The markets have just finished putting in the best quarter since 1998. How do you know? All you had to do was flip on a television, pick up a paper or scroll internet headlines. The media has been abuzz with comparisons and ebullience that the rally was evidence that the economy is back. Unfortunately, the reality is that the outsized rally wasn’t driven by a robust economic recovery, stable employment, fiscal stability, a booming housing market or an innovation wave like we saw in 1998. None of those variables are present in today’s landscape. Instead, the recent surge in the markets was based upon the combined effects of liquidity injections from “Operation Twist” in the U.S. and the “Long Term Refinancing Operations” (LTRO) in Europe. With both of these liquidity injected highs now starting to recede the “addicts” are starting to look for their next hit.
Wall Street was hoping to get their next “dime bag” of liquidity infected goodness at the most recent Fed meeting. Unfortunately, Ben “The Dealer” Bernanke didn’t show and the symptoms of withdrawal immediately hit Wall Street. What is worse is that we now realize that it isn’t just Wall Street that is addicted to the Fed’s “crack” – somewhere along the way the media got hooked too.
As shown in the chart above the current correction is within the confines of the year to date advance. Furthermore, investors should welcome a correction which provides much safer entry points to invest capital into the equity markets. Corrections are a necessary part of a healthy and sustainable bull market advance. While normal market “buying stampedes” generally last for 17-25 trading sessions on average – the most recent was almost twice that long pushing most technical parameters to extremely overbought levels. A correction has been long overdue.
This is why I was floored to see a recent article by Jeff Cox at CNBC which came during the selloff yesterday – “Investors looking for more Federal Reserve intervention can pretty much ignore the economic data and train their sights on one area: the stock market, and how much of a drop it will take before the central bank comes to the rescue.
Though the recent market selloff is worrisome, it could take as much as a 10 percent drop or more before the Fed acts. While central bank action ostensibly is geared toward using monetary policy to control the levers of prices and employment, the era of quantitative easing has brought with it increased focus on how the equity markets push the economy, and not the other way around.
As such, Chairman Ben Bernanke and his fellow Fed officials will be paying great attention to whether the sharp stock decline Wednesday, as well as the market’s generally lackluster performance the past three weeks, signals a need for more stimulus.“
You can almost feel the onset of withdrawal as you watch the media scramble for cover and asking each other how much longer until the next “fix” will arrive – a 5% decline or a 10% decline? The reality is that during normal, healthy, bull market cycles corrections of 10% are very common – not a sign of needed liquidity support. That is, of course, in normal and healthy bull markets. Today, the Fed must withdraw the support long enough to determine whether or not the economy, and the markets, can function on their own. They have found out the last two times this was not the case. Maybe this time will be different?
Furthermore, “the era of quantitative easing” while fueling rises in the stock market, primarily in junk assets, has not pushed the economy contradicting what is widely believed.
As opposed to 1998 – the environment today is not one driven by fiscal stability, 5% deposit rates, an innovation wave, full employment, a booming housing market, easy access to credit or a strong economic growth environment. After Trillions of dollars of injections at this point from bailouts, two rounds of QE, Permanent Open Market Operations, “Twist”, HAMP, HARP, Bank “Fraudclosure” settlements, etc. – we should have witnessed a much greater recovery that what we have seen to date. The message being sent by the economy, and missed by the mainstream media, is that IF the economy was truly recovering and the “underpinning for that all-important virtuous cycle that Mr. Bernanke and all economists talk about.” were truly in place – there would be NO NEED for further easing and liquidity programs. The fact that Wall Street, and now the media, have become hooked on QE to give them their daily dose of “happiness” is testament in itself of the real issues that we face going forward.
As we discussed in our recent post on the current bull market cycle – the advance from the 2009 lows has been almost entirely driven by liquidity programs. Each time (2010 and 2011) that the liquidity pump has been withdrawn from the markets there has been a near 20% decline. Therefore, the likely conclusion of this bull market cycle, when it occurs, will likely be just as nasty as the last two if history serves any guide as to the effects of mean reversion.
It is entirely obvious that we are in a race against time. There has been diminished effects from each liquidity program on both the economy and the financial markets to date. The problem is that the Fed cannot continue injecting liquidity into the markets indefinitely. There are limits that will be reached before a complete and irreversible overdose occurs. The simple truth is that while bull markets are indeed much more enjoyable than bear markets – the long term effects from a drug induced euphoria, which are widely debated but unknown, may make us all wish we had gone to “rehab” sooner.