The Fed is very confused because it now realizes that what we have been warning about for years is taking place. Normalizing monetary policy is impossible because the financial system has become completely dependent on its ridiculous liquidity support efforts of the last decade.
The fed funds rate on an inflation-adjusted basis is close to zero after a couple hundred basis points of tightening, yet Powell and Co. are feeling compelled to re-think plans about future policy. It used to take 2-3% real rates to slow the economy. However, because of the damage done by years of ultra-easy policy, GDP growth potential is not what it used to be. Enormous levels of debt have been accumulated on an aggregate basis at an unsustainable pace and now must be serviced. That is a big burden for the economy to carry.
Given the alternatives, we have no problems with a pause in further tightening if it means the Fed would just step to the background. That is likely wishful thinking on our part. A less active Fed would force market participants to figure things out for themselves and weigh risks with the notion that the central bank will not provide a backstop. At the same time, if it remains too restrictive now, that might mean that it would ultimately turn to aggressive measures like more QE in response to recession fears. Avoiding that is the other potential benefit of waiting for a while.
As it stands, the Fed over-reacted to year-end pressures in the markets as numerous players needed to shrink positions by 12/31 at a time when buyers are usually scarce. It went too far into the dovish camp. The arrival of 2019 alone would have caused the extremely oversold markets to rally without the Fed becoming so clearly an enabler of unstable market dynamics. Now it is has trapped itself into a clear stock price-supporting function.
Weakness emanating from China is impacting businesses everywhere. While the U.S. economy is weaker than it had been a few months ago, it is able to stand on its own two feet. Investors should learn to do the same. Short-term, momentum investing has caused them to become as impatient as we can ever recall.
The major net buyers of stocks in this cycle have been companies themselves as they managed their EPS in the low growth environment and made sure executives’ stock options were in the money. At the same time, investors gravitated in a big way away from active management to passive indexing and ETF’s, causing stocks that dominate the major indices and sector funds to become momentum names that were chased. What this has meant is that buyers who do little or no fundamental analysis have dominated the flows. That is why valuations have approached between two and three times normal.
A few big things get in the way of many investors understanding how overvalued stocks remain. The first couple are the use of forward earnings estimates and pro-forma, non-GAAP numbers. Wall Street’s old habit of discounting peak earnings at peak margins far into the future is the reason stocks typically broadly correct 40% around recessions. At the same time, the debt side of the balance sheet is mostly being ignored. That is leading to enterprise values (stock plus debt) that are commonly north of 15 times EBITDA. That is wildly overvalued versus historic numbers.
We are late in the economic cycle and central banks have exhausted a bag of tricks that proved futile in creating sustained growth and hindered future growth prospects. Equity valuations remain at extreme levels that rival past peaks that were followed by years of poor returns.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.