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Former NY Federal Reserve President William Dudley spoke on 11/15/21 concerning the Federal Reserve and the current market. His comments solidified my belief about the market’s overvaluation based on fundamental, historical, and technical models. By examining each model in sequence, the depth of the market overvaluation, the impact of the nation’s economic progression, and the animal nature of the economy all become more evident.To understand the link between the models and the current Federal Reserve policies, we should first consider the contemporary world economy. The world economy is analogous to living organisms, such as humans, composed of many individual cells with different requirements and functions. Similarly, the global economy functions as a whole, with many interdependent economies sustaining it. Much as an organism develops and grows, globalization has matured over the past eighty years, creating pervasive interlinking of economies. By examining historical, technical, and fundamental paradigms. a supporting argument materializes for the United States economy’s valuation and direction.
Historical analysis, or the view that history repeats itself, provides a birds–eye view of the role of mechanical and behavioral factors on the economic process. Human nature is consistent. But what else tends to remain unchanged? The forces of supply and demand on markets. What impacts do these forces have historically on the market?
Since 1946 the market has experienced 12 bear market corrections, a move down of 30%. They occurred on average every 5.54 years with about 24 months for recovery. Over these corrections, the average bear market loss was 32.5%. We have not experienced a bear market since October 2007. Each cycle represents an intersection where market participant behavior drives market mechanics. Participant fear drives the downside by increasing the supply of assets while reducing the demand represented by buyers. The reciprocal of this process happens on the upside but at a much slower pace.
Why do downside market corrections happen much more rapidly than the upside climbs? The speed of these corrections aligns with participant awareness and behavior. As market participants realize the bull market is over, they en masse head for the exits. The outcomes for some investors can be enormous— nothing prepares you for being short–sold 1000 S&P 500 put options contracts when the sellers disappear—the despair is contagious and almost unbearable. At that pivot point, the technical forces you ignored begin to roll over by breaking support level after support level on the way to a new market low.
If heeded, two technical indicators, the Relative Strength Index (RSI) and New High/ New Low (NH/NL) could temper the emotional component of trading. These indicators illuminate two vital and distinct dynamic forces inside the world of finance. RSI tracks the market’s momentum while NH/NL uncovers the breadth of the market. Moreover, both indicators have the significant advantage of not being stochastic, and have stood the test of time for indicating the market’s future direction.
RSI indicates weakness by signaling overbought conditions when the value moves towards 80 and oversold conditions below 30. Currently, RSI for the S&P 500 stands at 50.201 and has been steadily rising. However, RSI hasn’t yet reached the threshold of an overbought condition, signaling froth in the market, as confirmed by NH/NL.
NH/NL is the decreasing number of new lows with small moves in new highs demonstrates strain on the market, producing significant enough data to generate upward gaps in sentiment. Twelve years of market growth can affect expectations. All major indices, S&P, Dow, and NASDAQ saw new lows of 34, 4, 5, respectively. History and technical markers point to a resistance that should be coupled with a healthy level of skepticism when it comes to the continuation of the Bull Market.
Historical precedent and technical warnings do concern me, but the fundamentals of the economy truly take my breath away. The current fundamentals are:
- Inflation of 7%.
- Federal deficit $29 trillion.
- Unfunded Federal liabilities $161 trillion.
- Jan 2009 EPS 6.86 Nov 2021 162.41 Twelve Month real inflation–adjusted.
- Ten–year bond 1.439%, Average 5.96%
- Low 8/2020 .52%
- High 9/1981 15.84%
Debt, inflation, and lower than average long–term rates combined with aggressive earnings per share (EPS) valuations make a volatile cocktail. Unfortunately, the best economist or market prognosticators seem unwilling or unable to reach a consensus about what the next six to twelve months hold for the economy. Luckily being wrong about my position when the warning must be written has never been an issue for me. However, a warning doesn’t begin to describe the potential economic, financial, and societal dislocation I see in our future. Whether you calculate the forward value of a stock or the time value of payback, the one unifying factor, discount (interest) rates, determines the result. Interest rates like oil hit every financial and economic decision. The monetary intervention has artificially held rates low by eliminating typical price discovery. In 2009, the Federal Reserve led central banks worldwide began capital infusing by purchasing government debt, which pushed other prospective buyers out of the market. A twelve–year cap on price discovery means we must surmise the interest rate for selling future bonds.
The real interest rate calculation underlies my point of view. Nominal interest rate plus expected inflation equals real interest rate. Price discovery or the interest rate that would incentivize me to purchase a government bond would be closer to 5% versus the current 1.48%. I am not the only one confused by the disconnect between Federal Reserve policy and inflation. Mohamed A. El–Erian, while speaking to Bloomberg News, stated, “Would you think the Fed would be adding monetary policy stimulus with inflation running at 6%?” He seems to intimate that the Fed may be disregarding obvious market economic indicators they often reference in their communications with investors in favor of some other yet undetermined metric. Regardless of your view on policy, market expectations as observed through the market prices place peak Federal Funds rates around 1.75%, which is a historically low number.
This market cycle from 2007 to the present eerily reminds me of the raging dot com era when incredibly, an intelligent analyst stated, “earnings we do not need earnings it’s a new form of business.” In the wake of that grand miscalculation, we found the field littered with broken companies, broken dreams, and a return to the old market mechanics. Market mechanics have been stifled for the past twelve years. Reinvigorated market mechanics via price discovery stand in solid opposition to market participants, the Federal Reserve, and investors’ valuation of the stock and bond markets. Moreover, tight labor markets on the back of supply issues cloud the landscape and impact the Federal Reserve’s monetary inflation created in 2008. Why?
The accommodative monetary policy started after the 2008 housing crisis papered over the cracks in the system while shifting the monetary ramification to other less engaged parties. Namely, the average American taxpayer. What are the ramifications of this action concerning the current Federal Reserve policy?
The Federal Reserve’s objective of avoiding a “Taper Tantrum” increases the likelihood of experiencing precisely that outcome. Somewhere between the late first quarter and early third quarter of next year, the Federal Reserve will aggressively taper so they can begin rate increases. A collision course of reduced liquidity with the street’s myopic view of the end of the cycle will rapidly expose the lack of fundamentals in the economy, culminating in a seismic loss of wealth. A seismic loss indeed. Remember, the initial damage that caused the real estate bubble didn’t magically disappear due to free money. Such damage merely remains dormant until economic factors rebalance the paper job applied by the Fed over the past 12 years. Ghosts of the Christmas past will come back to haunt financial experts by reminding them of their original hubris.
Irving Fisher (Fisher Effect) proffers that labor demographics, political division, and the death of the middle class can all rise from the grave to smack the Fed’s policy in the face. The economy is an animal not easily tamed and often cruel to those who play with the fundamental underpinnings. Post–WWI Germany shows us what printing money does to an economy once people realize their declining wages and savings. Many pages on this outcome await to be written; let my comments be some of the first. My exclamation, “Seismic loss!” sums up my view of where we are going If you do not believe a Seismic Loss is a possibility, consider the rapidity with which the Federal Reserve can act. During the period 2004 to 2006, the Fed raised rates 17 times.
The 2004–2006 period had none of the monetary easing experienced over the past 12 plus years or the rate of inflation seen in our current economy. An increase of 4% would devalue bonds by 30% and stocks by 86%, leaving very few places to hide from the carnage. To my point, the past decade of easy money, low–interest rates, and tame employment numbers left many with the sense that negative rates of return had disappeared as an economic reality. As an individual whose been in the market for nearly three decades, I assure you that negative rates of return have not evaporated. Negative returns only lay dormant, waiting to catch those who didn’t learn from past markets.
Construction of real interest rates, (1+i) = (1+r)(1+πe), contains the nominal rate (i), and expected inflation(π) both determine the real ® or actual rate of return. The Federal Reserve truly controls neither of these factors. Notice the multiplicative form of the equation for real interest rates. For example, I believe a conservative view of interest rates for this time next year is 7.64%:
- r = 4%
- i = 3.5%
- Nominal Rate = (1+.04)(1+.035) = 7.64%
Impact on Stock Value (SV):
- SV = Do(1+g)/(r–g)
- Do = EPS ($3.00)
- g = Growth rate (1%)
- r = Rate of return (1.61%, 7.64%)
- SV1.61% = 496.72
- SV7.64% = $45.63
- 90.81% loss in value.
Impact on Bond Values (10–year semi with no option):
- Current 10 year 1.61%
- Q4 2022 10 year 7.64%
- 41.64% loss in value