Monthly Archives: November 2015

The Fed Giveth and the Fed Taketh Away

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“The FOMC decided today to keep its target range for the federal funds rate at 0 to 0.25 percent.”

Since the December 2008 Federal Open Market Committee (FOMC) meeting nearly seven years ago, the above-described policy guidance has been a mainstay in every subsequent statement. For those of you who may not have kept count, that is 61 meetings in a row.

The next FOMC meeting is only a few weeks away. Market participants have their ears glued to the rails of the interest rate train. Meanwhile, Wall Street remains infatuated with the direction and the pace of the Fed’s interest rate locomotive. For investors and Wall Street alike, the upcoming December 16th junction is no different. I take that back… it may be a little different.

As of November 24th, Fed funds futures place a 74% likelihood that the Fed committee members will support at least a 25 basis point (0.25%) hike to the Fed funds target. Clearly, there is a high probability that policy guidance coming out of meeting number 62 will be drastically different than what we’ve grown accustomed to over time.

So why is Wall Street so captivated by the possibility of a measly quarter point rate hike? The chart below shows the direct effect that Fed policy has had on the equity market and the U.S. economy since the “Great Recession.”

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As you can see, the Fed’s first economic lifeline was dropping the Fed funds target rate (the orange line) from roughly 5.25% in 2007 all the way down to zero by December of 2008. When the equity markets and economy failed to respond, the Fed then tossed a second economic lifeline by acquiring U.S. Treasuries and mortgage-backed securities – vis-à-vis quantitative easing (the purple line). Only after rates were at zero percent and the Fed’s balance sheet began to swell did the economy and markets begin to improve.

Nearly seven years later, the Fed funds rate is still at zero percent. The Fed balance sheet has ballooned to $4.2 trillion – roughly 9x its size prior to the first round of quantitative easing (QE1). And thanks to “Mr. Fed,” stocks have catapulted more than 200% off of the March 2009 lows in one of the longest bull market runs in history.

Now, while the Fed may only be starting with a paltry quarter point hike at inception, a directional shift (a.k.a. “tightening”) for the central bank of the United States may result in a directional shift for stocks. After all, an ultra-accommodating Fed stoked the stock fire in the first quarter of 2009.

Also, there’s a reason that I included the GDP Annual Growth Rate (the blue line) in the above chart. Not only are investors facing a shift in the direction of the Fed’s policy – from loosening to tightening – stocks must now overcome valuation considerations.

As the chart demonstrates, the Fed managed to yank GDP out of the recessionary pyres in 2009. The problem? The chart also shows that, throughout the economic “recovery,” GDP growth has never quite recovered its pre-recession levels.

An economy that fails to grow at a rate commensurate with pre-recession levels? In spite of a soaring stock market? In spite of rocketing real estate prices? Even with $4.2 trillion added to the Fed balance sheet? In fact, GDP is presently growing at half of its historical average, whereas stocks continue to trade as if economic growth has been performing adequately.

The net result is that stock valuations, or how overpriced they may be, are off the rails. There are only three other times in history when total stock market capitalization relative to GDP (Market Cap-To-GDP) has reached similar extremes – right before the Great Depression in 1929, the dot-com bubble in 2000, and the financial crisis in 2007.

Some folks are dismissing traditional stock valuations. Their reasoning? The metrics only hold water when interest rates are closer to normal levels. They say, “Overpriced, underpriced. Who cares when the borrowing costs are ridiculously low?”

Naturally, there are those who will rationalize their way into a “New Economy” or a new way to value stocks, particularly when greed obscures one’s vision. Nevertheless, the Fed’s directional shift toward tightening coupled with subpar GDP growth brings those old-school valuation methods back to the forefront.

Indeed, if the Fed’s multiple lifelines – QE1, QE2, Operation Twist, QE3 – acted as tailwinds for stock prices since March of 2009, shouldn’t one anticipate the directional shift of tightening to act as a headwind? In fact, the two other times in history when the Fed began raising borrowing costs into a decelerating economic backdrop were quickly followed by stock bears.

Stocks may have already seen the start of the bull market’s demise. After all, it has been more than six months since the S&P 500 has managed to reach a new high. Six months.

Perhaps now is the time to seek ways to help protect your investment portfolio from the inevitable bear mauling. Or, perhaps you are already sitting on a portfolio filled with cash, and you do not know what to do. Now may be the time to pursue a viable investment strategy that can take advantage of a precipitous drop in stock prices.

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