QE2 And Midterm Election Positions
November 01, 2010
In advance of the most news-filled week of the year—between the mid-term elections on Tuesday and the Fed’s monetary easing announcement on Wednesday—we offer our thoughts on the following investment questions:
Stocks have been up for eight consecutive weeks, and the S&P 500 has gained 13%. What has been driving the rally in the stock market?
Since Fed Chairman Bernanke unexpectedly announced plans for another round of quantitative easing (i.e. asset purchases funded with newly printed money) in late August, the stock market has been in a virtually uninterrupted advance. The anticipation of this monetary stimulus, rather than substantive improvement in the economic backdrop, has been the predominant factor driving the recent stock market rally. How do we know this? Because commodity prices, foreign currencies, and inflation expectations have ramped upward over the past two months in approximate proportion to the gains in stocks. In other words, U.S. stocks have made negligible upside progress relative to commodities and foreign currencies.
Is the stock market poised to “sell the fact” of the Fed announcement, after having “bought the rumor” over the past two months?
Although a number of Fed governors have voiced strong dissent to further quantitative easing, the Fed is universally expected to formally announce “QE2” at the conclusion of this week’s FOMC meeting on Wednesday. Ben Bernanke and other Fed officials have signaled this intention to the markets for two months. The only open question at this point are details of the program – its size and timetable and the degree to which it will conditioned upon economic conditions. Given that expectations of QE2 on a robust scale (i.e. $500 billion or more) have likely been priced into markets, we could be in for a classic case of “sell the fact” after the announcement, especially if the Fed decides on a more cautious, incremental approach. It would be pure conjecture to predict what the FOMC will announce on Wednesday, and how the market will react to the announcement. It is far more prudent to wait until after the fact to assess the announcement and the market’s reaction.
Are there other reasons to expect a fourth quarter correction?
Stocks are overextended after eight straight weeks of gains, and certainly due for a correction. Investor sentiment has become complacent and over-bullish on a short-term basis. For example, the percentage of bears in the most recent American Association of Individual Investors survey slid to 22% -the lowest level in more than three years (Exhibit 1). Our best guess is that an interim peak will be to be established in the next week or two, followed by a 5% to 8% correction.
What is the Fed trying to accomplish with QE2?
QE2 is merely the latest example of the Fed manipulating asset prices under the spurious premise that this will bring down the unemployment rate. We have written extensively about our view that Fed policy has been misguided since the late 1990s and the source of many of the problems that have afflicted the U.S. economy over the past fifteen years or so. It is frankly shocking that more voices are not now being raised in objection to Fed policy, which today (1) specifies higher inflation as a policy goal; (2) imposes negative real (inflation-adjusted) yields on bond maturities out to five years—a confiscatory policy for anyone seeking to protect purchasing power in high-quality fixed-income assets; and (3) accelerates the demise of the U.S. dollar as the dominant reserve currency.
The distortions in the bond market created by Fed manipulation have become truly mind-boggling. A case in point is the current 5-year TIPs bond yield of negative 0.46%. Between yield suppression through quantitative easing on the one hand and inflation targeting on the other, the Fed has engineered an environment where bond investors are all but guaranteed to lose purchasing power in fixed income investments. Thankfully, some prominent commentators are drawing attention to this deplorable state of affairs. PIMCO’s Bill Gross, in his just-published November investment outlook, described U.S. fiscal policy as a Ponzi scheme, called the Treasury bond market a “turkey” of an investment (Exhibit 2), and predicted that QE2 would be the last chapter in the 30-year bull market in bonds.
We agree with Gross’ assessment, but as always, the timing is tricky. It is entirely possible that the Fed will be able to sustain its manipulation of the bond market until one of the following events comes to pass: inflation becomes an undeniable problem, or there is a crisis of confidence in the U.S. dollar and U.S. government finances.
What does QE2 imply for the stock market?
It is hard to imagine a Fed policy more inviting of risk-taking in the stock market. The purpose of QE2 is to further suppress bond yields and force investors into riskier assets. With negative real interest rates not just on cash but on short maturity bonds, and with the Fed now openly targeting higher inflation and preparing to pump hundreds of billions of dollars of new money into the financial system, stocks will likely retain an upward bias into the first half of 2011. Investors will feel impelled to bump up their stock allocations because the Fed has created an environment that provides no low-risk options to maintain their purchasing power. Our best guess is that following an interim peak in early November, there will be a stock market correction that will probably only take the S&P 500 down to the 1125 area. This was the key resistance level during the midyear stock market correction and should now serve as strong support. For investors inclined to play the QE2 rally, this would be a reasonable place to add to equity exposure. Despite the tailwind to stocks from quantitative easing, we do not think a strong bull market is getting starting, and we think the upside potential in 2011 will be considerably less than the 20% gains that have been typical in the year following mid-term elections. Investors should recall that this recovery, and years one and two of this election cycle, have been anything but typical.
Everyone on Wall Street is aware of the remarkable historical record for Year 3s (i.e. the year following the mid-term election) of the four-year Presidential Cycle. In the past 19 election cycles -going back to FDR -there has not been one bear market in Year 3 of the Presidential Cycle. In addition, the upcoming six months from November through April are seasonally the strongest for the stock market. Taken together, the next three quarters, including the quarter currently in progress, historically provide three of the four biggest quarterly gains over the past 20 election cycles since 1929, with average returns of 5% to 6% per quarter (Exhibit 3).
Those are not the sort of odds you want to bet against, especially with a Federal Reserve pursuing asset price inflation as a method of stimulating economic activity. That said, we admit to being somewhat skeptical that election cycle and seasonal trends will play out at neatly and profitably as the historic record would suggest. The stock market has already rallied in anticipation of QE2 and it is hard to conceive that fiscal policy could provide any more stimulus in 2011, given our deficit of $1.3 trillion in fiscal 2010. It is futile to make any sort of longer term stock market predictions in an environment like this, with so many risks surrounding government policy, so we prefer to take it one month at a time.
Over the late spring and summer, markets were worried about the risk of a double-dip recession in the economy. In the past two months, as the economic data have marginally improved and the Fed has laid the groundwork for more monetary easing, markets have quickly priced out the risk of a double-dip. The Economic Cycle Research Institute (ECRI), whose widely followed leading economic indicators had for months been signaling an uncomfortably high degree of recession risk, just last week asserted that recession risks are off the table for the foreseeable future (for ECRI this implies the next two to three quarters):
“The good news is that the much-feared double-dip recession is not going to happen. That is the message from leading business cycle indicators, which are unmistakably veering away from the recession track, following the patterns seen in post-World War II slowdowns that didn't lead to recession. After completing an exhaustive review of key drivers of the business cycle, ranging from credit to inventories and measures of labor market conditions, we can forecast with confidence that the economy will avoid a double dip. But the bad news is that a revival in economic growth is not yet in sight. The slowing of economic growth that began in mid-2010 will continue through early 2011. Thus, private sector job growth, which is already easing, will slow further, keeping the double-dip debate alive.”
That doesn’t strike us as a particularly sanguine outlook, especially given how dependent the economy is on public spending, transfer payments, and monetary easing. Given the scope of government support for the economy, the underlying fundamentals are largely unfathomable. Until we see evidence of sustained private sector job creation and less dependence upon government stimulation, the economic recovery rests on an insecure foundation. However, given that many investors have been worried about a double-dip in the economy, ECRI’s forecast, if it is accurate, is a positive factor in terms of the stock market outlook.
What is the likely impact of the elections on the markets?
For months, markets have anticipated that the Republicans will gain control of the House of Representative and that this will result in more business-friendly government policy. Practically speaking, it is highly unpredictable what government policy will look like following this election. It seems doubtful there will be meaningful change, particularly as it relates to the paramount issue of getting the country’s fiscal house in order on a longer-term basis. Unless circumstances drastically change, the political climate simply doesn’t exist to enact serious reforms. Pragmatism, bi-partisanship and compromise will be in short supply, and most likely very little will get done. Markets may perceive gridlock as a positive for awhile, but time is running out to fix America’s fiscal mess, and if the government “kicks the can down the road” for another two years, we may find that a crisis is inevitable. In the near term, the stock market and economy still have to deal with the major uncertainty surrounding tax policy. Markets could be disappointed in November by a lack of legislative action on extending the tax cuts due to expire at year end (lame-duck Congresses rarely get anything done). At present, the top income tax rate is due to rise to 39.6%, the capital gains rate will rise to 20%, and dividends would revert to being treated as ordinary income.
Is it time to take profits in gold?
Gold is up 24% year to date, and is up 17% since its late July low at $1160. This is clearly not a low-risk time to be adding to gold positions. However, given government policies of currency debasement, we do not think it is time to take profits in core gold investments. Despite the fact that gold has risen for ten consecutive years, the end of the secular bull market in gold is probably still several years from now. We may well be entering the endgame for the U.S. dollar as the world’s dominant reserve currency, and the other major currencies in the world do not inspire confidence. Gold is rightly seen as an alternative to paper currencies and an attractive store of value. We expect the U.S. dollar price of gold to rise to at least $2,000 over the next two to three years.
Apart from gold, which areas of the financial markets appear to offer the best risk/reward characteristics on a medium to longer-term basis?
We continue to like high-quality U.S. stocks—large-cap companies with global franchises, solid balance sheets, and consistent earnings and dividends. The best ETF vehicles for accessing this asset class are the Vanguard Dividend Appreciation ETF (symbol: VIG) and the WisdomTree LargeCap Dividend Fund (symbol: DLN). We also favor emerging markets stocks— accessed through a core position in the Vanguard Emerging Markets ETF (symbol: VWO) and a complementary position in the dividend-weighted WisdomTree Emerging Markets Equity Income Fund (symbol: DEM). There is a tendency to extrapolate the problems of the U.S. to the rest of the world, but most emerging economies are experiencing dynamic growth and are in much better fiscal shape. Given that emerging markets account for 40% of global output, and emerging markets stocks account for 16% of global market capitalization, investors who are underweight emerging markets in the equity portion of their portfolios (i.e. emerging markets represent less than 16% of their stock allocation) should view global market sell-offs such as what we experienced in early summer as an opportunity to rebalance portfolios towards emerging markets investments. Emerging markets stocks are up nearly 30% from their early summer lows, so investors should wait for a correction of 10% or so to consider adding to positions.
J.D. Steinhilber is president of Agile Investments, a Nashville, Tenn.-based adviser. He can be contacted at: firstname.lastname@example.org.