Headwinds In The Market

Headwinds

When I prepare to write a post I outline the topics that I would like to discuss. For this post I had over 50. I could probably write a book about all the stuff that I would like to talk about. Instead, I have decided to select just a few of the most relevant topics to discuss.

Credit Cycles

Understanding credit cycles can be very valuable to investors. The expansion or contraction of credit (or money) is highly manipulated by the central bank. The Federal Reserve expands and contracts credit in an effort to help Americans. When the economy is slow, the Fed increases the supply of money and vice versa. However, it is important to understand that money isn’t just dollars. It is also the availability of credit, which is a huge driver of our economy. When the supply of money contracts, credit tightens and it makes it more difficult for businesses to get credit. The ripple effect reduces the net income of companies. Today we can see the beginning of credit tightening showing up in the high yield bond market. This is just a fancy name for junk bonds. Many people have said that the .25% December interest rate hike is virtually nothing and won’t have much of an impact at all. However, Dr. John Hussman wrote an article explaining why this .25% hike may have a much bigger impact than most realize. Essentially, Dr. Hussman explains that there is now a massive pool of zero-interest cash that was created by the Fed’s quantitative easing (QE) so this .25% will have a much greater impact than people understand. Here is a link to the article if you are interested in reading it. Personally, I think he makes an excellent argument. There are a lot of parallels between what is going on in the U.S today and what happen in Japan years ago. They had zero-interest rates after stimulating their economy and they attempted to raise interest rates. Unfortunately, their economy slowed down forcing them to have to cut interest rates about a year later. As a result, their stock market plummeted. We could be at risk for the same type of event if our Fed is forced to do the same thing.

Correlation between QE and stock market performance

For anyone that doesn’t understand what QE is, it is pretty simple. The Fed purchases financial assets with cash in the open market. The Fed has purchased almost $2 trillion dollars of bonds since 2009. This purchasing of bonds manipulated the market, forcing yields on bonds through the floor. As a result, investors piled into stocks which has inflated stock prices. Since QE3 ended in October 2014, stock market performance has been challenged. To see the correlation that I am referring to please look at the chart below that Doug Short produced. Doug’s website can be found here.

qe

In the chart above, the green sections indicate where the Fed was pumping cash into the system though QE. You can see the market pull backs that happen after both QE1 and QE2. In addition, stock prices have been virtually flat since October 2014. Historically the Fed has been able to stimulate the economy by lowering interest rates. However, this last cycle they felt the need to have zero-interest rate policy (ZIRP) and additionally pump money into the system. I think it’s important to understand how this has affected our markets in the last few years and how it could again if the Fed were to perform a QE4.

Yield spreads between the stock market and bond market

In the last few years, there have been a lot of investors that have bought dividend paying stocks for the yield. Investors have been chasing these higher yields and taking on the extra risk because bond yields have been so low. Today, equity yields continue to be higher than bond yields. Tom Lee of Fundstrat Global Advisors has said that this is a reason to be bullish on stocks in 2016. But he is right? Personally I think investors recognize the risks in the stock market and I think that they are having second thoughts about chasing an extra 1% of yield in stocks. Historically investors have continued to chase yields in stocks until the yield in stocks and bonds reached parity. I have doubts that this will happen this time do to the increased risks in stocks caused by the Fed’s manipulation through QE. It is hard to say at what spread investors are willing to take on the extra risk in stocks but I think by observing the market, it is more than that extra 1% of yield.

Market Cap to GDP

Warren Buffett has said that one of his favorite long-term valuation indicators is market cap to GDP. He has said that “it is probably the best single measure of where valuations stand at any given moment.” To see what market cap to GDP looks like today please see the chart below that was produced by Doug Short.

Buffett-Indicator

As you can see, we are about two standard deviations above the mean. The market was actually close to the mean in 2009 before the Fed began pumping money into the system with QE. Warren Buffett has acknowledged that this indicator suggests that market valuations are stretched. Warren Buffett’s Berkshire Hathaway made a couple of billion dollar purchases in 2015 but their cash pile grew throughout the year. Berkshire has over $66 billion in cash and it continues to grow demonstrating that it is tough to find reasonable valuations in the market.

Bottom Line

In the last week, I have heard several people say that we are in a 2008 type of situation. I personally think it is irresponsible to make these assumptions. There are a lot of things that could happen. One of which is stocks could drift sideways for a long period of time while companies grow into their expensive valuations. Another scenario is one in which stocks drift down for a period of time until valuations and equity yields align with investor risk appetites. Things don’t always have to end with a bubble popping. I don’t think anyone really knows what is going to happen. It is an extremely complex situation. However, I think it is important for investors to understand the environment that we are in.

As always, thanks for reading!

 

 

 

 

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