Last week, the Federal Reserve Open Market Committee (FOMC) began its statement on monetary policy indicating that recent data “suggests that economic growth has moderated somewhat.” While the Fed removed the phrase that “it can be patient in beginning to normalize the stance of monetary policy”, the Fed’s weaker view of the economy prompted an immediate retreat in Treasury yields, an abrupt drop in the foreign exchange value of the U.S. dollar, a surge in stock prices, and an upward spike in the dollar price of gold and oil. The basic thesis of all of these moves is that the Fed may wait longer before increasing the rate of interest that it pays to banks on idle cash reserves (viz., “raising interest rates”).
We agree – partly. As I noted a week ago, “From my perspective, it remains unclear whether the Fed will resist the temptation to defer hiking interest rates, given what we observe as a deteriorating economic landscape.” The problem for investors is that along with the initial moves in Treasury yields, the dollar, stocks, gold, and oil that followed the FOMC statement, we also saw credit spreads widen rather than narrow last week, while our measures of market internals continue to show divergences that indicate a shift investor preferences toward increasing risk aversion.
Since mid-2014, when we completed the awkward transition that followed my 2009 insistence on stress-testing our methods against Depression-era data (see A Better Lesson than “This Time is Different”, Setting the Record Straight and Hard Won Lessons and The Bird in the Hand for a full review), I’ve emphasized that the response of the financial markets to overvalued conditions, and to Fed policy, is conditional on whether investor preferences are risk-averse or risk-seeking. While we do expect that the FOMC will be much slower to raise rates than some members would prefer, we strongly believe that the singular focus on interest rates is misguided in the first place. The following comments from early February (see Expect a Decade of 1.7% Portfolio Returns from a Conventional Asset Mix) draw the crucial distinction, and capture the central lesson that should be drawn from our own experience.
“First and foremost, the response of the equity markets to Federal Reserve easing (and much other news) isconditional on the risk-tolerance of investors at the time, which we infer from observable market action such as internals and credit spreads, among other factors. Quantitative easing ‘works’ by creating default-free liquidity in an environment where that liquidity is viewed by investors as an inferior asset. That is, if investors are risk-seeking, as inferred from the uniformity of market action across securities, sectors and asset classes of all risk profiles, then yes – Fed easing will tend to support further advances in stock prices regardless of the level of valuation. On the other hand, once investors have shifted toward risk-aversion, overvalued markets become vulnerable to abrupt free-falls and crashes, and monetary easing is not materially supportive for stocks because default-free liquidity is desirable.
“Again, as I noted in The Line Between Rational Speculation and Market Collapse, investors should remember that the Fed did not tighten in 1929, but instead began cutting interest rates on February 11, 1930 – nearly two and a half years before the market bottomed. The Fed cut rates on January 3, 2001 just as a two-year bear market collapse was starting, and kept cutting all the way down. The Fed cut the federal funds rate on September 18, 2007 – several weeks before the top of the market, and kept cutting all the way down.
“What will matter significantly for investors is the condition of market internals, credit spreads, and other risk-sensitive measures in the event that U.S. economic activity begins to further reflect the downturn that is already evident abroad. It is that evidence of investor risk-preferences that will determine the proper response to any change in Fed policy.”
My impression is that while recent slowing is likely to deter the Fed from raising the interest rate on reserves, the enthusiasm of investors about this possibility is misplaced. In a context of widening credit spreads, extreme equity overvaluation, and divergent market internals, weaker economic evidence adds to downside concerns far more than the prospect of a continued zero interest rate compensates. The chart below shows the cumulative total return of the S&P 500 restricted to the same market return/risk classification that we identify at present. The small pullout shows recent quarters, with a sequence of quick but modest losses, a larger loss last October, and more recent churning action. While we’ve observed a recovery from the October low, such short-term behavior is not particularly uncommon, and similar churning has been indicative of top formation in previous instances (e.g. 1957, 1972, 1999-2000, and 2007). These choppy periods have generally been overwhelmed by the steep average market losses associated with these conditions.
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