The only “cure” the Fed had left was to drive us to socialized markets. Participants are simply debating the price to pay for stocks under the new regime. Now they want to mark up the big cap darlings and fade everything else, but that might change.
While the Fed is in the process of throwing trillions of dollars at the economy, GDP is collapsing at a record pace. It is a battle between these forces for now. Low money velocity, which has been in a downward trend for years, will offset the growth and inflationary effects of that newly created cash to some degree.
We have seen that over time rapid money growth loses its ability to drive stock prices higher in both Japan and Europe. In the U.S., were it not for corporate stock buybacks of $4 trillion in this cycle, investors would have figured out long ago that the Fed has much less power over their fortunes than many believe. Mean reversion has been tested to the extreme. The “this time is different” crowd is still winning. Earnings growth is falling significantly, but stock prices are rising. Talk about a big bet on future growth!
Investors are now betting that we can all ride out the current economic depression at the most expensive valuations for large caps ever seen simply because the Fed has gone full lunatic. However, even with the Fed’s support, history has shown investors still tend to run for the hills once risk aversion takes over. Profit reports over coming quarters might just be too tough a reality for the big cap bulls after pretending that a return to peak earnings is a done deal. Based on the damage to GDP, earnings in the coming quarter could collapse 50% or more.
All it has taken to prove the failure of Fed policies of the last decade was the current emergency push into the virtual nationalization of the U.S. economy to keep the system afloat. We would not have been this close to the brink if we had had our ducks in a row prior to this crisis. Our leaders are weak and seek easy answers to the point of being beyond ridiculous. Just borrow trillions more and let the Fed buy it to make the bad stuff go away.
The Fed has been looking for a chance to expand its reach for years because it knew that the heavily levered financial system it created would one day need enormous support to keep it afloat. The virus has simply provided that avenue. The move further into socialism that the powers that be are conducting is not good for long-term returns on invested capital. It may feel good for a short while, but it has pushed expected returns for large cap U.S. stocks to near zero again.
Those now calling for the Fed to begin its promised purchases of corporate bonds and ETFs ought to re-think that idea. The Fed should not be in the corporate bond market in a free market system. It is trying to skirt the law by setting up a special-purpose vehicle. This country made it through many tough times over the decades without Fed involvement in private bond markets. Bankruptcy does not mean companies shut down and fire all employees. They usually restructure and move on. The rule of law dictated how this process played out and it kept the system free of government involvement.
The Street is now begging the Fed to start buying corporate bonds because it knows current spreads do not pay them for the risks of this environment. Therein lies the risk mis-pricing problem the Fed has created. The same is true in stocks. Talking heads are dismayed that Buffett sold stocks and did not commit serious capital during the March swoon. He could not find anything cheap because the Fed got in the way. That left the market to the new generation of investors who do not place much credence on valuation as a guide.
Just remember, if the Fed had not spent the last decade destroying capitalism, you might be buying Treasuries at 3% or higher yields instead of corporate bonds at absolute yields below that level. True, if you do your credit work, they should beat Treasuries, but longer term the return profile of your portfolio is not exciting. It is just one example of how Fed involvement feels good in the short-term, but leads to lower future returns. The same thing applies to stocks. Current investors in the S&P 500 should expect returns near 0% over the coming 10 years based on valuations.
We still think the recovery will prove to be long and uneven, but even if the 30 million newly unemployed return to work today, large cap U.S. stocks are as expensive as they have ever been and offer annual returns close to zero over an investment horizon of ten years or more. It is important to focus on that math as difficult as that might be, especially when so many pundits and investors seem so confident that they can’t lose in the S&P 500.
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.