SHOULD STOCK INVESTORS FIGHT THE FED ? / BARRON´S MAGAZINE

Up and Down Wall Street

Should Stock Investors Fight the Fed?

History says that the first rate hikes by the central bank don’t hurt the stock market. But, this time, history could be wrong.

By Randall W. Forsyth           

Updated June 20, 2015 12:17 a.m. ET

 

There was a time, one I well remember, when few folks paid attention to Federal Reserve policy and still fewer fully understood its implications for investments.

Nowadays, to paraphrase Richard Nixon, we are all Fed watchers. Literally so, since the Fed Chair routinely holds a televised press conference following alternate meetings of the Federal Open Market Committee.

That helps to explicate not only the FOMC’s policy directive, but also the economic forecasts and projections for the federal-funds rate, the central bank’s traditional key policy tool.

Of course, Marty Zweig decades ago advised investors never to fight the Fed. But, back then, the only press conference held was a rather curious one conducted by the New York Fed for a handful of banking and money-market reporters. They pored over sheets of arcane numbers on loans and reserves, and sought to pry some details from the public information officer to help enlighten their readers about what the dry data meant (with little success, usually).

Moreover, the Fed back then didn’t even announce when it made changes in its fed-funds target. Fed watchers and reporters had to infer as much from reading the tea leaves of its open-market operations. And even after the central bank began to announce fed-funds rate changes in the early 1990s, then-Chairman Alan Greenspan famously quipped that he spent “a substantial amount of my time endeavoring to fend off questions and worry terribly that I might end up being too clear.”

These days, however, monetary policy has become almost a spectator sport. The FOMC’s statements, the background forecasts, the so-called dot plots graphing the panel’s members’ rate expectations, and the post-meeting presser are endlessly scrutinized. The aims have been first, to glean when the Fed will lift its fed-funds target from the 0% to 0.25% floor where it has been stuck since December 2008, at the depths of the financial crisis. And then, to figure out the upward course for rates from there.

As I wrote in the June 17 online edition of this column, even if Janet Yellen & Co. deliver a rate hike later this year, the trajectory afterward is likely to be lower than implied by the FOMC’s dot plot. And that also was the determination of the Treasury market last week.

If copper is often called the commodity with a Ph.D. in economics, then the Treasury’s two-year note is your all-purpose Fed watcher. Last week, its yield fell a hefty 10 basis points (a tenth of a percentage point), to 0.62% from 0.72%. That doesn’t sound like much in absolute terms, but it represented a 14% decline.

The rate of change in interest rates once was an important indicator for the stock market, notes Doug Ramsey, the chief investment officer at the Leuthold Group. But with rates at historically low levels near zero, percentage changes tend to get amplified. That is one legacy of the Fed’s quantitative-easing program, which more than quadrupled the size of its balance sheet from its precrisis levels.

Of course, the stock market has moved up pretty much in tandem with that balance sheet from its March 2009 lows when the Fed stepped up its securities purchases. Since then, the U.S. stock market’s value has increased 226%, or some $18.6 trillion, according to Wilshire Associates.

And since the announcement of the second phase, or QE2, in August 2010, stocks have added 104%, or $13.1 trillion. And since September 2012, when the launch of QE3 was revealed, U.S. stocks are up 49%, or $8.4 trillion.

More recently, Ramsey points out, the Fed’s balance sheet has stopped growing and actually has shrunk slightly in the past five months. The drop has been only about $25 billion out of a $4.45 trillion balance sheet, but the total no longer is shooting skyward.

And while the Nasdaq Composite and the Russell 2000 index of small-capitalization stocks made new highs last week, Ramsey notes that participation in the equity market’s advance has narrowed. Although the major averages are also within about a percent of their historic highs, less than half of New York Stock Exchange–listed stocks are above their 30-week moving average, a sign of waning momentum. That’s consistent with a topping process, which shouldn’t be surprising, coming after what he called in a phone chat last week an “historic bull run” of some 215% in the Standard & Poor’s 500 over some 75 months.

Meanwhile, the Fed seems hypersensitive to short-term stock swings. Ramsey recalled that its vice chairman, Stanley Fischer, commented recently—before there has been a single rate hike—that the pace of rate increases could be slowed if growth falls short. “It scares me what they could do if there were a 15% decline with zero interest rates,” he added.

Far from igniting inflation, contends Ramsey, zero interest rates have been deflationary by keeping noneconomic businesses funded, instead of dying. (Think of the so-called zombie companies kept alive during Japan’s two decades of zero rates.) Similarly, Ed Yardeni, the strategist whose name adorns the shingle of his advisory firm, contends that ultralow rates have spurred the expansion of supply more than demand. (Think of the shale-oil boom.)

Because of that, Ramsey recommends not chasing laggard groups in the current market, notably energy and materials stocks. In the previous cycle that peaked in 2007, value players flocked to financial issues—with disastrous results. Stick with winners, such as health care and technology.

In sum, Ramsey advises, this might be a time to ignore the hoary “Don’t Fight the Fed” notion. While other strategists’ data- mining suggests that the first couple of rate hikes won’t hurt the stock market, this time could be different.

Viewed from the perspective of the Fed’s balance sheet rather than interest rates, the tightening has started. And in this bull market, the course of the averages has been set by the balance sheet.

IT’S NOT EXACTLY THE DOGS of the Dow. But it seems somehow appropriate that the Shanghai Composite should be punished with its worst week since the 2008 financial crisis, ahead of the notorious Yulin Dog Meat Festival in Southwest China. As the Financial Times reported last week, the event, resulting in the slaughter of some 2,000 pooches, has rightly drawn the ire of animal activists.

More likely, the 13% swoon in the Shanghai index, including a 6.4% plunge on Friday, came amid the increasingly frothy conditions described here a week ago (“A World of Speculation,” June 15). Even as China’s market entered correction territory, it was still up 122% from the level a year earlier, which suggests that there could be more air to come out of—dare one say it?—a bubble. Corrections always are deemed to be “healthy,” except, that is, by those who rushed in near the highs.

In any case, while Chinese farmers were tending to their portfolios instead of their fields, Shanghai took a hit. Meanwhile, U.S. investors were exiting from bond funds, especially the riskier high-yield variety. Some $10.3 billion fled bond funds last week, as noted by our colleague Chris Dieterich on his Focus on Funds blog at Barrons.com, while equity funds added some $10.8 billion.

The shift to stocks comes just as the June 30 deadline for Greece to avoid default draws ever closer. With no agreement in sight, there’s a growing acquiescence that a default is likely and that Athens’ exit from the euro zone wouldn’t be catastrophic.

Much the same was said about Lehman Brothers before its failure in September 2008, especially given the warning signs from the near-collapse of Bear Stearns, staved off six months earlier by being absorbed into JPMorgan Chase JPM JPM in Your Value Your Change Short position (ticker: JPM.)

It may be that the Greek situation is hopeless, but not serious (to crib from David P. Goldman, the head Americas strategist at ReOrient Group in Hong Kong).

Research Affiliates’ Chris Brightman and Shane Shepherd write that the Greeks have accumulated debts that no honest man can pay, as Bruce Springsteen wrote in Atlantic City, his song about another bust place.

On that score, they observe, “For Greek citizens, tax evasion rises to the level of a national sport.”

To pay its debts, they say, Greece must either create wealth through sufficient economic growth, transfer wealth from other programs, or kick the can further down the road. The last is what has happened so far.

And as global markets hover near records, bulls wonder why it can’t continue, especially given the trivial size of the Greek economy.

The euro always was a marriage of convenience. The question now is whether the price of divorce is greater than the cost of staying together. Approximately two-thirds of Greeks would prefer to retain the euro, according to most polls.

Grexit, according to Brightman and Shepherd of Research Affiliates, would mean that Greek banks would fail and that capital controls would be imposed. A reintroduced drachma would spur exports, but imports would become prohibitively expensive. And the Greeks would still be constrained to living within the means of their economy.

While the lion’s share of Greece’s debts are held by official institutions, rather than European banks, as was the case when the crisis surfaced in 2010, to say the situation is contained seems to tempt the fates. After all, the same was said about subprime mortgages nearly a decade ago, and we know how that turned out: tragically.