Closing In On the Days of Milk and Cookies
by Sinclair Noe
DOW + 70 = 13,895
SPX + 8 = 1502
NAS + 19 = 3149
10 YR YLD + .10 = 1.95%
OIL + .06 = 96.01
GOLD – 8.10 = 1660.30
SILV – .44 = 31.28
Once upon a time, about five years ago to be more precise, we lived in a land of milk and cookies. Some of you are old enough to remember those happy days when the Dow Industrials hit the dizzying heights of 14,164 in October 9, 2007. The all-time high on the S&P 500 index was 1565, made on October 9, 2007.
Of course, the heady, happy days full of hubris were followed by cataclysmic, economic catastrophe as the global financial meltdown followed in short dis-order. Some of us saw it coming, even if we weren’t quite sure how it would hit us. Still, it’s an old and oft repeated story. “Pride goeth before destruction, and an haughty spirit before a fall”; but with humility comes wisdom.
What can we expect if we hit new highs? Likely a crash. That’s the pattern. Build it up to watch it fall. Part of the reason for the pattern is that the main driver for market gains has been the Federal Reserve’s near constant injections of stimulus into the markets; and if we hit highs, the thinking is that the Fed could back off the juice, and when that happens, the financial markets get a nasty case of the Cold Turkey shakes.
There is little debate over whether the Fed has played an integral role in pumping up the markets. A July, 2012 study from the New York Fed stated flatly that the market owed most of its post-1994 gains – that’s more than 1,000 points ago on the Standard & Poor’s 500 – to the 24-hour period before the Fed’s Open Markets Committee meetings. Central bank liquidity has been by far and away the most important driver of asset prices since that haughty October of 2007.
The Fed began purchasing $85 billion per month earlier in January as part of its expanded third round of quantitative easing. Initially, the Fed had planned to purchase $45 billion per month in mortgage backed securities. However, with the expiration of the second Operation Twist in December, the Fed rolled the purchases of treasury bonds into QE3 and began purchasing a total of $85 billion per month in securities this month.
This week marked a historic event for the Fed; their balance sheet grew to $3 trillion for the first time ever — the largest in the Fed’s nearly 100 year history. As of Jan. 23, the Fed’s balance sheet climbed by $48 billion to $3.01 trillion. The announcement coincided with the S&P 500 closing at its highest level since December 2007 as the index nears the psychological 1500 level.Three trillion is a lot of money. The shame is that the Fed couldn’t by more with that much.
You could point to the broader economy to make a case that the stimulus has been somewhat effective. The big theme of 2013, according to Wall Street investment shops, will be the “Great Rotation,” a massive move out of bonds and into stocks. Economic growth is expected to accelerate, facilitating the shift. The past seven years have seen a Great Divergence in terms of fund flows. Investors have poured $800bn into bond funds and redeemed $600bn from long- only equity funds. But recent data show the first genuine signs of equity-belief in years. The past 13 days have seen $35 billion come back into equity funds; $19 billion of which is via long-only.
Again, the Fed’s hand is seen guiding the markets. The structural long position in fixed income is simply threatened by low expected returns thanks to low rates and the mathematical reality that a small rise in rates can cause total return losses in portfolios. Retail inflows into equity markets have started to pick up; more inflows are expected to be reported in the weekly numbers; still, individual investors are lightly positioned in equities relative to history.
Quarterly earnings for the S&P 500 reached a crisis nadir of minus-9 cents a share for the fourth quarter of 2008, when QE began, to an expected profit of $25.18 a share for the fourth quarter of 2012; unfortunately the stimulus for corporate America hasn’t effectively filtered down to Main Street.
And all that earnings growth has a dark side. Wall Street is so addicted to Fed stimulus that good economic news is seen as bearish because of the reliance on the central bank backstop and the fears that an upturn will deter the Fed from further stimulus. Bullish economic news is bearish. Bearish economic news is bullish. Wall Streets thrives on pretzel logic. Maybe there is nothing the Fed can do to truly help the economy. Sure, the Fed can pump money into Wall Street; which is great if you’re a Wall Street banker; not so great for the rest of the country.
Today, Tim Geithner wraps up his tenure as Treasury Secretary, and the Washington Post has a report that supposedly shows that Geithner was tough on banks. The crux of the story is that Geithner is quoted as saying “F— the banks,” during some unspecified meeting. Strong words but nothing to indicate the banks have had anything but cowering compliance and sweetheart deals during Geithner’s tenure.
For now, the markets are going higher and the economy is improving. So far, we’ve managed to avoid a downturn. We narrowly avoided a tumble over the fiscal cliff with a down-to-the-wire deal on New Year’s Day. The three-month suspension of the US debt ceiling renders DC uneventful in the short term. The passage of the House Republican bill to suspend the debt ceiling for three months, allowing the government to keep paying its bills and giving lawmakers additional time to hammer out a long-term deal. We’ll hear the case for cutting spending. When combined with the tax increases that did occur as part of the fiscal cliff deal, the impact from those looming spending cuts could result in trimming the country’s economic growth of some 1.25% this year.
The CBO cautioned in November that “if all of that fiscal tightening occurs, real (inflation-adjusted) gross domestic product will drop by 0.5% in 2013, reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year.” In other words, the CBO predicted a recession in the first two quarters of the year. It looks like we’ve dodged that bullet, but only for a few months.
And the Fed has promised it will keep the Fed Funds rate unchanged into 2014, maybe longer. Maybe. Of course, there is a strong possibility that the Fed is just making it up as they go. This week, we saw the transcripts from the Fed in the pre-crisis, haughty, hubris-filled, record high days of 2007. The transcripts revealed the Fed had no clue what they were doing. With humility comes wisdom, and the transcripts were surely humbling, but only time will tell if there is wisdom in the pain. Can the market really stand on its own? What happens when the Fed dials back Quantitative Easing? The Fed thinks they can gradually turn the dial from”unlimited” to “just enough”. More likely, as soon as they touch the dial, the party is over.
Meanwhile, we’ve been trying to provide some insights into the economic bash that is an annual event in the Swiss resort town of Davos. Today, Mario Draghi, the European Central Bank President took the stage at the World Economic Forum and he took his bows. Draghi says the central bank measures last year had prevented a banking crisis. And he also praised government leaders for steps they took to strengthen the currency union, for example agreeing to put the central bank in charge of supervising banks — a change that will be phased in over the next year.
Draghi said the euro zone economy has stabilized at a very low level and should begin to recover in the second half of 2013. Data released today supported the thesis of a gradual recovery. The Ifo business climate index, a closely watched indicator of business confidence in Germany, rose more than expected. The survey suggested that the euro zone’s largest economy is growing again after a contraction at the end of 2012.
What’s more, the central bank says more euro zone banks than expected had chosen to make early repayment of three-year central bank loans they took out a year ago. The volume of early repayment is seen as a sign that at least some banks are healthier than they were, and able to raise money on their own. The central bank said 278 banks would pay back 137 billion euros, of a total of 489 billion euros they borrowed a year ago at exceedingly low interest rates.
Draghi did express concerns that the calm in the financial markets had not yet led to economic growth and better lives for European citizens. Once upon a time, I told you the Europeans were taking a page from the Federal Reserve’s playbook. Case in point.