Will the 2015 Holidays Bring Markets Cheer?

In the aftermath of the terrorist attacks in Paris on Friday the 13th, equity markets around the globe staged impressive gains on Monday, the first trading day after the attacks. Before the tragic events in Paris, analysts and market pundits had speculated whether markets had it in them to stage a traditional "Santa's" rally this season or if markets had seen most of their gains for the year after the slump in August and September. The question is: Does the market have any more juice?

The Obstacles

History and data seem to reflect market strength during the traditional holiday season, beginning in November. The attacks in Paris represent one obstacle to positive gains this holiday, but what other hurdles must the market overcome to give investors reason to cheer?

Commodities
There seems to be a strong correlation between the price of oil and equity prices. How long will this relationship last? For the time being, weak oil means weak equities. Has oil found a bottom near $40 or will we see further weakness? Because of the correlation with equities market cheerleaders are calling a bottom in oil. So far, they have been wrong on this.
There was a time when copper was fondly referred to as "Doctor" Copper. This was because copper was considered a metric for industrial and manufacturing production because so many items used copper in the manufacturing process. So went copper prices so went markets. This relationship seems to have ended either because it never really carried any real weight or because it stopped suiting the pundits that needed a "story" for the market to rise. Regardless, copper is down 30% this year alone and reflects weak demand from major industrial countries as well as China.
Strong Returns Booked in October
The sell offs in August and September set up October for massive gains, the best month in 4 years. The S&P 500 logged a gain of 8.3% and the Dow Industrials logged a gain of 8.5%. After this impressive comeback many analyst questioned what was left in the tank for the holidays and year end. Some of the Street's biggest bulls are sticking to their early forecasts for further gains but most have trimmed their expectations. The argument is that October pulled traditional late year gains forward.
Weak Fundamentals with Healthy Valuations
Corporate earnings have been coming down raising the overall market's P/E ratio with them. With October's stellar returns the price of the overall market is not cheap and as earnings fall the market gets more and more price. Further gains are challenged by these multiples and no one, even the staunchest bulls, are calling for multiples to expand at this point as the growth required to accompany them is not visible at this point in the cycle.
The Fed's December Meeting
Futures forecast a 70% chance of a Fed rate HIKE in December. This is elevated after a strong October labor report and decent wage gains. The market wants a rate increase but will it rue what it wishes for when it finally comes? Equity gains in the face of rising interest rates is not out of the question, and maybe will come with a sigh of relief, but it's not traditional that equities rally on tightening credit.

Flat 2015

The S&P 500 was flat for the year as of this publishing. Given the headwinds and strong bounce in October, markets will likely end the year near where they currently stand. After the Fed FINALLY raises rates at its December meeting, analysts will try to forecast markets in 2016 and the future path of rates and its effect on equities. There will always be bulls and there will always be bears and the markets will do what they will.

It's Fed Day! The "Will They Won't They?" Will Finally Be Answered

Today, Thursday September 17, 2015, is the final day of the Fed's two day meeting. This has been one of the most anticipated meetings in some time, and for good reason. Although any rate increase will be modest, the shift in policy direction and market perception will be massive, indicating the beginning of the end of easy money policies, and the start of a tightening cycle.

NO FED RATE HIKE

"Won't they!" The Fed decided to hold off on raising the Fed Funds rate at today's meeting. The move would have been more symbolic than material. Any move would have been limited and would only been a statement move that "liftoff" has begun. Today's non-action puts that off for at least another meeting, which is in October.

Was This the Right Decision

"What is the Fed afraid of?" If the U.S. economy is as strong as Yellen repeated it was over and over in her post meeting press conference, what is the Fed obsessing over? According to Yellen's comments, China's economy and market volatility influenced the Fed's decision not to raise rates at this meeting. So has the Fed introduced an additional factor in their decision making process? On the surface it appears that is what they have done. If the Fed has introduced an additional consideration, it complicates the proper equation to make policy decisions going forward. If different metrics can be introduced regarding policy decisions, it makes anticipating Fed moves nearly impossible and hinders the Fed's desire to be more transparent in its decision making process. Unfortunately, the Fed has introduced more uncertainty in to an uncertain environment and market volatility is likely to continue. Now investors get to continue to game the Fed.

If the Market is Always Right, Why are Central Banks Meddling?

One of the first investment lessons about asset markets is that price is king, price is always right. The market will dictate what the price is for an asset. This is a basic tenet of investing in asset markets. The price may be different next year, next week or tomorrow, but today the price is right. This is something all investors agree upon. However, if this is widely held as gospel within the investing community, why are central banks around the developed world waging an unprecedented assault on global asset markets, force-feeding asset prices on markets?

ZIRP and QE

Zero-interest rate policies (ZIRP) and quantitative easing have dominated global central banks for the better part of the last seven years. The US Fed established its Fed funds rate at near zero back in December 2008 and hasn't budged since. In addition to this policy the Fed also implemented quantitative easing, or QE, its asset purchase program to keep longer term rates lower and to inject liquidity in to the marketplace. Both of these policies have been mimicked over the years by various central banks around the globe, some to a lesser extent and others to a greater extent. The latest effort taking place in Europe on  Thursday, September 3rd, where Mario Draghi, the European Central Bank's president, threatened to provide additional stimulus in the wake of the weakening Chinese economy and its potential threat to the Euro Zone's middling economy. The purpose of these policy actions is to manipulate markets. The price of assets are directly affected when the Fed makes a move. But this is normal and happens all the time, right? It is normal and the Fed and Treasury make policy decisions often in hopes to affect markets. That is why they have the ability to make policy changes. If they didn't affect markets, why bother? Although this is all true, it's the extremity and duration of the policies that are twisting markets and not allowing them to function properly.

Dislocations and Misallocations

One of the effects of all the Fed intervention is creating market dislocations. Under normal circumstances, assets price themselves as a function of other assets in the market place. For example, corporate bonds typically price at some function to US treasuries, some spread. Corporate bond prices reflect their inherent risk vs US treasuries through a spread in yield. This spread reflects the premium necessary to adequately compensate investors for the additional risk. During this latest era of easy money, these spreads have been compressed and have not represented the additional risk investors have been taking. This is a problem because it disguises the actual risk that is being taken by the investor, the creditor, and the executive boards of companies that are accessing the capital markets, and creating imbalances.

An additional symptom of the extended current policies is a misallocation of capital resources. Corporations are buying back their own stock and issuing dividends at historic rates. They are doing this financial engineering to prop up stock values and mask the absence of true business expansion through capital expenditures. Companies are not growing so the economy and GDP growth is reflecting this reality, while stock values keep rising. Another misallocation this creates is fund flows from safer investments to riskier investments, often outside of a normal investors risk profile, or better said, the "search for yield." An example of this phenomenon are retirees buying more stocks and less bonds suitable for their normal risk profile, in order to increase revenue.

Pushing On A String: Maybe More Stimulus Is Not the Answer

As Greece faces another default and global markets are mounting a unified "freak out" session, the fact that China's PBOC (Peoples Bank of China) cut rates over the weekend and markets sold off in Asia on Monday, is not getting as much attention as one would anticipate (or maybe that is the real reason markets are selling off and Greece is just a cover story). The ominous inference is that if a rate cut does not have a desired effect of boosting markets, what will? And more ominous, broadly speaking, is the concern over whether central bank stimulus has lost its impact on affecting markets.

Concerted Central Bank Easing

Like good soldiers falling in line, the world's central banks, one after the other, have participated in one of the most orchestrated global stimulus efforts in history. The fact that each central bank seems to have taken its turn at easing is too coincidental to think it was not a concerted effort by governments to stagger their efforts to get a prolonged effect from additional stimulus. This is not to say that there was absolutely no overlap in stimulus programs from different countries but the manner in which the US and Japan followed by the EU announced and implemented their plans appears very coordinated. With global rates at, near or in some cases below zero, new forms of stimulus are required. With the US, Japan and finally the EU implementing their own forms of quantitative easing (QE) that form of stimulus seems to be off the table as an option unless central banks can artfully form a different variety that markets have not seen yet. With governements venturing in to uncharted financial territory they may wonder, why not keep going? Once you've left the reservation what boundaries are you constrained by?

Zero Return World

As central banks have globally reduced interest rates to zero, capital has staged a massive hunt for yield, any yield. The equity markets and junk bond markets have been major beneficiaries of this hunt for yield. Real estate has made its own comeback, as well. Market strategists have justified higher multiples on equities as equivalent returns on corporate debt have declined. In an extreme scenario, corporate debt would yield 1.0% and stock multiples would correspondingly rise to near 100, resulting in near zero asset returns with little to no consideration of risk. In essence, central banks are responsible for creating this environment through their stimulus programs and their unintended consequences. Proponents claim that the recession was not worse because of the Fed's efforts, but that is a lazy defense that cannot be proven or disproven. The most notable impact of stimulus has been its impact on asset prices. The economic recovery has been uneven and on-going for over 7 years. Markets are a discounting mechanism so it is natural that they improve ahead of the data but to date that relationship is out of whack. In this case, the data is way behind the market's performance and is still huffing and puffing to catch up. The result: very low returns across all asset classes. The real barometer of the economy: commodities. Old gauges of a healthy economy, oil demand and copper demand, have declined. Market participants have conveniently disregarded these old markets indicators.

The Proverbial String

Outside of China, central banks cannot force their constituents to borrow, buy and invest. This is the conundrum that the US and the other developed economies face. The labor market has improved but wages are stagnant. Auto sales have stages a huge comeback but it looks like that cycle is about to end with another generation of buyers stuck in extended subprime auto loans sucking up any available consumer discretionary income. This is with interest rates at zero. If things deteriorate from here, what levers does the Fed have? There are no rate cuts left. How does the Fed encourage consumers to borrow going forward? Regulations have left the financial industry hindered and US corporations are more interested in investing in their own stock than to implement capital expenditures plans that would normally create organic economic growth. As these corporations issue debt for financial engineering, the cash remaining on the balance sheets will be needed to retire this debt as rates inevitably rise, eliminating any option for capex spending. This seems to leave the Fed in the precarious position of pushing on a string when and if it needs to battle the next inevitable financial crisis.

Will Anything Dent the Markets?

Today's headline on Business Insider: BANK OF AMERICA: "We're heading for an earnings

recession." This premise has been floated by more than a few analysts and business media personalities. At this point, it is the worst kept secret that a deceleration in earnings growth is being forecast by most stock analysts. The question being asked now is whether the first deceleration in earnings growth in six years will be enough to spark a correction in the stock market with other markets following suit.

It's the Economy Stupid

Since the depths of the recession, most observers of the stock market's six-year and counting rise, have viewed it with skepticism and a healthy dose of dubious acceptance. Record earnings growth and an accommodative Fed have contributed to the market's run with market bulls responding to the bear's cynicism by pointing out the strong earnings and low price-earnings multiples as reasons for continued optimism. Now the bulls are faced with a more sober reality: decelerating earnings and their correspondingly higher price-earnings multiples. What will the bulls point to now to justify an ever rising market? With multiples stretched beyond historical norms, asking for yet higher multiples seems unlikely. The chart to the right reflects the S&P 500 valuations (red line) versus declining

earnings (blue wave). There is a discernible departure between price and earnings growth. The only way to justify yet higher prices is a forecast for higher earnings growth going forward. But with forward earnings being reduced, how far out does the market have to look to find brighter skies? How much are investors willing to "pay up" for stocks based on distant earnings? One of the bull's popular refrains over the course of the market's recovery from its lows has been "the second half of the year looks better than the first." A recent concern, admitted by a popular market bull, was of second quarter earnings. The bull confessed that the market could get by with weak first quarter earnings but if second quarter earnings come in weak, it could present a problem for the market. Until now, each market hiccup has been offset by Fed support.

How Long Will the Market Rise on Continued Accommodation?

With earnings growth possibly turning negative, a rising market will look to Fed accommodation to provide bulls with more momentum and will give market bears fuel to feed their growing cynicism. Even market bulls concede that at least a 10% correction would be healthy. But each dip is met with more buying. When is the dip not met by sanguine buyers? Each hint that the Fed will postpone raising its rates is met with a market rally, the most recent happening after the long Easter weekend. A weaker than anticipated labor report was met with a triple digit gain in the Dow Industrials on the first day the market was open after the release of the labor report. How long can this response to the notion of lower rates for longer last? The Fed has already declared that it will be more accommodative for longer and will err on the side of caution and risk being too accommodative. It has tried to be as a transparent as possible and has avoided "surprising" the market with its policies. Although the Fed has expressed a desire to raise rates, it has also conveyed its "patience" to the market about its approach. There will come a point when investors will hit a wall and stop buying at ever higher valuations. That point is probably sooner rather than later. If earnings growth does not reverse and accelerate higher investors will baulk at paying correspondingly higher multiples as their risk profile is breached. What is the market's fair value in a permanent zero-rate environment? If investors never anticipated higher rates, what bid would they place on stocks? In a zero-rate world, a new metric would need to be used as a risk comparison. US treasuries would not be appropriate or adequate. Maybe a foreign bond rate or inflation (CPI) becomes the new risk barometer.

It's the Market Stupid

The Fed may choose not to raise rates based upon the performance of the economic data points they follow before the markets ultimately force their hand. The market has already disagreed with the rate forecast the Fed had been describing only to have their views confirmed by the Fed's actions to postpone raising. The same may prove to be true regarding when the Fed needs to raise rates. The market will be ahead of the Fed when they should raise rates. The market will not accept lower rates and will demand higher returns. This will cause rates to rise and stocks to pull back accordingly. When does this happen? As soon as the risk-return profile for investors shifts and capital flees US markets for greener pastures. Those greener pastures will have German, French, Spanish and Italian accents. As the Euro zone heals and growth improves, US capital will find its way over the Atlantic in a meaningful way. This process has already started. The ECB is in the nascent stage of its own QE program and has a ways to go, allowing for further easing and additional stimulus. If capital finds its way overseas in a meaningful way, the next dip in the US may not finds its fair share of buyers.

The Fed's Word Games

With the Fed meeting this week, attention is focused yet again on its statement, not its monetary tools. As many Fed followers correctly predicted, the Fed's arsenal of tools to combat weak growth and low inflation is waning, and has resulted on its increased reliance on the wording of its statements to influence and soothe markets. With rates at or near zero and the completion of its quantitative easing program (QE), the Fed has changed its approach to affecting markets focusing on communicating its intentions rather than implementing actual policies tools.

March 18, 2015 - Fed Releases Statement and Removes "Patient"

The Fed issued its statement on Wednesday and did not disappoint markets, as every market rallied as a result. Stock indices, energy, commodities, and bonds all rallied, some to record levels. What happened? Removing 'Patient' from its statement should have been bearish for markets, however, the Fed also lowered rate guidance in December, which helped soothe markets. Rallies like today's are often 'relief' rallies and can be short lived. As a result, the US 10-year treasury yield fell below 2.0%. Here is the Fed's March Dot Plot: Chart of FOMC participants of rate forecasts. The Fed cut its December rate forecast by 50 basis points. This alone has caused all markets to uniformly rally.

How Long Do the Fed's Words Alone Soothe Markets?

For the time being, the Fed is getting the benefit of the doubt. Its words alone have soothed market expectations and kept equity markets buoyed. Most analysts agree, at least, that markets are 'fairly' valued if not overvalued. At what point do values hit the proverbial wall? Is the market's magic number the reciprocal of the 10-year US treasury, the equivalent metric from the fixed income market? If the risk-free rate of return is 2.0%, then the equivalent equity multiple should be 50, a far cry from the current 16.5 that the S&P 500 trades at. Why aren't we there yet? The historical average multiple is what is holding the market back. That multiple for the S&P 500 is around 15, leaving markets a little 'pricey'. Six years in to the current bull market without a significant 10% pullback is leaving investors and analysts a little hesitant to place bigger bets on the largest indices. The latest 'story' from money managers are that small cap stocks are the next growth area within the equities universe. With lofty current multiples and in the face of higher rates, that window may be short lived, as small caps fare worse than their larger cap brethren when liquidity starts to dry up. As multiples across the investment spectrum rise, the search for yield will only intensify. No one knows when or at what levels markets seize up, but the Fed's words will not infinitely soothe away the concerns the market is bound to have. At the moment the market tunes out Fed-speak, the market will crack and the long-awaited market correction will follow.

The US Mortgage Conundrum

The housing industry has been an economic driver for the US economy for over a century. Between

the materials needed to construct real estate and the services surrounding its marketing and sale, the economic impact is broad and far reaching. When the housing market struggles, the economy as a whole may struggle. One aspect of the housing industry that is as important as any is mortgage finance. Historically, American homeowners have financed their home purchases using a traditional 15 or 30-year fixed rate mortgage offered by most lending institutions. Adjustable, or variable rate mortgages, have always been available in the US market but have made up a smaller portion of the market, roughly 10%. However, this might change as the US financial industry is experiencing seismic shifts among the players and regulations that affect residential lending.

Characteristics of Other Developed Nations' Mortgage Industries

The mortgage industry looks very different outside of the US. Two things that stand out are the types of mortgages that are widely used and the structure of the mortgage industry. Variable rate mortgages are far more common outside the US as well as more short and medium term rollover features. Government support through institutions like Freddie Mac and Fannie Mae are unique to the US mortgage industry and are far less common overseas. Default rates are lower outside of the US, where variable rate mortgages are more common, defying evidence that these loans are inherently more risky. To think that the US could learn a lesson or two from foreign nation's mortgage markets is not consistent with the lead the US typically takes in areas of finance and credit.

Housing and Banking are Flagging, Is Mortgage Finance to Blame?

While US stock markets continue to enjoy the now 6-year old bull market, this success throws in to sharp relief the weakness found in the US real estate market. While there are patches of strength in popular markets in the west and the northeast, the broader real estate market is experiencing overall weakness. Away from the success of Silicon Valley and Wall Street, which support their real estate markets, the rest of the country is not as fortunate. There have been several theories about why real estate is floundering, from a weak labor market to a preference for rentals by 'Generation Xers.' However, an obvious place to look has been ignored by many: the lending institutions. After the collapse of the subprime market and the real estate market itself, lenders of all kinds found themselves under siege by regulators and legislators looking to place blame and attempt to recover losses. The response to the crisis was to pull back and restrict credit creation. The large banks that did not go bankrupt or get absorbed by competitors, pulled in their reins and started tightening lending standards and limiting their mortgage products, such as popular home equity loans, or HELOCs (Home Equity Line of Credit).
What no one was paying much attention to was how much lenders were limiting their credit and how strict they had become. Anyone who tried to get a loan during this time, 2009-2013, knows how difficult it had become. After several years separated the crisis from the recovery, and the real estate market continued to struggle, some other specter was at odds with the market. As the Fed maintained its zero-interest rate policy (ZIRP), margins for financial institutions continued to compress. Now, years later, profit margins for banks have tightened resulting in less incentive to make the loans that were once its bread and butter. This economic reality combined with increased scrutiny and tightened regulation, has caused lenders to make the rational and logical business decision to reduce loan origination. If the profits are limited and the penalties are severe, why pursue the business?

What Is to be Done?

What can be done to invigorate this market and incentivize lenders to originate more loans? Maybe this is the wrong question. Maybe the better question is: Who can step in and fill the void in lending left by traditional lenders? If we assume tighter profit margins are a reality going forward, the answer could lie in nontraditional sources of credit that can survive and thrive on the thinner margins that exist today. One such place could be lenders such as Kickstarter or the Lending Club. Investors accustomed to thinner returns could be enticed by these margins and provide the liquidity borrowers need to fund their real estate purchases. The application process could be similar to the traditional lenders, so it would not require re-invention. One obstacle to overcome is to gain an acceptance and comfort level in this type of credit creation by the masses. One way to achieve this acceptance would be a collaboration between existing brick and mortar companies looking to gain access to this market with these new lenders. One example of this would be a partnership between Kickstarter and E*trade.

Will QE Work in Europe?

After years of assurances and promises, Mario Draghi, the president of the European Central Bank (ECB) announced the passage of the European Community's version of quantitative easing (QE). The plan is an open-ended pledge of about 1 trillion euros to purchase both public and private bonds at about 60 billion euros per month until September 2016. Sovereign debt will require additional risk-sharing arrangements. Despite it's wide anticipation, markets from Europe and beyond cheered the move. Now that the monetary pledge has come to fruition, will it have the benefits the ECB and Mario Draghi hoped for?

Why Does Europe Need QE?

Europe needs QE for two simple reasons: to ward off impending deflation and to increase liquidity. The biggest danger the European economy currently faces are falling prices. The dangers of deflation have been well documented on this blog. Lower prices often beget lower prices which can then be disruptive to financial markets (ex: financial institutions rely on the value of underlying assets or inventory remaining stable or increasing).

Reasons It Could Work

Christine Lagarde, the president of the International Monetary Fund (IMF) has claimed that QE is already working. As she points out, the move lower in the exchange rate of the Euro proves that just the anticipation of QE has assisted the European community and its economy. The weaker euro allows European companies to be more competitive in the global marketplace. Additionally, any increase in inflation in Europe will help those economies associated with the Euro.

America as a Proxy

European bankers need only look across the Atlantic for a recent real life example of the effects of QE. The Fed initiated its version of QE in the fall of 2008. The Fed maintained its asset-purchasing program in some form over the following six years. The evidence is far from concrete but the program has been credited for keeping the American economy from slipping in to full blown depression. The main catalyst for implementing the unorthodox policy being the failure of Lehman Brothers. It is debatable whether the US would have suffered a more severe downturn in the absence of QE but most analysts concede that the program was helpful. The context under which both programs were implemented is different. The US economy was not trying to stave off deflation while that seems to be the European Union's biggest fear. Under American QE, asset prices increased creating a intended wealth effect, that helped encourage consumer spending and business capital expenditures. Despite the amount of stimulus the real economy in the US is struggling with low growth but is still the healthiest economy in a weak global environment.

Why It May Not Work

The European version of QE is more complex than its American counterpart. The European Union is comprised of 28 sovereign nations, each with its own banking system, whereas the US only had one central bank to work with. 28 different countries means 28 different political interests and clearly things get more complex from there. Figuring out how much sovereign debt to purchase from each country is a complex undertaking. Will each country benefit equally? Will each country feel the program has been handled equitably? The answers to these questions most certainly will be 'No'. How can Greece and Germany be treated equally? Adding to the complexity are the changing governments in each sovereign nation. It will be a struggle to keep up with the dynamic political terrain throughout the as of now 18-month program.

What if Consumers and Corporations Just Refuse to Spend and Borrow?

What no one seems to be addressing is the elephant in the room: What happens if Europeans are just different consumers and businessmen than Americans? Can QE really have a similar effect on different cultures? Europeans borrow and spend differently than Americans. Their mortgages are different and their housing is different. Adjustable rate mortgages are widely used and do not require being refinanced as often. Europeans aren't used to buying new cars every five years. Auto loan incentives may not induce buyers overseas like they do stateside. The corporate and business culture is different as well. European companies are restricted in their ability to fire their workers. High rates of unemployment, particularly among youth, is not unusual, so affecting employment will be muted. In the US, 10% unemployment was considered lofty, and getting it down to historical averages meant getting people back to work who could then become active consumers again. In Europe, it is harder to create more consumers from the ranks of the unemployed.

Boom or Doom?

The immediate fear in Europe regarding its QE program is that bond prices are so high the government will be buying bonds at elevated levels, not giving itself any cushion in the event of a down draft in prices. With rates at historic low levels, and in some cases negative, the ECB may not help but lose money on its purchases. The easy answer to this concern is the ECB can sit on the bonds until maturity.
Many of the concerns that will be analyzed and dissected over the next 18 months are moot. The ECB had to implement some strategy to fend off deflation and get the European Union and its economy back to growth. A weaker Euro should assist in that endeavor. Rates cannot realistically go any lower but the extra liquidity should find its way in to the economy in some form or another. Asset prices should rise and this in itself is a form of inflation and can lead to additional spending by consumers and businesses which ideally will lead to some inflation and hopefully economic growth. In the meantime, it's good theatre for the Americans.