We ask those that think this landscape is normal what might happen if the Fed stepped away from its recent absurd involvement in the repo market where it now regularly lends $50-80 billion to finance the market activities of players who should be told to shrink their balance sheets instead. It won’t do that because it can’t take the consequences. This is not normal. It is the Fed’s latest weapon in the war on free markets. The Fed tries to conceal both the real cost of living for the average person and the true price of most stocks.
Watching China totally control their markets during the pandemic while spinning optimistic narratives is the extreme example of government control at work, but the deciders everywhere care only about where stocks close that day. The fact that pricing absurdities like Greek bonds trading near yields of 1% exist doesn’t imply that investors should take insane risks everywhere. It should serve to indicate how distorted prices have become and lead to extreme caution.
The narrowness of the advance in equities is telling policy makers that the prescription is not working. The stock indices, being driven by large cap tech, make it appear as though few investors are concerned about economic malaise. However, Treasury bonds, broader stock indices, and commodities are expressing doubts that have only grown louder with the onset of the coronavirus pandemic. Retail investors have taken to call option buying in a big way, even as measures of underlying market strength suggest caution is in order. It’s manic.
In this heavily propagandized environment, with central banks and politicians putting themselves at the center of global economies, it’s easy to ignore what is taking place. You might be missing the story because we even hear people who should know better talking about a “booming” economy in the U.S. For instance, while Team Trump often touts how the economy and jobs picture is so much better under his presidency, it’s just not accurate. This is not a political comment (we don’t like most politicians of any persuasion), just a fact.
Extreme Fed policy was meant to be an emergency measure begun in 2009 to stave off a catastrophe. It made sense then for a short while. However, the Fed promised its schemes would be stimulative to the real economy, allowing it to back away and let the free markets and the economy do their thing. In the end, the medicines and dosages it prescribed proved too extreme and took the economy off in a direction that was vastly different from how it was meant to naturally operate. Huge distortions have followed and remain with us to this day. Recently entering the repo market to lend to Wall Street took the cake and smacks of desperation.
Though it caused pain to the real economy, the Fed has been able to convince investors to play along. Whenever they grew skittish, the central banks stepped in. This continued until the Fed and the equity market took on a life of its own, completely divorced from the underlying economy. Corporate stock buybacks ruled while investors never really added much net equity exposure. They did swap active for passive in a huge way. This meant that investors could avoid putting a sharp pencil to financial statements. We think the Fed gets undue credit because buybacks and ETF’s have been the real forces behind stocks.
Stocks have become like underlying securities, not viewed as a right to a stream of cash flows in and of themselves as ETF’s took over. Most investors buy blindly based on very little analysis, only gut feelings and sentiment. But passive is actually a very active endeavor and has become a momentum trade of its own. Five stocks comprise 17% of the S&P 500.
Markets no longer easily sort through the fundamentals because so much is masked by the ETF cover. We saw a lot of weakness in recent quarterly earnings reports, but few seem to notice. The disconnect is bridged increasingly by creative EPS measures that differ markedly from GAAP earnings. For instance, not counting employee stock options as an expense is common. It’s as if employees work for free. Without that and other gimmicks, it would be easier for investors to see the charade.
A look at rails or semi stocks is enlightening. We are amazed that both groups can trade near all-time highs despite deteriorating revenues. Investors want to own them now because they think things will get better in the respective industries. They might, but the stocks already reflect extremely good news. Investors don’t much care. On the other hand, stocks that are not a big component of an ETF are ignored and discarded like a high school popularity contest is taking place.
The Fed remains trapped because it knows it can’t stop taking over markets or it will be discovered as having made the biggest monetary policy blunder known to mankind. The longer it allows the madness to continue, the closer equity prices come to collapsing under their own weight. Sooner or later, equity investors might decide they do not like what they hold if earnings uncertainty increases as we expect.
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.