In 2013, we witnessed one of the most bullish stock market runs of all time with the S&P gaining 29.6% while the Nasdaq 100 gained a whopping 38.3% (see “Equity indexes soar,” below). It was an incredible, but also an abnormal, year. It seemed like the market was higher almost every day. Equities reacted positively to bad news as well as good news. How can bad economic data be bullish? It sounds funny but it is really how the market reacted on negative economic data. Bad news meant the possibility of more quantitative easing or a less likelihood of tapering, or the reduction of bond purchasing from the Federal Reserve. As a result, it appeared as though any economic news was interpreted by the markets as bullish U.S. equities: If the economy is bad the Fed will support the market and if the economy is good or better than expected, the market will rally on its own.
The one exception was when Federal Reserve Board Chairman Ben Bernanke let slip in May during testimony before Congress that at some point before year-end the Fed would have to begin reducing its bond purchases. Equity and fixed income markets reacted violently to Bernanke’s remarks in May and again in June when he put a little more detail behind the concept of tapering (see “It’s the Fed, stupid,” below). This was an indication that market strength was more a creation of Fed policy than organic growth and the inevitable end to endless QE would end the bull run.
We now have seen five consecutive years of positive annual returns on the S&P. The last time we had seen that was 2003 to 2007, which was followed by a loss of 38% in 2008. Since 1970 there has only been one instance where the market had positive returns for more than five consecutive years and that was from 1982 to 1989 (see “Time for a fall?” below). By the time this article is published, we should have a better idea of how deep the correction that hit in January goes and whether there will be a deeper one, or even the start of a bear market.
Whether this turns into a bear market or not only time will tell, but there are signs it will. There are numerous variables this year, which include a change at the top of the Federal Reserve as well as a few of its board members. It is unknown whether or not Chairman Janet Yellen will continue with former Fed Chairman Ben Bernanke’s tapering plan of $10 billion per month or if she will make adjustments to this program.
Early signs indicate the Fed will continue to taper $10 billion per month and continuously wean the economy until there are no monthly bond purchases.
The Fed has made it clear that it is data driven and can change policy at any moment, but will they? At the very least the Fed showed that one bad data point would not change its commitment to tapering as it cut $10 billion from QE3 at its January meeting following a weaker-than-expected employment report for December. The next test will be the March meeting, as the January nonfarm payroll number was also significantly below expectations. The Fed’s decision to continue its program in the face of poor economic data is a sign of its dedication to continue tapering asset purchases. With the chaos in the emerging markets even some of the more dovish Fed members have come out and said, in so many words, that the emerging markets better get used to tapering because it will continue.
This statement of dedication on the part of the Fed could be interpreted as bearish for stocks, which would be one possible explanation for the January decline in equities. Perhaps now the question becomes, with this new variable of Fed taper, what is the realistic fair value of equities?
Dave Hightower, the founding principal of The Hightower Report, recently said, “I see the tapering as a little kid getting a shot; it is something that you need to go through. There is a lot less anxiety in the market now and you have to be generally upbeat about the economy going forward.” He went on to say that “some of the other large global economies such as India, Brazil and China are now beginning to see inflation come down. It is hard for me not to be upbeat about prospects as long as you can keep these high anxiety issues under control.”
On the flip side, an argument could be made that tapering will continue to negatively affect the stock market and that the market will devalue to a realistic level from these artificially inflated prices that the Fed has supported for the last few years. Now the question becomes, ‘what has been priced in and what is still to come’?
There has been only a modest reduction in the amount of asset purchases so far. The Fed continues to purchase at a very high rate of $65 billion per month as of February 2014. We have lost perspective. If the economy cannot stand on its own after all the QE, then the QE is not working.
New regs kick in
We also are starting to see new banking regulations coming into play in 2014. This includes more stringent leverage ratios and the requirement of keeping a higher percentage of reserves with the central banks. This also can be a negative factor. Of the $10 billion per month in tapering, $5 billion of it is mortgage-backed securities. This means that the Fed will be buying $5 billion less mortgage backed securities from banks each month until they are purchasing none. Banks will be passing off less mortgage loans to the Fed and will be required to keep higher reserves, causing them to write fewer loans.
If the banks were not giving out loans as they were expected to during Fed intervention and easing, what will they do in a less accomodative environment? Bottom line is the banks will have less to lend so what they do lend will come at a premium. It will be harder to get a home, car or any loan, and U.S. sales will pay the price. We will see a gradual shift from easing to tightening. It is difficult to predict what the unintended consequences will be of more regulations.
The unemployment rate is going down and has been doing so consistently. That means that the economy is getting better, right? Wrong. As of the January report the unemployment rate was at 6.6%, down just over 30% from the January 2010 unemployment rate of 9.7%. However, the employment-population ratio is exactly the same at 58.5%.
How is that possible that only 58.5% of the U.S. population over the age of 16 is employed, just as it was in 2010, but the unemployment rate is down three percentage points? Retiring baby boomers can explain it all.
A considerable number of the working age population have dropped off unemployment rolls or are no longer seeking employment. The Bureau of Labor Statistics data shows workers remain discouraged and many are unable to find full time employment, or have given up trying. This is worse than the 9.7% unemployment. At least when we were at 9.7% those people that dropped off had some sort of income, even if it was only unemployment benefits. It is a vicious cycle; if people are not working then consumer spending decreases, if consumer spending decreases then earnings go down, if earnings/profits go down so does the stock price along with corporations having to lay off or at the very least not hire or expand.
Some will argue that there are strong corporate profits. True, we are seeing positive earnings, but are they sustainable without the revenue growth needed to feed it and a healthy jobs market?
What we are seeing to achieve these earnings are lower wages and under employment, not revenue growth. Short-term this in conjunction with the intervention by the Federal Reserve can support a bull market, but long-term the market will directly correlate to the macroeconomic data and the lack of employment.
The employment-population ratio from the Bureau of Labor Statistics shows that the percentage of people working is no better today than it was three years ago (see “Standing in place, below.)
There are just as many, if not more, bulls out there as there are bears; each equally able to defend their opinion on why the stock market should move lower or why it will continue the bull trend in 2014 and that this is merely a healthy correction.
Jeremy Boston of Boston & Zechiel Management says, “I believe we see the market remain strong into spring and a correction going into summer with a strong market after that until year-end.” He adds, “Tapering will not negatively affect the market because the Fed is cutting purchases minimally per month and there is still a lot of money being put into the economy.”
Realistically we can see the S&P trade down to 1624.00 or a 38.2% retracement from the June 2012 low and still be in a bull market (see “Tech talk: Small correction, large correction or new bear?"). With the market getting shaky at these levels, we will start to see continued profit taking and a shift in investor demand from stocks.
There’s a chance we’ll see a completely different market this year with a major spike in volatility — which has been suppressed for a very long time — and large swings, but ultimately moving lower.
It is too early to tell if this is only a correction or a turnaround in the market. But if equities can sustain a massive bull move in the challenging economic conditions of the last five years, they can suffer losses in a stronger economic environment without support from the Fed.
Frank Cholly began his career in 1998 at the CBOT’s Treasury bond and soybean pits. He then expanded his brokerage duties to senior commodities broker at Lind-Waldock prior to joining RJO Futures in 2011. He can be reached at email@example.com.