By Don Schreiber, Jr. – WBI Founder and CEO
The modern era of U.S. Federal Reserve monetary policy started with the appointment of Fed Chair Paul Volcker by President Jimmy Carter in 1979. At the time the U.S. was in the throes of Stagflation. Before this period interest rates were set and fixed by Federal Reserve Board action. Volcker allowed markets to determine where interest rates should be. After rates were held too low for too long, Volcker then let rates rise precipitously, thereby reducing inflation pressure. As he raised rates, 10-year treasury yields soared to just under 16% as the stock market faltered.1 Additionally, as inflation pressure eased, Volcker’s Fed turned from tightening to easing to jump-start the economy and lift markets.
The first monetary policy driven Fed “put” was firmly in place, which unleashed a tremendous economic growth cycle and the greatest bull market run in history. The Dow Jones Industrial Average soared from 777 in August of 1982 to 11,497 by the end of 1999.2 By 1996, Fed Chair Alan Greenspan was becoming concerned by overheating in the economy and overvaluation in the markets. He famously suggested investors were suffering from “irrational exuberance,” which he sought to curb by hiking rates. Determined to reel in an excessively easy monetary policy, he started a policy tightening program that eventually raised rates by 176%.3 The Fed tends to raise rates too far and too fast and this time was no different; the economy and markets started to slow, and in early 2000 markets began to crack. The most egregiously overvalued part of the market, the bubble in tech stocks, burst in March of 2000 driving the tech-heavy NASDAQ index to a decline of 77% before hitting bottom in 2002.4
Greenspan then reversed course to support the economy and markets by cutting interest rates, once again installing a Fed “put” through the second half of 2006. Monetary easing paved the way for fast-paced economic growth and positive market conditions until the Fed changed their storyboard by hiking rates to cool the economy. Higher interest rates started to take a bite out of growth by the end of 2007 and markets faltered badly in 2008. The asset bubble moved from tech stocks in the late 1990s to residential real estate and packaged mortgage products by late 2007. As this asset bubble burst, the world was caught in the grips of the 2008 Financial Crisis, damaging economies and markets globally. We see the deflationary effects that were forced into the global economic system by the Financial Crisis still weighing on the world’s economies today.
By looking back, it’s pretty easy to see a pattern of boom-bust cycles developed and driven by Fed Monetary Policy. For the past ten years, the Fed and global central bankers have been forced into a position of massive monetary accommodation, with seemingly no end in sight. Due to a weakening economy, the U.S. Fed seems to have paused on its policy of monetary easing to gradual tightening and just might reverse course altogether. The low economic growth rate in this recovery has limited the economy’s resiliency and ability to absorb the Fed’s tightening program. Concerned investors fled from markets in Q4 2018 as markets dipped into bear market territory for the first time since the 2009 recovery started.5 Against the anemic economic growth backdrop, Fed rate hikes torpedoed a strengthening economic growth trend unleashed by the stimulus from the 2017 Tax Act. Fed Chair Powell, to his credit, reversed course in December of 2018, halting further rate tightening and even suggesting he would be open to reducing the Fed’s balance sheet reduction program to ease liquidity constraints. The Fed has become particularly good at jawboning to calm and support markets. It would seem the Fed “put” is back on for the time being and we expect the markets may continue the positive bull trend that started just before the New Year. However, the strength of the Fed “put” will likely be tested in early April as questionable economic and corporate fundamentals come into focus.
We believe systemic risks lurk just beneath the surface of U.S. markets as economic and corporate fundamentals turn negative. Last year’s blistering pace of double-digit earnings gains is turning into negative forecasts for Q1 2019.6 Stock investors who had previously ignored negative earnings trends, when the Fed was supportive, will have to do so again for the rally to continue. For at least the first half of 2019, negative earnings trends are forecasted to continue. Unfortunately, negative earnings trends that last two quarters tend to continue and have triggered bear markets about 8 out of 10 times since the Great Depression.7
The global economic backdrop is also a land mine of excess debt levels and falling economic trends, which is never a good combination. Euro and Asian economies are faltering and are on the brink of recession, and at the same time, their central bankers are trying to move from negative interest rates and massive quantitative easing (QE) programs to monetary tightening. If a recession ensues, central bankers will face a policy crisis because they likely don’t have sufficient firepower to lower rates further or continue QE operations. They threw the monetary policy “kitchen sink” at their respective economies to get the modicum of growth they’ve had. Sadly, we think it unlikely the U.S. economy will be immune to the recession flu suffered by its major trading partners.
Trade wars put even more pressure on faltering economies and without quickly achieved resolutions economic conditions will deteriorate more rapidly than otherwise would be the case. Even with central bankers’ attempts to control markets, the U.S. bull market is beginning to unravel. The earnings recession of 2015 and 2016 caused two 10% corrections and the forecasted economic and fundamental weakness at the end of 2018 drove most market averages into bear market territory, down approximately 20% or so.8
The main point is that economic risks abound. The Fed and Central Bankers are artificially manipulating the markets, walking a very slippery tightrope attempting to maintain positive consumer sentiment and spending which drives the majority of economic growth and momentum. Let’s hope consumers continue to believe in the “everything is ok” fallacy because the alternative is much too scary to contemplate. Hope floats — delusion and denial seem to be the only choice we have.
Over the past several years we have adjusted to central bank intervention by improving our Power Factor ® security selection models to participate more fully in upmarket trends. We also allow portfolios to get more quickly invested from a high cash position to improve performance potential. At the same time, we have refined our stop-loss process, where applicable, to improve loss protection by parabolically adjusting stops as we achieve goals. We feel these tweaks to our risk management process allow us to harvest more gain and to reduce loss. As investment managers, who manage risk to capital as our first priority, we try to stay anchored in reality while keeping a tight trigger on stops to raise cash in the event “Fed Speak” doesn’t continue to shine with investors and markets stop their upward trend.
Important Information
Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr., and should not be construed as investment advice. Don Schreiber, Jr. or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.
The WBI Dynamic Trailing Stop (DTS) is not a stop loss order or stop limit order placed with a brokerage firm, but an internal process for monitoring price movements. While the DTS may be used to initiate WBI’s process for selling a security, it does not assure that a particular execution price will be received.
Stagflation is a condition of slow economic growth and relatively high unemployment, or economic stagnation, accompanied by rising prices, or inflation.
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SOURCES
1 Mislinksi, Jill. “Treasury Yields: A Long-Term Perspective”. Advisor Perspectives. Feb. 5 2019.
2 “Closing milestones of the Dow Jones Industrial Average”. Wikipedia. Feb. 19 2019.
3 “Federal Funds Target Rate-Upper Bound”. Bloomberg. Nov. 7 2018.
4 Glassman, James K. “3 Lessons for Investors From the Tech Bubble”. Nasdaq.com. Feb. 11 2015.
5 Rooney, Kate “We are now in a bear market — here’s what that means.” CNBC.com. Dec.. 24 2018.
6 Domm, Patti “More Bad News: Street Sees Q1 Profits declining and full-year growth rates cut in half” CNBC.com. Feb. 5 2019.
7 Ponczek, Sarah “S&P 500 Rally Hits a Wall as Earnings Estimates Are Fading Fast”. Bloomberg.com. Feb. 8 2019.
8 Darie, Tatiana “Wall Street Is Split on Profits: Does an ‘Earnings Recession’ Loom?”. Bloomberg.com. Feb. 16 2019.