With Taper Tantrum Behind Us, Can Good News Be Good News Again?

At its December 18 Fed meeting, the US Central Bank announced its plans to start tapering back its policy of purchasing treasuries and mortgage backed bonds commonly known and referred to as quantitative easing or QE. Starting in January the Central Bank will reduce its purchases of these securities to $75 billion a month, a reduction of $10 billion. Based upon a slowly recovering economy the Fed's intent is to announce a further $10 billion reduction at each of its eight meetings in 2014 which would result in eliminating the program altogether. As markets have relied on the stimulus program to support asset prices, potential withdrawal of the program was greeted with a certain amount of apprehension creating an environment where bad news was received positively by markets and good news was not so well received. A fair question is: As Fed policy normalizes in 2014 will the markets reaction to good and bad news do the same?

Good News is Bad for Asset Prices

Financial markets can be unpredictable and fickle things. One of the great conundrums of the last five years has been the notion of markets responding counterintuitively to economic data. The market participants that performed the best during the financial recovery were those who embraced the notion that weaker data would encourage an accommodative Fed which would provide more and more stimulus. This position required an iron constitution to accept and anticipate counterintuitive market behavior to varied economic data. And market behavior proved to be very unpredictable. In addition to being an "unloved" bull market by most investors, the equity market's rise was widely resisted as retail investors avoided equities while professional money managers resisted as well as shorted equities, which was a truly losing cause. The most disastrous results were from those managers who could not adapt to the idea that bad was good or good was bad. For tenured managers this shift was too overwhelming to acknowledge. Headlines of failed hedge funds littered the financial press each and every week for years. Predicting market behavior became first anticipating the data and then forecasting the market's response to that data, which is not a new concept but now it had a new twist. The only thing more bizarre than the market's response to data was the media's portrayal of how the market would react to data. End of month labor reports became circus-like with the multitude of analysts and professionals that CNBC and other financial programs would trot out and interview. All of the analysis and pontificating was based on a notion that weak data would keep the Fed on hold from removing liquidity from the market and helping maintain the bull market. The biggest fear became a large and positive labor report.

With the Fed's Decision to Announce the Taper, is it Time to Shift the Thinking Again?

Will the most successful money managers in 2014 be the ones that can go back to the old school way of interpreting economic data? If so, how and when will we know how the market is responding to the data? How many data points will we need to spot a trend? Based upon the equity market's reaction to the Fed's statement, it seems the market is ready to embrace good economic data again and reward the markets accordingly. To be sure, the reference to markets is equities, not all asset classes. Commodities such as gold have already weakened significantly and fixed income have suffered as yields have started to climb again after falling briefly. There was much revelry when yields did not skyrocket with the Fed's announcement. I think much is being made about this, when in reality, why should we be so confident that rates won't take their good old time to start to rise? One reason investors might point to a subdued yield environment is the fact that the Fed seemed very concerned about inflation, and more specifically, the lack thereof. The one thing that may scare the Fed more than good old fashioned inflation is not so good old fashioned deflation. As few outside of an economics classroom appreciate, deflation is truly a worrisome concept. In a nut shell, consumers stop consuming in anticipation of lower prices and the mechanics and benefits of debt break down with deflation. For a culture and society that lives for debt, this is debilitating. Japan in the 90s is the case study of deflation. Trust me, it's worse than inflation.

The Fed Soothed Markets By Assuring Them of Low Short Term Rates Forever (Hyperbole)

One of the things the Fed would like to accomplish is an ability to soothe markets more through guidance and commentary than through actual action. If the Fed is successful, it can accomplish its intended goals of assisting markets without the fear of unintended consequences of increasing its balance sheet. If the market accepts this approach and acknowledges the Fed's accommodative position, then good economic data can be interpreted as good for markets and vice versa. This can happen perhaps because without the market actually performing quantitative easing, the market can move away from the fear of losing stimulus and accept good news for what it is, an improving economy which should lead to improving financial markets: higher equity values and normalized interest rates.

Ironically, As Equity Markets Are a Discounting Mechanism, is There Remaining Upside?

As money managers are wont to do, equity forecasts for 2014 are naturally upbeat. Most range from modest, if any, growth, to the sublime of an additional 20% on top of 2013 gains. However, given the growth in equity values to date versus the modest GDP growth in the real economy, is good economic data just doing "catch up" leaving the equity markets flat in 2014? With most managers at the least acknowledging a fairly priced equity market, what room is there left for further short and intermediate term asset value growth? If equity markets continue to function as they always have, the improving economy has been long since priced in to todays values. Maybe what the markets are left with is that good news is just a sigh of relief and not an exultation or catastrophe.

Thanksgiving and Shopping: An American Tradition and Controversy

This Thanksgiving holiday brought with it a little more than just turkey, stuffing, and a serving of pumpkin pie. It also brought a mild bout of controversy. The decision by some retailers to open their doors before what is traditionally considered the start of Black Friday caused a bit of a national stir by some folks that believe Thursday should be sacred and kept to families crowding around their tables and their TVs for a feast and some NFL football. In hindsight it's hard to justify opening early when early retail results show customers only moved up their purchases by half a day and did not continue to buy throughout the holiday weekend. At least part of the rationale by these retailers for opening early is the late date of Thanksgiving and the loss of six shopping days this holiday season. It's unclear whether these "lost" days can be recovered this year or if they would make a difference any how.

The Race to Open Earlier

Walmart and Macy's are two of the more prominent retailers to open earlier on Thanksgiving and jump the traditional start of Black Friday door busting sales. To listen to some of the interviews by the CEOs of each of the retailers in their explanations for opening on Thanksgiving a tone of defensiveness could be detected. The CEO of Macy's, Terry Lundgren, indicated that his company was in the service industry and that his customers wanted the store open on Thanksgiving. In defending his company after reports of violence at some Walmart stores, U.S. CEO Bill Simon explained that out of the millions of shoppers hitting the stores during Black Friday, some incidents should be expected, and that not all of Walmart's customers are nice people. The spin is that this is the trend and it's what the customer wants. But who are these customers that are demanding that these stores change their hours to accommodate their shopping needs? And is Walmart competing with Macy's and vice versa? And is Walmart so egregious when Kmart opens at 6 A.M. on Thanksgiving?

Moving Sales Forward?

Empirical evidence seems to indicate that sales made on Thanksgiving may only have been brought forward from the traditional start of shopping on Black Friday. People interviewed outside of shopping malls over the weekend seemed to think foot traffic was no different than any other weekend. If this is true, do retailers really benefit from opening early? Do sales made on Thursday beat sales made on Friday? Some folks actually think they might. Based on Master Card Advisors' data and the finite amount of funds consumers allocate to shopping for the holiday season, getting first crack at those shopping dollars is critical to retailers. Studies seem to indicate that consumers will spend most of their holiday budget at the first two stores they patronize. This would seem to illustrate the importance of getting to customers before your competition.

Bad Publicity?

But does getting first crack at customers justify the bad publicity that some of these retailers received in the media over the holiday? In the case of Walmart, bad publicity seems to be a way of life. Between gender bias suits, near poverty level wages, and just plain poor public relations gaffes, such as having employees receive food donations from customers over the holidays, it seems no publicity is bad enough publicity for the retail giant. Based on the lines outside of Macy's flagship store in New York on Thursday, publicity seems to be anything but bad for this middle tier retailer.

Online Competition: Cyber Monday

As more and more consumers have access to electronic tablets, such as iPads and the sort, and become more comfortable shopping online, are brick and mortar retailers under more pressure to offer something the online retailers such as Amazon and eBay cannot? Does the retailer need to stress the shopping "experience" of being out with the kids and the family to compete with the online behemoths? As more consumers transact online, traditional retailers will need to fight back with their own online stores as a convenience and offer their stores as sites to pick up merchandise. Although the data in many cases is "top secret", it is widely believed that online sales still only make up a small portion of total retail sales. The combination of providing an online store and presence along with their brick and mortar stores seems to give the traditional retailers the advantage, for now.

What's It All Mean?

The world and the U.S. is undergoing a seminal change in how shopping and consumerism is transacted. If 70% of our economy is made up by consumer spending than the importance of this sea change cannot be underestimated. The rise of Apple's mobile devices such as the iPad are one big example of what is facilitating this evolution in consumer habits. As our habits change it is not surprising that big retailers feel the need to evolve as well. With regards to the traditional holiday season that means breaking down old boundaries once thought sacrosanct. There is no going back once we've moved forward. The irony of this consumer evolution: Will Black Friday and even Cyber Monday go the way of the dinosaurs?

To Infinity and Beyond?

The Market is a slow moving freight train and will not be denied. On Monday November 18, 2013, the Dow Jones Industrials and the S&P 500, at least temporarily, eclipsed round milestones of 16,000 and 1,800, respectively. The bulls general explanations for the Market's strength is stimulus from the Fed. But not all bulls are created equal. Some are more bullish than others.

The Explanations 

The Mildly Bullish Case

At least one group of bulls believes that because of the Fed's policies the Market will continue to move higher through the end of the year. They surmise that as long as the Fed is in place the Market will have a floor, a put, so to speak. This group is not wildly bullish because of this line of thinking. In fact, at least part of this group is somewhat apprehensive about the bull case based on continued Fed intervention. There is an acknowledgement of the weakness in the foundation of this type of bullish scenario. If Fed support is your only basis for a bull case then it stands to reason that you equally believe the Market can fall if that support is removed, thus fear of 'tapering'.

The Medium Bullish Case

The vast majority of bulls fall in to this camp. The line of thinking here is that along with Fed support providing a floor for stock values true economic fundamentals underpin the stock market's move higher. These bulls point to incremental improvements in leading indicators, improving durable goods figures, lower jobless claims, low interest rates along with subdued inflation. This group likes to point to historical valuation multiples to represent this market as not overvalued, and in fact, suggest at the worst, this market is fairly valued. Their claim is that improving economic fundamentals will allow for expanding multiples, even with GDP growth of 1.50% to 2.0%. This group's fears are that record profit margins are not sustainable, corporate financial engineering (issuing debt to buy back stock and pay dividends) will fall off as interest rates rise and cash balances fall, and that earnings growth will suffer as a result hampering further equity gains. (These fears are shared by the folks in the 'Mildly Bullish Case'.

The Ultra or Uber Bullish Case

As with any philosophy there always exists an extreme tail group. This group is proudly headed by Wharton Business School professor Jeremy Siegel, who we all love because of his congenial nature and wildly overzealous and unabashed optimism. How could you not embrace Professor Siegel? Well, one reason might be that his forecasts may not account enough for some level of risk in the Market. "Where are the risks in the Market, Professor Siegel? Ya, I don't see any either???" Some level of sobriety when speaking about the Market's potential would make some folks feel better. But we digress. This group's claim to fame is that people and investors are inherently driven by greed. That is not a condemnation, it is merely an observation. Most of us want to accumulate wealth in order to maintain a certain standard of living and comfort for ourselves as well as our children. Therefore, the natural inclination is for us to want to be optimistic about the future and it's prospects. That is the bread and butter of this group. Their bullish case encompasses all of the bullish factors above but goes a step or two beyond. This group not only writes off fears of tapering but insists the Fed is likely to increase stimulus therefore creating an even higher floor for equity values. As for valuations? The Market is grossly undervalued at these multiples and has more room to expand. As for earnings and their prospects going forward? American ingenuity and corporations are on the cusp of great things. The untapped potential is ready to explode. This group's fear(s)? Fear? What fear?

Conclusion

Even the Ultra Bullish Group has got a leg to stand on, regardless of what the Market does going forward. The nature of man is to move forward. Optimism is a natural human sentiment and is reflected in all markets. The natural course of all sustainable markets is to move higher (inflation being one elemental reason). Do markets get ahead of themselves and 'correct'? Yes, they do. But the bulls will always have this natural human element to support them. For this reason, they have the easier slog in the investing world than do the bears. The bears are 'swimming against the current' in a matter of speaking, by taking a position that is not the natural predilection of human nature. In a way, the Market really is on a path to infinity and beyond. The 'rub' is the timing, and each investors is finite. Viewed from an infinite perspective, the Market can and probably will always rise. However, because our investing timelines are captured in snapshots within the Market's larger timeline, and  because of declines within the rising trend, investors can mistime the Market and suffer losses. Therefore, gains are not always guaranteed despite the natural tendency to the upside. This fact exposes the recklessness of the Ultra Bullish Group. There is, indeed, a time to be cautious, if not, downright bearish. So, to infinity and beyond? Yes, but with some caveats.

The Great Irony Of Barack Obama's Presidency - An Observation

Arguably, no US president in history has benefited the 1%, either directly or indirectly, more than Barack Obama.

When President Obama took office on January 20, 2009, the US economy was in dire straits. The Dow Jones Industrial Average closed at 8,077 that day, having fallen from a then high of 14,093. The Standard & Poor's 500 Index (S&P 500) closed at 831.95, declining from a then high of 1,561. Both indices would continue a ongoing decline to their lows in early March of that year. As a response to the economic climate at the time, the FOMC continued a policy that has become known as Quantitative Easing (QE). The initial QE began in November 2008 under George W. Bush's administration when the FOMC would buy $600 billion in mortgage backed bonds to help mitigate the subprime lending crisis and real estate market collapse. In November 2010, the FOMC began an additional round of bond purchases known as QE2 as a response to the economy not growing as robustly as the Fed would like. In September 2012, a third round of easing, or QE3, was announced which included purchasing $40 billion per month in mortgage backed debt. In December 2012, the FOMC announced an additional amount of purchases of $45 billion per month in Treasury securities. After warning of a possible "tapering" of bond purchases at the FOMC's June 2013 meeting, the Fed elected not to "taper" at it's September 2013 meeting, which was not widely anticipated. This caught markets off guard and has since led to new all time highs in some of the equity indices, specifically the Russell 2000 and the S&P 500, and renewed vigor in the treasuries  market.

Intended Or Unintended Consequences

One of the results of all of the QE programs has been stock and bond value appreciation. The stated desire to drive down interest rates raises bond values as bond prices move opposite to yields. The additional liquidity produced by the bond buying programs has caused money flows in to equities driving those values higher. Because most of these assets are held by the wealthy they seemingly benefit this group the most. On the flip side, when these assets were declining, the so called 1% lost the most wealth. The debate here is not what counts substantively as more or less valuable to folks of different economic classes, but whose material wealth and ostensibly their standard of living was improved during a certain period in history under a certain president.

The President's Background

Given President Obama's background compared to US presidents who preceded him, the results of his administration's policies and their subsequent benefit to a group that the President does not claim to favor, seem ironic. President Obama was raised in a middle class family mostly overseas, Hawaii and Indonesia, studied political science before getting his law degree from Harvard. Before getting his law degree, President Obama worked as a community organizer in Chicago, doing tasks such as setting up job programs, tenants rights organizations and educational programs. This does not paint the picture of a President whose administration would embark on one of history's largest asset revaluations.

Widening Wealth Gap In America

One of the most widely discussed results of the revaluation of assets in the US is the growing disparity in wealth between the upper and lower classes. Many books have been written analyzing this current phenomena and it's deleterious effect on American society. The policies the current administration has used have been referred to as a regressive tax, distributing money from the lower and middle classes to the wealthy in the form of QE, or stimulus. Is there a wider benefit to all Americans? A claim can be made that these policies have mitigated the US recession and avoided a full on depression which would hurt all Americans. Again, would everyone suffer equally? Do the ultra wealthy suffer as much losing millions of dollars in investments as the middle class family forced out of their $300,000 home? On the flip side, does everyone prosper equally? The discussion here is not either question mentioned above but the notion of a widening wealth gap between different economic classes under a president who's background would give no hint that this would occur. To be sure, a key campaign promise of the Obama administration was health care reform, the Affordable Care Act, which was a big sticking point of the Tea Party which resisted passing the latest budget and extending the debt ceiling. This campaign promise is a policy that would easily be associated with a president of Mr. Obama's background. Those in the Tea Party were not voicing their displeasure over their rising investment portfolios or lower interest rate mortgage and car loans. Apparently those folks do not associate their increasing wealth with the President's policies.

How Did He Get Here?

In the administration's effort to "save" the US economy and not appear ineffective, it turned to the FOMC to use monetary policy to support a flagging economy that is yet to pick up steam. One of the tools it has used is QE. QE stimulates the economy by injecting money in to it. This money flows in to assets and is meant to create a wealth effect. With consumers feeling more wealthy they should theoretically be more inclined to spend thus stimulating the economy and creating a virtuous cycle. The administration could use fiscal policy to affect the economy as well, but with the contention and rancor in Congress the easier route is through monetary policy. Perhaps it is this over-reliance on monetary policy, and lack of a healthy mix of both monetary and fiscal policy, that has created an environment beyond the President's control and seemingly out of step with his true character and nature.

Now That The Govt Has Kicked The Can Down The Road Again, What Can We Expect?

Now that Senate Majority Leader Harry Reid and House Speaker John Boehner have decided to agree to disagree Congress will apparently move forward and approve the bill extending the debt limit and opening the government back up for business. The outcome of these now ritualistic events are the worst kept secret since Luke discovered who his father was. It's Darth Vader, if you didn't know. This is how our government functions (or does not function, depending on your perspective) now. The rancor has reached epic proportions, when you consider the seriousness of the impact if the parties involved were actually serious about anything. Would either party let the US Government not only shutdown but more importantly default on it's worldwide obligations? It really is hard to fathom despite our lowly opinion of the folks that we elected to legislate on our behalf.

How Did They Agree To Disagree?

They really did not agree on much. The agreement is all of a continuing resolution to keep things status quo until December when we will revisit this all over again. The debt limit has been extended until February 7, 2014 at which time it will need to be extended again. So this is really more can kicking than agreeing.

Whither The Markets?

Despite general annoyance at what goes on in Washington DC most folks only care about the impact any of these machinations have on the bond and equity markets,  both of which impact their wallets. Equities will rally, at least initially. It is important to point out that equity markets never really faltered throughout this ordeal and are nearly as high as they've ever been and in the case of the small cap Russell 2000, they are at record highs. So where do we realistically go from these levels? Most likely higher. Markets don't tend to change trend until they do and until then they generally continue to follow suit. "It's a bull market until it isn't." This is a popular market refrain. As long as the Fed continues to inject it's stimulus in to the market through it's quantitative easing the market should continue to see gains. When the stimulus ends the market gains will end. Until then, pour another drink.

The bond market is a different animal than the equity markets. It is the "rational" of the two. Whereas the equity markets tend to be more emotion driven, the bond market takes a more sober tack. Given the Fed's QE (quantitative easing) it is not likely that yields can or will climb too high. Again, once the tapering does begin, yields probably will climb. However, unless the Fed increases the stimulus it is unlikely yields and therefore mortgage rates will fall back to their historic lows. If you procrastinated on that refinance four months ago, might be wise to get up on in there and get it done. It will probably take something none of us want to see for the Fed to start injecting that much additional stimulus.

What Have We Learned From All Of This?

Well, it's safe to say that the markets have learned to almost completely disregard what goes on in Washington except when it pertains to stimulus. The absence of any significant sell off in either market reflects this disregard. It's mostly the media that makes any kind of hullaballoo about the goings on in the nation's capital. With a couple months respite from thinking about budgets and debt limits consumers can go back to the malls, the analysts and money managers can go back to trying to figure them out and the media can pick up on the next big story, maybe Syria makes it's way back on to the front page.

Should The Fed Have Tapered?

At the last Fed meeting on Wednesday, September 18, the Fed elected to bypass the widely anticipated beginning of tapering its historical stimulus package. Following its decision to forego some sort of tapering, there was much consternation and hand wringing regarding the confusion the Fed created by not following the script the market had laid down for the Fed to follow. Apparently the Fed did not get the memo that it is supposed to do exactly what the majority on the Street anticipate. Many market participants claimed that the Fed misled them with its intentions and caught them off guard. Many are claiming that instead of creating more transparency with its post meeting briefings it is creating more confusion by being too open about their intentions. How exactly does that work? Many of these comments are laced with a certain amount of bitterness from being caught off guard by the Feds inaction.

Did The Fed Mislead The Street?

Leading up to the meeting it did seem that the Fed had indicated from its earlier meeting in June that it would indeed consider scaling back some of its stimulus possibly as early as its next meeting. Thus began the street's incessant forecasting of the timing and amount of the impending first taper. To go back and read the notes from the Fed meeting in June there is no specific reference to either the timing or amount of any such taper. So the Street created its own details of the initial taper and that became gospel to all of the financial news outlets including CNBC and Fox News. These two news outlets ran daily commentaries about the prospective tapering and therefore reinforced the notion of a taper at the September meeting and between $10 and $15 billion as the initial reduction of stimulus. Where did the Street get these amounts from? They are not written down anywhere in the Fed's minutes. The Street jumped to conclusions on tapering, placed trades accordingly, got it wrong and the trades went against them, and now it's upset. Perhaps the Street will learn a valuable lesson from this latest episode. Not to front run a Fed that is not sure itself what it is going to do from meeting to meeting.

Did The Fed Miss An Opportunity?

The question remains, did the Fed miss an opportunity to begin tapering? Most economists that have been interviewed believe that some sort of tapering is warranted as the benefits of stimulus have less apparent impact on the real economy and only serve to drive up values of risk assets. This is an interesting question. The logic for tapering at the September meeting was that the Street had presumably priced in a reduction of stimulus and markets would not be adversely affected. A side benefit was that the Street would interpret tapering as a vote of confidence by the Fed on the state of the economy. After the initial rally in markets, particularly equity markets, markets have since sold off. Hindsight is 20/20 and it is very difficult to say how the Street would have handled an actual taper and not the idea of a taper. It is fair to say however that given the markets behavior since the "non taper" it is hard to imagine the market behaving any worse. The Fed has indicated that it is leaving the door open to any and all options regarding its stimulus package. After reviewing the latest data it has determined that tapering back was not warranted. With this in mind it is hard to justify the Fed tapering at this time.

Are Historically Low Mortgage Rates Gone for Good?

First of all I would like to acknowledge those that lost their lives on September 11, 2001 and the loved ones they left behind.

Since July of this year as the 10-year treasury yield has climbed mortgage rates have followed suit. As mortgage rates are a function of the 10-year treasury yield, when treasury bonds sell off and their yield climbs mortgage rates typically climb as well. To contemplate why mortgage rates might come down in the future it is important to understand why they have moved higher in the present.

Why Have Treasury Bonds Sold Off?

Although the Federal Reserve controls short term interest rates it has little direct control over long term interest rates. The Federal Reserve raises and lowers the Federal Funds rate, the rate that banks lend to each other for overnight loans. Long term rates are a function of those short term rates plus a "premium" for tying funds up over a longer period. The plot of interest rates over time is known as the yield curve. The "normal" yield curve is upward sloping with long term interest rates higher than the short term rates. This curve reflects a healthy economy where future economic prospects are good and higher long term rates reflect the markets belief that the Fed will raise rates to control prospective inflation. However, on occasion the yield curve becomes inverted where short term rates are higher than long term rates. This yield curve typically indicates a weaker economy as economic prospects are dim. Current economic data points to an improving economy. Money managers and analysts suggest this as the reason long term interest rates are climbing. This may be one reason but it may not tell the whole story.

The speed at which rates have gone up suggests a stronger reason for the rise. The debate between popular analysts on TV whether rates can stay low for much longer is a reflection of money managers shifting funds away from fixed income to other asset classes, in many cases equities. As bonds are sold their yields rise. Bond price and yield have an inverse relationship. The opposite is also true. If bonds are purchased their price rises and their yields fall. So what would cause the sentiment among money managers and the general investing public to change regarding the outlook for bonds? If the economic outlook for the US and global economy were to deteriorate money managers will seek the safety of treasury bonds.

So What Direction Are Rates Likely To Go?

Depending on your outlook for the economy, you will either believe rates will stay elevated and keep rising or will fall back down to their historic lows. Most analysts suggest that rates are capped and will not rise much further and going forward may even fall back. The logic behind the cap is the historical spread between the Federal Funds rate and the 10-year treasury, which has never exceeded 400 basis points or 4.0%. Given the tepid economic growth both in the US and abroad it's hard to believe that rates will continue their rise. The traditional bond spread suggests a cap of 4.25% on the 10-year treasury and therefore a mortgage rate for a 30-year fixed rate loan of about 6.80% which is roughly 230 basis points above todays rate. The argument for rising rates is continued economic strength, which is unlikely. Current levels of unemployment and lower levels of consumer credit do not indicate an environment for greater economic acceleration. The argument for falling rates is weaker economic growth which is also unlikely. An improved real estate market and rising equities values continue to increase the wealth of average Americans. So where does that leave mortgage rates? Rates are probably range bound at this point. As the 10-year treasury yield trades between 2.50% and 3.00% mortgage rates will trade accordingly between 3.90% and 4.60%.

Will We Ever See Rates Back At Their Historic Lows?

For mortgage rates to fall back to their historic lows, the US economy would have to enter a recession, which is on the low end of probability. It is certainly possible. What is more realistic and probabilistic is that the economy slows from its current pace without entering recession and rates fall back close to their lows. This would actually qualify as almost catastrophic, not wanting to speak in hyperbole. The Federal Reserve would almost have to consider their efforts to rejuvenate the economy a failure after spending trillions of dollars with such low growth as a result.

An Inconvenient Consumer

Jim Cramer of CNBC Article on August 14: "Though Hardly Bearish, Cramer Grows Less Bullish"

The article describes Cramers caution due to Macy's disappointing earnings announcement. The article goes on to describe how Cramer explains that there are not enough catalysts in the economy to support the stock market if we lose the consumer. He also cautions that areas like financials could be hurt as higher interest rates take a bite out of housing. In other words, without the consumer the economy takes a hit and as a result the stock market loses steam.

Well, let's see if we all understand this correctly:

The stock market crashes in 2008-9.

Real estate crashes.

Financials face a crisis and the Fed bails them out with tax payer money  (read: consumer).

Corporations cut back dramatically and let go of staff (read: consumer)

Corporations earnings skyrocket as a result of layoffs and stocks subsequently surge making a handful of beneficiaries super wealthy (read: NOT the consumer)

Corporations will only hire part time workers at reduced wages and reduced hours (read: lower discretionary incomes).

Now, four years later, after a massive surge in profitability and cash hoarding by corporations (read: no CapEx spending) the consumer must be relied upon to spend so markets can maintain their momentum and it's up to the consumer (read: on his back) to do this? Really? While corporations sit on a reported trillion dollars in reserves? Really, again?

Sorry, Mr. Cramer, but this is asking a bit too much just so you can maintain your bullish sanguinity on your CNBC program. Welcome to the real world where most people are struggling to get by and not participating in the surge in equities that they helped support. How about if the markets give some back?

Will We Commit Sins of the Past?

Today is August 1st and equity markets are surging. The Dow is eclipsing 15,630, up 0.87%, the S&P 500 has pierced 1,706, up 1.20%, and the Russell 2000 continues to outperform, up 1.30% to 1,058. The financial press is reporting the rise is due to good economic data abroad (read: China) and domestic (read: fewer jobless claims than anticipated). This is all subterfuge for the real reason: it's the first of the month and funds are buying, plain and simple. However, the dark side to all of this are rising interest rates. The 10-year treasury touched 2.70%, up 12 basis points, or 4.28%. This is important to note because consumer rates are driven by the 10-year treasury, such as mortgage rates. This brings us to the point of todays missive: what happens when rates rise enough to stifle the real estate market and lending markets?

Rising Mortgage Rates, Declining Standards?

The rise in interest rates has already taken a toll on the refinance market. Applications for refinance loans  are down significantly from just 6 weeks ago. Applications overall are down, which includes purchase loans. As mortgage rates continue to rise, refinance loans make less sense to homeowners and the cost to buy a home becomes less affordable to prospective homebuyers forcing them to pursue a cheaper home or declining to buy entirely. And what of the effect on lenders and financial institutions? Banking analysts are cheering a steepening yield curve but what about lost revenues from less lending? It's likely that there will be a trade off between the two and initially revenues will probably dip before lending reasserts itself. But how can that happen with rates rising? Who will these borrowers be and what will be their motives for taking out a higher rate loan? The short answer: borrowers who qualify under lower lending standards which is the inevitable outcome in the lending industry. Already some lenders are lowering their guidelines for loans. It can take the form of more flexible loan products, such as a higher loan-to-value allowance and or lower underwriting guidelines such as lower credit scores. All of these things add up to making loans more available to more borrowers to keep generating loan business. This process is inevitable and it's already happening. When one lender starts the easing process the rest are sure to follow. The ultimate result is a weakening of the industry and future problems down the road.

Are We Destined to Make the Same Mistakes and Face the Same Problems?

Yes.

Here's why: Pressure. The system from the top down is predicated on making money. The tightening lending standards are a reaction to an event (financial debacle or similar). As soon as enough time has passed and the market has healed itself, the fear of making bad loans is far outweighed by the fear of not making money. The more flexible lending standards and more exotic credit products are justified by a healthier economy and in this case, real estate market. And so the cycle repeats itself as the market inevitably heals itself  and allows itself to expand and grow. And it works for a while and the industry thrives until the next calamity. By the way, what is the "system" referred to above? The system is our way of life, the financial markets and the structure put in place to support it (legal, governmental, etc.). Although the tone here seems somber and apocalyptic, it is not. To the contrary, these are just observations of what are natural events happening given a set of circumstances. This is not a condemnation of the system or how it behaves. In fact, it would be unusual if things did not unfold the way that they do.

Markets Sending Conflicting Signals

Since Fed Chairman Bernanke's press conference back in mid June, markets have been erratic. Interest rates have soared along with oil, while equity markets swooned and have stormed back, and gold has attempted to halt its decline as well as other commodities. With markets hanging on every word from the Fed Chairman, volatility has come back to the markets. After the market close July 10, the Fed Chairman spoke in an attempt to clarify the Feds position on easing and markets responded positively the following day. Most markets rallied as a result. Economic data has been light this week, the first week of earnings, so there were not a lot of other data points to justify the markets positive bias. The treasury market rallied sending its yield down 11 basis points, while the Dow, S&P 500, Nasdaq, and Russell 2000 all closed with gains of at least 1.10%, with the stand out Russell 2000 logging its 5th straight record close.

What Gives With The Market Moves?

The current explanation for the equity markets resurgence is a widely held belief that the markets overreacted to the Fed Chairmans comments to the media after the June meeting. The the Chairmans soothing words on July 11th, markets have recorded record gains, eliminating Junes swoon. Although rates continue at elevated levels relative to May, treasuries have staged a mini comeback sending yields well below the highs. This is little reassurance for prospective borrowers who are still staring at higher interest rates for home loans and other purchases. The question is why are equities and fixed income rallying together? Typically these two markets are associated with being negatively correlated, when one rises the other falls. The surmised "Great Rotation" was based on this understanding. As money would flow out of fixed income assets and in to equities, rates would rise as equities benefited with higher prices. However, it seems what is taking place is a combined reaction by both markets to the overreaction to the Feds June meeting and a "short" covering by investors in  both markets. An indication that this may indeed be the case would be both markets behavior early next week. By then shorts have probably covered and the markets should see some consolidation until either earnings act as a catalyst or some other market moving event takes place.

Oil Is Up Over $100 a Barrel But Gasoline Prices At the Pump Hold Firm. Huh?

There has been much made of the rise in the price of oil and lack of corresponding move in the amount consumers are charged at the pump, particularly during the traditionally high driving season. Articles are starting to hint that higher gas prices are coming as a result of the rise in oil, but why hasn't it happened yet? Typically when oil rises gas prices at the pump react spontaneously, and when oil falls gas prices at the pump "fall like a feather". This time around there is almost a stubborn resistance of gas prices to follow oil higher. Most analysts point to falling American demand at the pump to explain this phenomenon. However, as the traditional summer driving season heats up and American families hit the road, gas prices have not only held steady but seemed to have bucked the trend and in some cases declined as summer has rolled on. As the economy continues to improve and demand continues to grow it is likely prices will ultimately give in and start to rise creating a headwind for consumers. Until that happens, happy driving!

The Dollar is Being Blamed For the Rise In Commodities

One thing that most analysts agree on is that the U.S. dollars decline has led to the rise in commodities like the metals and oil. Gold has found support and has currently stopped declining while copper and other metals associated with a growing economy have firmed. What is not so easy to explain is how these commodities will perform going forward with expected economic weakness out of China and other "BRIC" economies that were supposed to lead the global growth story. After witnessing the dollars strength against other currencies, particularly the Japanese yen, the dollar has declined recently, most likely the result of relaxed anxieties by the market of further rate rises in U.S. treasuries. Typically, a currency's strength is a function of that currency's interest rate structure. A strong currency is associated with higher interest rates as it attracts investors which drive up the exchange rate against other currencies.

2013 Mid Point - Where Are Markets Headed For the Remainder of The Year?

Today is the last trading day of June. Monday is July 1st and the first trading day of the 3rd quarter and the start of the second half of the year. The first half of the year could be characterized as successful from the Feds perspective as its policy of quantitative easing resulted in record low interest rates as well as the best first half for equities since 1999. Mortgage rates remained at record lows and more homeowners were enticed to refinance their existing loans or take out new loans to purchase property. But as we look forward to the second half of the year, what should we expect from the bond market as well as the equity market?

June Ended with a Thud Amongst Increased Volatility and Rising Rates

On June 19th the Fed issued its policy statement and Fed Chairman Ben Bernanke gave his post meeting press conference. It did not take long for markets to start deteriorating. The equity markets sold off and effectively ended a never ending rally, finally giving investors the pullback they had been clamoring for. Interest rates had been rising but the chairmans words were fuel for the fire and treasuries sold off dramatically spiking all interest rates with them including mortgage rates. Most strategists conveyed that rates could and should rise. It was how fast rates started rising that most strategists warned about. In 2 months time mortgage rates rose 1%. ( See an earlier June article about the impact of the rise in mortgage rates on consumers.)

Looking Forward: The Bond Market and Interest Rates

The 10-year treasury sold off on the final trading day of June and closed with a yield of 2.519%. The yield is 0.81% higher than 6 months ago. Because so many rates are predicated on the 10-year treasury yield, all consumer credit is affected particularly mortgage rates. The biggest fear is that rising rates will harm the nascent housing recovery. This is probably a legitimate concern. However, it is no bigger a concern than the lack of participation by first time homebuyers squeezed out of the market by large investors such as Blackstone Group buying up properties as investments and causing the prices to become less affordable. The combination of the two dynamics will cause the housing recovery to stall out. Going forward most strategists see interest rates as range bound. It doesn't seem logical that rates will rise with such an anemic economic recovery. The problem is that there are other forces at work that will affect bond prices. The least of which is created by the markets themselves. The sentiment in the market place that rates must go up will ultimately cause them to rise. Money managers are advising clients to get out of bonds and rethink their portfolio mix. Once a sentiment takes hold in the market place it is very difficult to reverse. As a result, despite a weak economy, interest rates will continue to rise and the Fed will be helpless to stop it. This week saw many Fed governors come out publicly to calm markets after the firestorm created after Bernanke's testimony. The governors were trying to talk markets down. Although rates ended off their highs, the markets seemed somewhat unimpressed with these governors soothing words. 

Looking Forward: The Equity Markets

After having an impressive first half of the year, equity markets stumbled in June and experienced the kind of volatility traders love and investors lose sleep over. The equity markets were on a nice trajectory through the first 6 months of the year and then June hit and the markets lost their composure. A nice 6 month chart of the Dow Jones Industrials reflects the change. The equity market has a nice gradual slope from January to May, fighting off the sell in May crowd only to get brought back to reality by June swoon. June actually produced a negative return for the major index. Again, Bernanke's words after the Fed meeting caused markets to swoon at the thought of an end to quantitative easing. That and weak data out of China, which is now more important to investors than anything else, was enough to produce the pullback that market participants had been calling for. The equity markets, unlike the bond market, seemed impressed by the soothing words of the other Fed governors and rallied the final week of June to avoid an even worse June performance. Going forward, how effective will Fed speak be to calm and talk up equity markets? As the market is a discounting mechanism and QE "forever" seems to have not only been priced in to the markets but even lost some potency, and with earnings growth outlooks tempered but not really priced in, equity markets are facing some serious headwinds in the second half of the year. As earnings disappoint equity markets will likely give back some of the multiple expansion they experienced the first half of the year. Multiple expansion is only legitimate if forward guidance can justify it. With more companies lowering expectations, beating lowered expectations will not alone cause markets to cheer at these elevated levels.

Forecasts and Guesses For The Second Half of The Year

The tone of this article at best is sober so the forecasts should be equally sober. The 10-year treasury will continue to struggle and its yield will rise to end the year at the psychologically important level of 3.00%. There will be fits and starts but the yield will have a positive slope and not for the right reasons.

The equity markets, despite the bulls incessant calls for more gains, will fall to end the year, and this will be a good thing. Look for the Dow to end the year around 14,000, the S&P 500 to end at 1,500, and the Russell 2000 to end the year at 850. There is no technical or logical reason for these numbers other than the rationale that investors will increasingly agonize over the Feds next moves and will start to look less favorably on the impacts of QE and price in negative concerns.

Immediate Reaction to Fed Statement and Bernanke's Discussion

The reaction to the Feds statement and particularly the Fed chairmans comments afterwards was dramatic. The equity markets sold off dramatically and the treasury market sold off with the 10-year note yielding 2.32% rising 12 basis points. Mortgage rates are likely to reflect the 10-year note sell off on Thursday. Mortgage rates are likely to rise at least 25 basis points as a result.

The change in language by the Fed that may have spooked the markets was the Feds description of the waning risks to the economy. This is different from previous language that described continued risks to the economy. Also, Mr. Bernanke was vague if not completely opaque regarding President Obama's comments to Charlie Rose of PBS just days earlier regarding his future with the Fed, which most expect to end when his term ends in January 2014.

Two Fed members (Bullard and George) dissented regarding the Feds policy.

FOMC Meeting: Its Impact and the Expectations

The Fed concludes its two day meeting Wednesday, June 19, with much anticipation. All eyes are on the Fed chairman and whether he will give more insight in to the possible reduction of quantitative easing, now popularly referred to as "tapering".  The financial community and the broader community can thank the media for yet another catch phrase to banter about, not unlike formal popular phrases such as "irrational exuberance", "fiscal cliff", "new normal", and acronyms like "BRICs", "PIGS", and "ZIRP". Although these catch phrases typically go by the wayside after their usefulness runs its course and the media gets exhausted, taper may actually hang around a bit longer than the others. Although there are no real expectations that the Fed will announce a beginning to tapering of the existing QE policy at this meeting, there are growing concerns that inevitably the Fed will have to taper at some point in the future. There are heightened concerns that as a result of the impending end of Ben Bernanke's tenure there will be a "handing off" of sorts of the current policy to Bernanke's successor with at least some indication that an exit is being considered by the current Fed members. This concern is reflected in the bond market through rising rates and in the equity markets through increased volatility.

The impact on the bond and equity markets from the Feds statement may be muted. Bond yields have risen substantially the past 6 weeks and equity markets have seen increased volatility, while rising back to the former highs of the recent past. Although economic data such as labor market and real estate market data have shown relative improvement, the metrics set by the Fed which will drive the decision making policy have not been met. Unemployment still rests higher than the Feds target and inflation has not come close to the Feds desired target. With regards to inflation, if there is any real concern it's that it may be too low. There is increasing evidence that deflation may become a bigger concern than previously thought. Few anticipated that the result of Fed money printing (QE) would be falling prices, but inflation metrics such as PPI and CPI are reflecting weaker prices not stronger prices. This would be a dangerous development as deflation destroys what makes credit markets and the US economic system work. In a nutshell, increasing prices make borrowing and using leverage economically viable by effectively lowering its cost. Deflation eliminates or at least mitigates this process. As such, it seems unlikely the Feds hand will be forced to announce any concrete plans to begin tapering and the markets reaction to the statement should be muted.

The markets expectations of the Fed are another matter. The Fed is not entirely in control of market behavior or market sentiment, for that matter. Regardless of the Feds statement, the market may decide that it will move on without the Fed and price assets without considering Fed comment and guidance. The market will ultimately decide whether it trusts the Fed. The market is seeking clarity from the Fed after many Fed members have made both dovish and hawkish statements about Fed policy going forward. This market uncertainty causes the rise in rates and the volatility seen in the equity market. It will be the Feds job to soothe markets by clarifying its position on current policy and its future course. The Fed chairman has been doing this for nearly eight years now and is quite adept at it. Ben Bernanke will try not to add additional uncertainty to the market and will seek to allay any fears the market has regarding current policy and the transition from his leadership to his successors leadership.

Here We Go Again: Mortgage Rates Are On the Rise. What's the Impact On the Market?

After seeing rates hit all time lows on the 30-year fixed mortgage, rates it seems are starting to move higher. The press and media are reporting that we're seeing the end of the 30 year bull market in bonds and that rates are going higher from here. Or at least they are not going any lower than what we've seen the last several years. This may or may not be the case. Rates have risen only to come back down again as soon as additional weakness in the economy has surfaced. To be sure, if a sustained weakness prevails in the stock market, the bond market could see renewed interest by safe haven seeking investors. Just the same, what do rising interest rates mean to the average homeowner and the housing recovery?

Typically, rising rates are not beneficial to the real estate market. Higher mortgage rates mean higher payments and less purchasing power for buyers and less incentive for homeowners looking to lower their monthly obligations through a refinance. All of these things result in less economic activity. Less purchasing power means fewer affordable homes for first time homebuyers, a staple of a healthy real estate market. The ripple effect of fewer home sales is difficult to quantify but it can mean fewer sales commissions to realtors and loan agents, fewer sales of furniture and other housing related items, and fewer taxes collected by local governments. The impact can be significant. As rates have been extremely low for some time now and many borrowers that could and did take advantage of the low rates, sometimes on multiple occasions, borrowers of all kinds have become very sensitive to rate movements. Modest rate increases can dramatically affect lending volume, as evidenced by the Mortgage Bankers Association weekly mortgage updates.

Recently, the rise in rates has garnered a lot of attention and created much consternation in the investing community. Many analysts insist it's not rising rates that are causing them concern but the rate at which the rise has occurred. Since the last Fed meeting in the first week of May, mortgage rates on a 30-year fixed mortgage have risen just shy of 1%. For a 30-year conforming loan amount of $417,000, the interest and principal payment would rise just over $29 with a rise in the rate by just 0.125% or 1/8 of 1.0%.  This does not sound all that impressive or substantial. However, to put this in to context, this rise would result in a loss of purchasing power of just over $6,400. Still not impressed? This was by just an 1/8 of 1.0% rise in rates. Rates have risen 7 times this amount by 7/8 of 1.0%. The loss in purchasing power by this move in rates is $41,960. Still not impressed? This is in a month. Now you're impressed. This is why analysts are claiming it's not the rise in rates as much as it is the rate of the rise. If you're a first time homebuyer and you waited a month to move forward with your purchase recently, you were just priced out of the market. So what would be the alternative? Either prices have to come down to meet this new economic reality or fewer homes are sold and the ripple effect discussed earlier takes effect. Neither alternative are that attractive or appealing. For the prospective refinance borrower, these types of moves are deal breakers. Ironically, it's environments like these that often times get borrowers off the sidelines and motivated to effect a transaction. What is so alarming to analysts is how quickly things can turn and how fragile the economy may be to any hiccup in the recovery. For example, a misstep by the Fed in its policies or a black swan event or exogenous event out of our control.

Interest rates will probably rise at some point to what economists describe as normal levels and this will be healthy for the economy. Artificially low rates can cause imbalances and distortions in the economy that may be unanticipated. Ideally this rise will occur gradually and cause few disruptions to the economy. Rates are still low by historical standards and most homeowners should still take advantage of these low rates to lessen the burden of their mortgage payments. Housing prices should find their equilibrium in a rising rate environment where first time homebuyers can successfully purchase a home that is within their budgets.

The Fed Should Taper While Confidence is High

The Federal Reserve would be wise to consider tapering economic stimulus while investors have confidence in the approach and its results. Waiting too long could have deleterious results. Two negative outcomes immediately come to mind. The first would be a bigger equity market correction than necessary and the second would be a more dramatic spike in interest rates.

What is With the Value of Investor Confidence?

In the investing world investor confidence reigns supreme. It is always subtly present no matter how discrete. Every tool used by the Fed in supporting the economy and the markets relies on it. Why is this the case? Shouldn't markets be more rational? Not necessarily. Because markets are influenced by humans and humans are emotional, this tends to have a big impact on how markets behave.

Strike While Confidence is Still High

Friday, the equity markets sold off and many investors were rattled, as reflected by the biggest losses coming at the close. After two weeks of talk of possible early tapering, investors finally seemed to embrace "sell in May". Despite the late weakness in the equity markets, investor confidence remains high and the Fed is still getting the benefit of the doubt regarding the efficacy of its economic stimulus known as quantitative easing (QE). It's not too late for the Fed to taper and have the markets interpret it as the Feds confidence the economy is on a self sustaining path of growth. By doing this, it could be that markets rally in the face of tapering as investors see better economic growth and therefore discount higher future earnings. One negative alternative mentioned at the outset however is that investors lose confidence in the Feds approach and believe the Fed is being forced to taper before it wants to. This is a scenario where markets may sell off and possibly dramatically. Under this scenario, it's possible the bond market sells off and yields spike as a result and that the equity markets sell off  as investors seek the safety of the sidelines looking to book first half of the year gains. Early year gains in the equity markets create an environment where investors are more inclined to book profits and ride out a possible market correction which only exacerbates a sell off.

For this reason, it would be wise for the Fed to consider tapering earlier rather than later. If investors lose confidence and markets start to decline, tapering by the Fed may only exacerbate declines and result in harming both future economic growth and employment. Unfortunately, this is the part of the whole process that was expected to be the hardest to manage, the eventual exit of stimulus.

The Fed is Going Against The Basic Advice of Every Financial Advisor

The Federal Reserve is years in to and trillions of dollars vested in it's rehabilitation of the economy known as Quantitative Easing. To be sure, the Fed has the best interests of the economy and the wealth of the nation in mind. Unfortunately the tool it has decided to use and reuse is it's unforeseen effects, most notably the "yield grab".

The common mantra of every financial advisor to each of their clients is "diversification, diversification,  and diversification". Just the other day a well-respected and experienced money manager with a large fund was asked his opinion on the stock market and it's recent stellar performance. His take was maintain the long term view and stay diversified. By taking this approach the common investor can avoid the stress and the resulting mistakes short term and medium term traders make.

There is only one problem with this venerable advice: the Fed won't let you do it. Diversify, that is. The Fed doesn't make it illegal to diversify, that wouldn't work. No, through their actions the Fed has orchestrated one of the most massive "squeezes" ever seen. By printing money (QE) and purchasing mortgage backed securities and treasuries and therefore reducing the yield curve, everything from FDIC insured savings accounts to junk bonds (corporate) offer very little in return to investors. As a result, investors pursuit of yield has forced them to allocate monies that would normally be invested more cautiously in to more risky equity assets.

Unfortunately, and perhaps the cruelest twist to this effect are the investors that are most affected. Investors that are nearing retirement or are already retired and would normally allocate more and more towards less risky fixed income investments are left without many options. At a time in their lives that financial advisors would be suggesting they get more exposure to insured bond funds and reduce exposure to equities these investors cannot afford to as there  just isn't any yield. The result is less diversification and more reliance on equities. As long as equity markets are rising this doesn't present a problem. Unfortunately, equity markets don't move in one direction. They also go down and sometimes they go down a lot. This can be very uncomfortable for an investor living on the return of those investments.

Fixed income and their yields are not the only asset class suffering. Recently most commodities are also being affected. As the Feds policies pump up the equity markets unfortunately those policies have not had the desired effect on the economy as a whole. As a result, as the economy has not responded well to the Feds money printing, commodity values are reflecting such and are falling leaving another losing asset class that investors cannot rely on. It may be that equities can "save the day" and suffice as the lone asset class that investors need to rely on. However, this does not change the fact that the Feds actions are responsible for forcing investors away from responsible investing habits and creating the potential for catastrophic results should some black swan event rear its head.