December 26, 2018
There were two clear paths the Fed could have taken last week, and they clearly chose the wrong path. How a central bank can, on the one hand, lower their own growth forecast for the economy and then, on the other hand, rationalize raising interest rates against a frayed market landscape, escapes my understanding. Even worse, Fed Chairman Jerome Powell laid an 800-pound egg at his post-FOMC news conference in his Q&A, where few, if any, sensible questions were asked by the financial media. Instead, it was a Swedish meatball session, similar to an Obama press briefing. Why so remains anybody’s guess.
Powell ‘deep-sixed’ the stock market during his press conference, when he said, policy does not need to be accommodative now, and that he doesn’t believe the current policy is restrictive. He added that he does not see the Fed altering its approach to balance-sheet normalization and sees the preferred policy method being the use of the fed funds rate.
This poppycock runs counter to what both the bond and stock markets are voicing out loud. Doubleline’s “bond king”, Jeff Gundlach, laid it out very clearly in a long interview on CNBC before the FOMC met. He noted that ever since the Fed began its Quantitative Tightening (QT) initiative in October 2017, the Fed has shed around $365 billion of its $4.14 trillion off its balance sheet. His models suggest that every $100 billion in QT is the equivalent of a quarter-point rate hike. So, adding up the nine rate hikes since QT began, plus the impact of QT, the market has had to absorb the equivalent of around 13 rate hikes.
Why the Fed hasn’t factored in the negative effects of that “sucking sound” of money coming out of the system truly escapes not only Gundlach, but anyone who has a working knowledge of the economics of liquidity. Without a full-blown white paper to back up my assertion, it seems to make obvious sense that the sinking S&P 500 seems at least somewhat linked to the Fed’s balance sheet policy. After all, from 2009 to 2012, the Fed was slowly growing their balance sheet as stocks were moving significantly higher.
When the Fed really embraced QE in late 2012, the balance sheet expansion (blue line below) increased dramatically and stocks diligently rallied. From 2015 to September 2017, the Fed stopped growing the balance sheet; but then in October 2017, the Fed started decreasing their balance sheet by up to $10 billion per month, which changed to $20 billion/month in January 2018, then $30 billion a month in April to $40 billion a month in July and then to its present rate of $50 billion per month in October.
And then it got worse. As last week went on, the Fed trotted out New York Fed President John Williams on Friday morning, when the 25-year Fed veteran offered a seemingly more dovish-minded perspective by saying in a CNBC interview that the Fed is listening to the market and that a balance sheet runoff is not ‘inflexible.” Those remarks triggered a brief rally, but true to recent form, there was selling into strength. Clearly, the Fed was trying to walk-back their dot-plot-robot mentality, displayed fully on Wednesday, but all that did was give the impression of “Amateur Night at the Chinese Fire Drill.”
The Fed’s credibility went straight out the window and stocks tumbled again, making it the worst week on Wall Street in 10 years. This ranks right up there with the worst plays ever, right up there with Miami Dolphins kicker Garo Yepremian’s epic attempted throw in Super Bowl VII. This was especially true for me when Dallas Fed President Robert Kaplan made a big deal on a CNBC interview on December 6, stating that “one of the key tools we have with the Central Bank is patience, and I think we ought to be using that tool.” Being that Kaplan is a voting member, investors took his comments to heart. What a Benedict Arnold move on his part, talking up a Fed that is “feeling the market” and then voting behind closed doors in “lockstep fashion” to raise interest rates. The retail world calls it “bait and switch.”
How arrogant and hypocritical – and most of all, damaging to the public trust. This kind of shameful public display is akin to “deep state” machinations, sandbagging the investing world to create upheaval.
There is no way I can be convinced that waiting on further economic data and corporate guidance from fourth quarter results – all of which is crossing the tape in the next 45 days – wouldn’t have been the intelligent move. Even former Treasury Secretary Larry Summers, a big Trump opponent, agrees.
The Writing is on “the Wall” (and other charts)
You’d think for just one time that the Fed would have taken a more macro view of the economic situation. Some other chafing elements that weighed on investor sentiment last week included the likelihood of a government shutdown due to disagreements over funding a border wall, which happened late Friday.
Add to that a bothersome sense that the U.S. and China aren’t going to be able to reach a trade agreement on structural issues in their prescribed 90-day window and the growing understanding that credit markets appear to be anticipating a growth slowdown due to tighter monetary policy that is being heavily priced into falling oil price ($45.59/bbl) and copper ($2.67/lb), which fed into those growth concerns.
All this uncertainty, and the inability to sustain any rebound effort from short-term oversold conditions, ultimately held back any sustained buying interest and led to a flight to safety in U.S. Treasuries. The Fed-sensitive 2-year yield and benchmark 10-year dropped 10 basis points each to 2.63% and 2.79%.
At this juncture, there are two charts that matter from my perspective. First is the 5-year chart of the S&P 500. The major bull-trend line that is still rising comes into play at 2,350, which the market could very well test in the days ahead. That’s about 2.7% lower than where the S&P closed on Friday (2,416).
The second chart is that of the CBOE Volatility Index (VIX), which closed at $30.11 Friday, signifying sentiment moving from concern to fear to panic. Market technicians will state that such a spike in the VIX marks capitulation and, given how some of the best-of-breed stocks traded late last week, I would agree.
Because the final week of the year is going to be where trading could be thin, further high levels of volatility are almost a given, and if the S&P tests 2,350 the VIX will likely trade higher as well, or a post-Christmas bargain hunting scenario unfolds that would likely begin to define a bottom.
And now for some year-end numbers to stew on.
According to the latest weekly FactSet Earnings Insight report (December 21, 2018), the forward 12-month P/E ratio for the S&P 500 is now 14.2, assuming the S&P will earn the consensus forecast of $175.50 a share. This P/E ratio is below the 5-year average (16.4) and below the 10-year average (14.6).
For 2019, the estimated earnings growth rate for CY 2019 is 7.9%. The estimated (year-over-year) revenue growth rate for CY 2019 is 5.3%. All 11 sectors are expected to report year-over-year growth in revenues, led by the Communication Services and Healthcare sectors.
The Industrials sector is expected to report the highest year-over-year earnings growth of all 11 sectors at 11.4%. The Consumer Discretionary sector is expected to report the second highest year-over-year earnings growth at 9.8%. Despite concerns of rising costs, the estimated net profit margin (based on aggregate estimates for revenues and earnings) for the S&P 500 for 2019 is 11.8%. If 11.8% is the actual net profit margin for the index, it will mark the highest (annual) net profit margin for the index since FactSet began tracking this metric in CY 2008. Eight of the 11 sectors are projected to see higher net profit margins in CY 2019 relative to CY 2018.
Numbers can, and will, change going forward, but using the current data, equity valuations are pretty compelling at these levels. Now is when investors should consider seriously upgrading their portfolios – selling any second- and third-tier companies and buying into the thoroughbred blue-chip dividend-growth stocks that have been taken down with the broader market. This is a time-tested ‘cut-and-build’ strategy that only comes along once about every five to 10 years. And now is one of those times.