In October 1968, with the United States fighting wars against poverty at home and perceived communist threats abroad, the S&P 500 Index climbed on the back of an overheated economy to record highs in both real and nominal terms. The boom times were not to last. Adjusted for inflation, stocks would not return to their late 1968 levels until mid-1992 (chart data). In nominal terms, full recovery took about seven years from a January 1973 peak.
I offer this cautionary tale by way of explaining why recent decades have differed so dramatically for equity market investors from those generally unprofitable years a generation or two ago. Unlike current conditions, what characterized the period beginning in the late 1960’s were cost of living increases that compelled President Richard Nixon to impose wage and price controls and the Federal Reserve to raise interest rates to levels that today would seem unfathomable.
At the vanguard of the Fed’s anti-inflation effort was the late Paul Volcker, the central bank’s chairman from 1979-1987. Volcker allowed benchmark rates to reach nearly 20%, but his tough love approach to price stability is widely credited with subduing inflationary expectations and thus sowing the seeds for the long economic expansions and bull markets to follow.
So, while recessions are the most obvious and direct causes of severe market declines, it’s rising inflation that triggers economic downturns by motivating the Fed to take away the monetary punchbowl. Of course, recessions cause corporate profits to fall as well, but earnings are only half the story. The other half concerns the impact of rates on valuations.
Historically, the equity market’s price-earnings ratio has moved inversely to bond yields as money flowed out of stocks and into higher-yielding assets. Viewed another way, the equity market’s earnings yield – its P/E ratio expressed as a percent – closely tracked the yield on Treasury bonds. (A P/E ratio of 20 equals an earning yield of 5%, or 1.00/20=0.05)
Which brings our story to the outlook for stocks in the months ahead.
Among the enduring mysteries of what’s become the longest expansion on record is the breakdown in the relationship between unemployment and inflation, also known as the Phillips Curve. In the past, tight labor markets have fueled fast-rising wages and benefits, which in turn fed through to consumer prices and finally to higher interest rates. This time, not so much. Despite the lowest jobless rate since the boom days of the late 1960’s, inflation has consistently undershot the Fed’s 2% target, as measured by the central bank’s preferred metric, the Core Personal Consumption Expenditures Price Index. That’s allowed rates to stay low by historical standards, thus extending the bull market in stocks.
Some economists believe the recent failure of the Phillips Curve to explain inflation can be attributed to a changed definition of full employment while others think a myriad of complex global factors are at work.
Conclusion
What matters most for investors, however, is that inflation expectations remain anchored and that core inflation stays at or below the Fed’s 2% target. Until that changes, we aren’t likely to find the Fed’s fingerprints on whatever weapon eventually brings about the demise of the longest bull market in U.S. history.
Still interested in understanding more when it comes to inflation? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to what’s ahead for stocks and inflation! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries
In a not surprising fashion, the Federal Reserve held interest rates unchanged with the federal funds rate at 1.5% to 1.75% and adjusted its post-meeting statement to reflect what appears to be a stronger commitment to push up inflation. The decision was unanimous.
Federal Reserve Chairman Jerome Powell quoted, “We believe the current stance of monetary policy is appropriate to support sustained economic growth, a strong labor market and inflation returning to our symmetric 2% objective,” Fed Chair Jerome Powell said at a news conference following the central bank’s unanimous decision to maintain the key overnight lending rate in a range of between 1.50% and 1.75%.
Meeting market expectations, the FOMC said Wednesday it will hold its benchmark funds rate, a range where it has been since the latter part of last year. Officials hope they can allure inflation higher by committing to keeping rates low until the inflation level rises. They even indicated, through the “symmetric” terminology, that they will allow inflation to run above target for some time.
Fed Powell also noted signs that global economic growth was stabilizing and diminishing uncertainties around trade policy, concern about both of which were major factors in the Fed’s decisions to cut rates three times last year.
After indicating a list of positive developments, including the initial trade agreement reached recently by the United States and China and some suggestion in global manufacturing hitting a possible bottom, Powell noted China’s economy would see at least a short-term hit from the coronavirus outbreak.
On another note, there was not much in regards to comments in their statement. There were few changes in the statement, outside of the change of date and rotating members, there were changes to the wording of the statement comparative to December: the dampening of household spending was characterized as rising at a “moderate” pace (downgraded from “strong”) and inflation was seen as “returning to” target (instead of “near”).None of this really teetered the scales in a meaningful way, and the decision to extend overnight and term repos will more than likely be received positively by financial markets.
With Federal Reserve officials likely to hold interest rates steady, the focus of their meeting today shifts to modifying their control of short-term rates. The Fed’s statement did not announce any immediate changes to the central bank’s current exercise of buying $60 billion monthly of U.S. Treasury bills to ensure adequate short-term liquidity in bank funding markets.
The overnight and term repo market shook the financial world in September when an unexpected rate spike upset short-term lending, prompting the Federal Reserve to intervene. The Federal Reserve successfully flooded markets with cash in the fourth quarter of last year to avoid a spike in overnight lending rates and ensure the central bank keeps control of the federal funds rate.
Powell said the Fed would likely begin scaling back that amount sometime in April-June 2020, when the amount of reserves in the banking system would likely be deemed suitable. After that, purchases would be made and the Fed’s balance sheet expanded as necessary to ensure the level of bank reserves remained “ample,” he said.
The Fed’s big problem now is figuring out when and how to wind down the program. The undertaking could be more complicated if some market participants are right that the moves have stimulated a stock market bull rally.
Yields on U.S. Treasury securities crushed lower as Powell spoke, while benchmark U.S. stock market indexes gave up all of their gains on the day.
Conclusion
In my opinion, the Fed is going to push it all in, as they would say in poker. I will remind people that there are 3 types of reasons people make decisions… One because of greed, two because of fear, and three because of need, so there is really no other decision but they need to do it. The Fed is in a box, what would anyone want them to do? Give up and say “well we did all we could do, good luck.”
Still interested in understanding more when it comes to Federal Reserve? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to the Federal Open Market Committee! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries
In September 2019, the interest rate for the overnight money market — a short-term lending market where banks borrow cash from each other to meet reserve requirements at the end of a business day — surged to 10 percent.
Banks weren’t willing to lend out capital for the Federal Reserve’s target interest rate of 2 percent. The Fed responded to the cash crunch by financing these so-called repurchasing agreements (repos, for short) directly. It offered the 2 percent interest on these short-term loans (they’re usually paid back in days or weeks) to bring the interest rate down and pump cash into a strapped lending market. It has been offering these overnight loans on a daily basis ever since.
When the Federal Reserve began offering these daily agreements in late September 2019 it was the first time it has intervened in repo markets since the Great Recession. The United States’ central bank has funneled roughly $500 billion into the repo market since then in what was originally pitched as temporary operations that would end on October 10, 2019 — but the daily repo bids are still coming.
The Fed is even considering lending directly to smaller financial institutions and hedge funds through the repo market — an unprecedented move in the history of the century-old institution.
With the Fed gripping the reins of this obscure but essential sector of the U.S. financial realm for the first time since the 2007–2008 financial crisis, should the average American be anxious about the state of the U.S. financial market?
“Leverage Is Necessary”
“The key question is … should the average American be worried?”
To finance these repos, the Federal Reserve buys U.S. treasury bills, mortgage-back securities and other highly liquid securities from the banks for cash. These securities act as collateral for the underlying loan, and the banks buy them back with interest over the course of a few days to weeks — hence, “repurchasing agreement,” or “repo”.
The repo market is necessary for keeping these banks solvent and satisfying their regulated reserve requirements (the amount each bank must keep in accounts at Federal Reserve member branches relative to the size of their balance sheet).
“All the banks are under regulation to control the balance sheet exposure they have,” explained Gang Hu, managing partner at WinShore Capital hedge fund. These balance sheets consist of both cash and debt — any fiduciary obligation involving money. Banks borrow money against their assets (aka leveraging) to make investments and add to their balance sheets and even pay off other debt. So, when they don’t have enough cash in the bank, this can cause liquidity crunches and threaten the constitution of the lending market.
“The system cannot operate without leverage,” Hu said. “There’s simply not enough USD currency to support the number of assets that are floating around in the system. The financial system intrinsically comes with leverage.”
Hu added that this leverage is essential but can also be dangerous if managed incorrectly
“In a good economy, leverage is the greatest thing ever — you make more money,” he said. “But in the downturn, you induce financial crisis and financial instability. And right now, the financial instability is the biggest concern at this point with the Fed.”
Why Did the Fed Step In?
Ironically, the cash crunch that necessitated the Fed’s repo intervention arose from regulations that are meant to keep cash in reserves to prevent a run on banks or other liquidity crises.
Reuters, for instance, reported that bankers and analysts believe that J.P. Morgan, the largest bank in the U.S., may have had liquidity to finance these repos itself if it hadn’t withdrawn 57 percent of its cash ($158 billion from the Federal Reserve throughout 2019) and if new regulations didn’t mandate stricter reserve requirements.
Without enough cash in the bank to finance the repos and satisfy these reserve requirements, J.P. Morgan was more reluctant to lend out what it had left. During this time, Hu said, J.P. Morgan had the money, but it couldn’t legally lend it out
“There have been a number of supervisory and regulatory issues raised. We’re looking carefully at those,” Federal Reserve chairman Jerome Powell said in a December 2019 press conference.
The U.S.’s second-largest bank, Bank of America, also drew in cash from their Fed account in 2019 but at a less drastic 30 percent.
As banks withdrew their cash, the Federal Reserve was shedding its balance sheet. Hu said that a cash-strapped status for J.P. Morgan and friends was certainly “one of the reasons” the Fed stepped into the repo markets, but another reason (which is also related to why the banks were drawing on their Fed accounts) may have been that, as the Fed sold off assets on its balance sheet, there’s less cash in the banks and the money market.
“When the base money continues to shrink with the balance sheet, even while the number of assets [like MBS, bonds, etc.] continues to grow, that means there’s more leverage in the system,” Hu said. “The solution that the Fed came out was to start buying [Treasury bonds], to provide repo to the market. All these actions were aimed to increase the base money in the system.”
This cash is necessary to keep leverage afloat, Hu continued.
“If you’re levered, you have to be levered every day,” he said. “If you have one bad day, you go bankrupt. That’s why in September [2019] people were paying 10 percent [interest for repurchasing agreements], because if you don’t have money, you go bankrupt.”
The Fed May Extend Its Repo Reach
And that’s why the Fed stepped in, not just to control short-term money market rates, but to flush the system with cash to balance out debt obligations. These report markets are vital not only for the lifeblood of big institutions, but for smaller ones, as well.
Reuters saying and I quote, “Without reliable sources of loans through the repo market, the financial system risks losing a valuable source of liquidity. Hedge funds, for example, use it to finance investments in U.S. Treasury securities and banks turn to it as option for raising suddenly-needed cash for clients.”
Hedge funds like Hu’s and other small institutions can only participate in the repo market if a bigger institution brokers the transaction, but now the Fed is considering lending directly to smaller institutions like hedge funds.
Hedge funds typically operate on high leverage with the goal of providing steady and significant returns for their investors. If the Fed lends to these offices and other smaller ones like it directly, it would be in a bid to ease leverage in this sector of finance, as well.
“The Fed is not only preserving the reserve [of member banks] but increasing it, but the key is: to what extent?” Hu asked.
“The Fed has been hesitant to go the last step,” Hu continued, referring to the fact that it hasn’t loosened reserve requirements to allow more leverage from the banks. “They decreased the leverage in the system, but they did not allow the banks to have looser regulation … I think the Fed is reluctant to increase leverage in the system because they understand that leverage goes both ways.”
Where’s the Limit?
And what if it goes the wrong way? That’s the rational question that any American might ask when confronted with the fact that banks have been greased with $500 billion in Federal liquidity to keep financial markets from stalling. So far, the repo operations have somewhat calmed a roiled repo market, but the Fed keeps on lending with a market intervention originally billed as temporary in September 2019.
The question now is, when is it enough?
“If you listen to the Fed, the Fed is aware of this,” Hu said, referring to the gravity of adding several hundred billion dollars into these markets. “If this $500 billion becomes $1 trillion or $2 trillion, then the average American should worry. But now, the Fed’s argument is that we’ve gone too far with shrinking the balance, that since September [2019] we’ve had too little in reserves and that this has hurt the system.”
Dennis Lockhart, former head of the Atlanta branch of the Federal Reserve, likened the Fed’s open market operations to a “trial and error” exercise in a CNBC interview. Lockhart also noted that he doesn’t equate these liquidity injections with quantitative easing — the Fed’s practice of purchasing long-term Treasury bonds to print new cash.
Quantitative easing, Hu assented, tries to control long-term interest rates with reliable, long-term liquidity; repo market intervention, conversely, controls interest rates for immediate short-term liquidity.
Still, the final effect is the same — the Fed purchases assets to flush banks with cash. And like the Fed’s quantitative easing during the Great Recession (which led to the inflated balance sheet of over $4 trillion we have today), the uncharted territory for these repos is that ultimate question: Where do they end?
Hu believes that they will begin winding down and the market will stabilize around April 15, 2020 — federal tax day. But he said that it will be a “challenge to unwind this thing” and that it will be a painstaking process.
“I trust that they will do it slowly, gradually, because you can’t ask the bank to pay you $100 billion in one day,” Hu said.
With no clear end in sight and billions in liquidity entering a little-known yet crucial market for the U.S. financial system, some Americans might be wondering if and when the dam is going to break. Or how much capital needs to enter the system to keep the leverage from flooding the levee.
“In September [2019], we’ve seen the limit of the system,” Hu said.
Conclusion
Halfway through the first month of the New Year, with the Fed still sponsoring repo agreements, we might now be asking, “Does the limit even exist?”
Still interested in understanding more when it comes to Fed Repo Facility? If so, contact our firm at 843-999-1570 and someone will be able to explain more in depth of what you need to know when it comes to stock market investing! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries
I figured it seems fitting to write this article in the market environment in which we find ourselves today.
“If the job has been correctly done when a common stock is purchased, the time to sell it is — almost never.” — Philip A. Fisher, Common Stocks and Uncommon Profits, 1958
With the major market indices continuing to reach new highs, some investors are wondering if they should sell their stocks. After all, if prices are high & the holdings have been profitable, why not sell & take the gains?
On Wall Street, the preference to sell can be especially popular. Many brokerage & research firms publish price targets for stocks & recommend selling them once the target has been reached. Other firms routinely recommend moving to all-cash positions based on market, macroeconomic or geopolitical forecasts. Still others view stocks as little more than trading vehicles & move in/out many times over the course of a month, week, day or microsecond, as in the case of high-frequency traders.
At the other end of the spectrum are investors who never sell at all. In an article published in 1984, author Robert Kirby described a situation where his purchase recommendations were followed, but his sell recommendations were ignored. After many years, the result was an odd assortment of small holdings, several large holdings, & one huge holding of Haloid which later turned into a zillion shares of Xerox. Kirby, of course, had recommended that Haloid be sold.
In our investment club, our analytical work focuses on the underlying businesses of the stocks. We think of our club as part-owners of those businesses &, as long-term investors, our club owns the shares for as long as the company’s management team is doing its job to increase shareholder value. Given enough time, a company’s share price is likely to increase along with growth in its revenues, earnings, & dividends.
However, companies can change & industries evolve, & management teams can lose their way. Sometimes better opportunities develop elsewhere.
“If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.” — Benjamin Graham, The Intelligent Investor, 1949
Conclusion
At the end of the day, investors are well-served if the job of analyzing a company includes a thorough review of its underlying business & fundamental characteristics — this holds true for selling & buying. If the company selected for purchase passes criteria on all counts, it could be a long time before it needs to be sold. And selling a high-quality, adeptly managed company just to take profits rarely is a viable long-term investment strategy.
Still interested in understanding more when it comes to selling a stock investment? If so, contact our Firm at 843-945-0051 and someone will be able to explain more in depth of what you need to know when it comes to stock market investing! With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries
This will almost sound like a broken record, but once again I hold not one single short position, in anything. I’m long U.S. and global stocks. But also managing cash and portfolio balance as usual while feeling as though I’m playing a game of Musical Chairs while the music still plays (did you catch the pun… Broken record, music still plays. I know, I’m here all night).
I have long equity positions because in a manic up phase I have little interest in eroding the situation with short hedging. Besides, gold stocks are doing that balancing job right now and that balancing act has been working well since June.
Below is an annual chart of the $SPX (each bar = a year) going back 92ish years. Long enough periods which included many crises, panics + wars – yet how many red bars do you see? Nobody knows when the next red bar will show up; but in the grand scheme of things, does it matter? We can also see the 2008 crash as merely a blip.
Equities
People will say… Just stay in and prosper! No problem in real time because the U.S. stock market always comes back… ALWAYS. This is the kind of stuff that appears near tops; like stuff that uses ultra-long-term yearly charts in log scale to smooth out the problems. So the next time this happens, try to forget that it was caused by epic policy distortions within the system and just remember it’s actually a smooth ride assuming the next thing is like the last thing and you live long enough to reap the benefits. The Macro Tourist notes in a recent blog that CNBC anchor Becky Quick got into something of a competition with her wealth manager guest, who is only 80% exposed to stocks. Becky’s all-in at 100%!
However, I would like to point out that Becky was not bragging about this allocation at any time during the past decade. No, she has chosen December 2019 with the S&P 500 up more than 360% since the bottom to let us know about her over-allocation.
Herein lays my point. Just like this summer when bonds had already ripped 13 handles higher, market participants usually express this sort of arrogance at points when they feel confident. Extremely confident.
What do I take from this? It’s not the time to be reaching for exposure. I don’t need to know anything else except that CNBC anchors are competing with their guests about the size of their stock allocations.
And of course there was the president with his dangerous “409 K” tweet taunting people as if merely performing in line with the S&P 500 (as opposed to near doubling its performance), which was a failure.
Conclusion, it’s a manic upside with investment managers all aboard, newsletters all aboard, CNBC anchors all aboard and all those discount brokerages that opened during the real sentiment blow off in January 2018.
These sentiment knee-jerks have refreshed the market on very short-term bases. It’s dangerous but as of in the now still ongoing and racing up the mountain.
With that said, “We have great challenges & great opportunities, and with our help we’ll meet them together!” – Jason Pries
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