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There is an old adage in the investment business that states “Don’t Fight The Fed.” Martin Zweig was a famous investment manager back before most of today’s investment managers were alive or in the business – just like me except for the famous part 🙂 He coined this phrase when he appeared on a PBS show called Wall Street Week, and he meant was that when the Federal Reserve starts to ease or tighten monetary policy it is a powerful force that impacts the stock market that should not be ignored.
Back when Martin Zweig was alive and trading, the Fed used very traditional monetary policy moves like raising and lowering the Fed Funds Rate (the rate of interest banks pay to borrow overnight from the Fed). Those tweaks were enough to adjust the economy from being too sluggish or too overheated toward a more middle of the road level of economic activity. Today, we have a very different situation.
When we were in the midst of the 2007-2009 subprime mortgage loan induced stock market crash, the Federal Reserve lowered interest rates to zero percent in order to juice the economy toward recovery. Unfortunately, it was not recovering fast enough or with enough strength, so they adopted the novel step (copied from Japan) of buying government bonds as a way to get additional liquidity into the financial markets. What we found was that the financial markets became addicted to the liquidity, and as the Fed attempted to stop buying bonds for an extended time, the stock market would go down. We thus entered into a vicious cycle where our financial markets became addicted to the mainlining of liquidity that found its way into the stock market.
The graph above (courtesy of the Calculated Risk blog) shows you the ups and downs of the market during the six years of Quantitative Easing (the name of the program for the Fed’s bond buying activity) and how the stock market reacted when it was happening and when it ended.
You may have two questions at this point – we have addressed both over the years here on the blog, but you may be a new reader or just don’t recall the conversation, so let me give you the readers digest version:
(1) What is the source of the liquidity? Where does it come from? In order to buy the government bonds, the Fed buys the bonds from investment houses by crediting their accounts for the cost of the bonds – the tricky part is that they do not have the money on hand to pay for the bonds so the in essence print the money in digital format. This puts more money into the financial system than previously existed, expanding the liquidity in the economy; and
(2) How does the liquidity get into the stock market to push it higher? With interest rates so low, corporate America was able to borrow billions of dollars each year at minimal interest rates. They would use that money to buy back their own stock from their shareholders. Those buyback programs created demand for stock that was not otherwise there and it allowed the companies to show increasing earnings per share even though in most cases their earnings we the same or less than in previous years. How does that work? Here is an example: if a company had 100 shares of stock outstanding last year and they by back 20 shares this year, there are now only 80 shares held by the public. If last year their total earnings were $400, then their earnings per share were $4, but if this year their earnings are the same $400 then their earnings per share are $5 as they only have 80 shares to spread the earnings over. It makes it look like the company is performing better when in fact they are stagnant.
The graph above (courtesy of the Visual Capitalist blog) shows you the impact of stock buybacks on the stock market. There has been a direct correlation between the stock market’s rise and the amount of stock being bought back by companies – in fact, in many years, the buybacks were the only reason the market was positive.
So why the trip down memory lane? Because last September, the Fed restarted its quantitative easing program when the first sign of economic problems arose (the collapse of the Repo market, another item discussed in previous blog posts that I won’t bore you with again) and they accelerated it in the past several weeks in concert with the covid-induced economic shutdown/collapse. However the extent of this buying spree known as QE4 (the middle graph above shows the previous cycle ended with QE3 in 2015) dwarf the previous programs.
The graph above (from the Kass Daily Diary) shows that the Federal Reserve has bought more treasuries in this QE4 than have been issued by the Treasury Department. Meaning that not only are they buying newly issued treasury securities, they are buying outstanding securities from individual holders all in an effort to inject liquidity into the financial system to keep us from experiencing a 1930’s-style depression.
If the top graph doesn’t convince you of the size of the QE program, then maybe the graph below (from the Kass Daily Diary) will help.
This graph shows you that the Federal Reserve owns 70% of all outstanding Treasury Bonds maturing in 2039 to 2041. This is an enormous amount of money that was created out of thin air and digitally inserted into our economy.
So where does the Don’t Fight The Fed? part come in? As you can tell from the middle chart above, the smaller in amount previous QE’s made their way into the stock market through corporate stock buybacks. The question we have this time is whether corporations will repeat their behaviour or will they be more frugal. The subprime mortgage market crash was a completely different economic event from the covid shutdown crash. The current crash came from a nearly complete end to many businesses revenue streams – companies had to scramble for access to credit lines to remain open.
Gone were the days where they had cash reserves on hand to get through economic slowdowns – they had been taught that cash was a non-earning asset and that Wall Street analysts wanted to see stock repurchase programs with any excess liquidity in order to keep their stock on analyst’s Buy List. CEO compensation was structured around stock prices continuing to move higher and if earnings are flat and cash reserves earned zero, then stock buyback programs were the only avenue to pursue.
I think we have seen a structural change in how corporations will operate. Cash reserves will again become fashionable – and maybe even graded positively by the analysts. Many other changes are likely in store as well: downsizing real estate needs given the positive experience of having a large percentage of staff working from home; moving overseas manufacturing facilities back to North America where the companies have more control over their operations; less reliance on just-in-time inventory being shipped from Asia and more reliance on keeping inventory on hand in domestic factories, to name three.
The graph at the opening of this post should be familiar to those of you who have been reading the blog over the last year. I started posting this as the megaphone pattern developed in late 2018 and early 2019 and have updated it as the market has moved forward in time. You will recall that after the crash, I drew in the various shaded areas to give you a feel for where the market would likely go post-crash along with weighted chances for the different scenarios. Fortunately, we followed the scenario that I weighted 75% chance of occurring and the market bounced off that level and moved up to the Relief Rally Target Zone. You can see I drew some arrows in on a potential path for the market over coming months, and it has adhered to that path somewhat so far. The important thing to remember from past discussions is the importance of the Relief Rally Target Zone – this is where the battle will be fought to determine if we get a second leg down to retest the lows, if we move sideways in and out of the zone building a trading range for an extended period of time, or head higher sooner rather than later based upon the economy improving faster than anticipated.
So far, I’d judge this as a market trying to develop a trading range. It may be tough to see the price line on the graph but it is the combined red/black line that represents the weekly performance of the S&P 500 Index. That line had moved nicely above the zone but is now trading back in the middle of it. Even though we are getting some very positive economic readings from employment, manufacturing, and retail sales, it is critical to remember that these are off severely depressed levels. We still have 45 million people unemployed (an closer to 60 million if you include small business owners who cannot reopen their businesses), we have factories operating a partial capacity if they are even open yet, and we have multiple bankruptcies and even more downsizing/store closings across the nation in the retail industry.
There is a definitely tailwind to push the market higher in the form of the largest Federal Reserve monetary policy operation in history, however the primary buyer of stocks in the form of corporate buybacks may not materialize as they once did – at least not in the short-term. Because of this, we maintain our cautious buy invest strategy, ready to raise cash if the direction of the stock market looks to deteriorate but remaining invested for the continued recovery in stock prices.
Keep track of the blog as we will post updates as major things happen or as information becomes available pertinent to our investment management activities and our clients benchmark beating portfolio performance.