We entered the last month of the decade with the major stock market indices at new highs: the Dow closing over 28,000, the S&P 500 over 3100, and the Nasdaq Composite over 8600. While market pundits searched for reasons for the euphoria—from expectations of a China trade deal to fading fears of a near-term recession—the real reason may be far more technical: The Fed added significant liquidity.
Before we examine the Fed’s actions, however, let’s look at what the economy is saying. The Astor Economic Index (AEI) is currently reading about “average,” which is significantly lower than a year ago.
Interestingly, despite that economic strength in late 2018, the equity markets at that time were in a tailspin. As we wrote then, it was our view that the strength of the economy meant the market could withstand a correction and bounce back in 2019, and it did just that. Lucky for us as the economic data and the AEI started to roll over and we were able to reduce beta at higher levels.
Now, it might appear to some that the opposite is happening, with a much less robust economy and the markets are “melting up.” Not so fast— it’s time to take a deeper look at what’s behind the rally.
First, an “average” reading for the economy still suggests a positive return for stocks; it just comes with more risk. However, keep in mind that average is just one mouse click away from below average growth where expected returns are less positively sloped. Recent data readings such as GDP, ISM and even Jobless Claims—collectively, the foundation of the economy—show a struggle to break away from long-term averages. Employment, of course, has been exceptionally strong over the long-term average (over the past 5 yrs or so). However, even there, the longevity of the trend means that when minor weaknesses are first detected, they’ll likely have a bigger impact. This is what is unique about the way that Astor looks at economic data—on a relative basis over long-term averages.
The Fed in Action
Now that we have a handle on the economy, let’s return to our discussion about the Fed and liquidity. A persistent, but little-discussed, problem occurred in the overnight funding market. (The repo market in late September and into October, a shortage of “overnight funds” (balances that banks trade with each other to square up their balance sheets) sent the overnight “repo rate” to nearly 9%. Mind you, this was not a financial crisis, but a technical glitch, due largely to the fact that banks are required to keep larger balances these days, plus an unanticipated substantial corporate liquidity need.
The Federal Reserve responded by adding liquidity—not just once, but with a commitment to keep doing so to promote stability. As Fed Chairman Jerome Powell said in a speech in early October, “It is clear that without a sufficient quantity of reserves in the banking system, even routine increases in funding pressures can lead to outsized movements in money market interest rates.”
The Fed emphasized that these were “technical measures”, and not the “quantitative easing” that occurred during and immediately following the financial crisis to promote liquidity and get the economy growing again. Powell might not to call it QE but, in my opinion, it is having a similar impact on stock prices. There is no denying that the Fed is pumping a significant amount of liquidity into the system, the effects of which (intended and unintended) are difficult to articulate. But perhaps a large financial institution that engages in arbitrage now has more leverage, or institutional traders can more easily manage their positions as the added liquidity somehow creates opportunities. Whatever the result, there is no doubt that more liquidity in the system has boosted the market.
The effects may be difficult to articulate but, as they say, a chart is worth a thousand words.
Is it a coincidence that money supply growth appears to be 90% correlated to the rally in the stock market over the past few months?
While I am not a market timer and do not engage in short-term predictions, I can’t help but question the link between the Fed’s actions and the stock market rally. With the AEI at “average” and with data unlikely to show improvement in the near term, higher stock prices are to be expected; however, the magnitude seems unrealistic. If the market has moved to new highs largely because of “technical measures” by the Fed, without the correlating improvement in economic data then how sustainable would that move really be?
To be very clear, though, I am not suggesting that we’re headed into a bear market just yet, nor have we, at Astor, changed our opinion about being long stocks. With the economy growing, higher stock prices are to be expected.
However, as we head into 2020, a trade deal with China appears to be uncertain and could even be more disruptive than first suggested. Interest rate policies seem unclear and subject to change quickly based on factors not considered in the past.
The impeachment process (no matter what side you are on) can begin to shake confidence in the system and alter some of the policies either in place (which some might like) or expected to be reversed (as some might be hoping). Elections are always a time of uncertainty, which is further exacerbated by the huge Democratic field. There may even be some uncertainty for the Republican nominee, which adds more drama.
What Does This All Mean?
We are headed for serious uncertainty and the stock market does not like uncertainty. So, here’s what we know: The recent rally is hard to connect to improving fundamentals and appears to be connected to Fed action. Given the current fundamentals positive returns for stocks seems likely. However, the slope and magnitude recently seem out of line., Therefore, the likelihood of solid returns will be relative to when you measure the return start date. Negative returns from current levels would still be considered positive returns when compared to 12-18 months prior. To our way of thinking, holding equities still makes sense even if we return over 1 to 3 years are a much more realistic view.
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The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data.. All conclusions are those of Astor and are subject to change.