was in September and January of 2018, about 9 and 17 months ago respectively. Powerful rallies and declines have essentially offset one another with no net gain for the past year and a half. Most foreign equity markets are even further below their respective former highs.

On the fixed income side, the story has been much the same. This year’s bond market rally has simply offset rising interest rates that characterized the prior two years. From the interest rate lows in mid-2016, annualized total returns on intermediate U.S. Treasuries have been 1% or less.

Weak economic conditions are exacerbated by ongoing extreme levels of stock market overvaluation and excessive debt. Despite severe overvaluation for several years, stocks have been able to rise with central bank support. It is important to recognize that prior to this decade, however, equity purchases made near these heights of overvaluation in the past 130 years have experienced losses or minimal positive returns over subsequent 7 to 12 year spans. And the existence of historically high amounts of debt worldwide increases the risk should any of the many economic, military or political uncertainties eventually undermine investor confidence.

Seeing that equity price rewards come from anticipating ongoing central bank stimulus rather than sound fundamental economic growth puts investors in a very difficult position. To make money, they have to assume positions that historically have been punished but which have recently remained productive because central bankers continue to provide relatively free money, pulling consumption forward and passing the resultant debt along to our children and grandchildren. The question: Should investors bet on the Fed and other central bankers’ ability to push equity prices even higher despite deteriorating economic fundamentals? No one knows the correct answer to that question, but every investor has to weigh the probability of a continuation of central bankers’ past success versus the consequences of markets reverting to long-term levels of normal valuation.

The answer to the question is not likely to determine simply whether stocks rise or fall 10% or so in the years ahead. Since the Great Recession, trusting central bankers has produced far higher returns in most years. On the other hand, in the first decade of this century, the U.S. equity markets suffered two declines of 50% or more because of extreme overvaluation and excessive indebtedness. We have solved neither of these problems. The government rescue that provided the powerful equity results of the past decade has, in fact, magnified the debt problem. And fundamentally, using normalized five-year averages, the U.S. is today running at lower measures of GDP, productivity and wage growth than those that led to the Great Recession more than a decade ago. And the current market is more overvalued than it was at the 2007 market peak before the 57% collapse that took away 13 years of stock market price progress.

U.S. investors have become complacent because, as destructive as the 2000 and 2007 bear markets were, the government was successful in rescuing the economy and the markets, and prices today are substantially higher. A sobering reflection, however, is that the current environment resembles Japan in the late 1980s more than the U.S. in the late 1990s. Markets today are not rising on new era enthusiasm like that which characterized the dramatic evolution of the internet at the end of the century. Today’s market advance is much more a result of confidence in central bankers providing gobs of free money and underwriting risk assumption, as was the case in Japan in the 1980s. At its peak, the Nikkei was the largest stock market in the world. Almost inconceivably, that market fell by more than 80% and 30 years later is still over 40% below its 1989 high.

Markets may or may not behave as they have in the past, but precedent is a safer bet than the unprecedented. Should central bankers remain in control for a while longer, equity investors who continue to profit will still have to make a timely sell decision to retain those profits, unless central bankers are also able to eliminate the business cycle and keep prices elevated above current levels.

As indicated earlier, the vast majority of Wall Street firms are mildly bullish and are not forecasting an imminent recession. They never have. Goldman Sachs, however, notes that its historically accurate quantitative Bull/Bear Market Indicator recently registered a greater degree of risk of a bear market than that before the two prior bear markets in this century and is at the highest risk level in 50 years.

Every investor needs to weigh carefully his/her/its ability to withstand a significant and potentially long-lasting equity market decline against the desire to maximize returns in the years immediately ahead. The past decade has demonstrated the durability of profit potential, but current conditions are unique and fraught with uncertainty and risk.