May 4th, 2013
Macro Factors and Their Impact on Monetary Policy, The Economy and Financial Markets
by Jim Welsh, Forward Markets
Co-authored with David Martin and Jim O'Donnell
Sooner or later most car drivers have this experience. You're driving on the freeway, listening to some good music, the sun is shining, and you decide to switch lanes. You check the rear view mirror, note everything looks clear, turn on your right blinker, and begin to ease into the lane on your right. Suddenly this smooth process is interrupted by the sound of someone laying on their horn. You check the rear view mirror, see the car you're about to collide with, wonder where it came from, and promptly move back into your original lane. If you're lucky, you'll also see the other driver gesture their appreciation of your driving skills. After regaining your composure after the close call, you realize the car you didn't see must have been in your blind spot.
At important tops and bottoms in the stock market, many investors are impacted by their blind spot and it often costs them dearly. By their nature, markets are forward looking and discount the future, and if one listens closely, the message of the market can be discerned. As such, markets anticipate changes in the economy, whether it is the changing level of interest rates, stock prices, home values, gold, oil, copper, or any asset whose price is determined by supply and demand. The opinion that the markets are a discounting mechanism is expressed almost daily on CNBC or Bloomberg and in financial publications. For the most part, the direction of any market is aligned with the views of participants. If the 'news' is negative, most investors will be inclined to sell and the market will be in a declining phase. When investors are positive and supported by good 'news', there will be more buyers than sellers and the market will be in an uptrend. This process may seem elementary and obvious and it is. The process that creates the blind spot is reinforced by three factors - fundamentals, time, and human nature.
At the beginning of a new trend there will be some fundamental basis that justifies the reason to become positive or negative. Over time, more market participants will agree with the fundamental reasons supporting the trend, and will take the appropriate action - buying if the fundamental reason is positive or selling if the fundamentals are poor. The market responds to the increase of buying or selling, forcing more investors to take action, which further reinforces the trend. Humans project the recent past into the future, which means investors have a tendency to invest looking through the rear view mirror. If the stock market has been trending higher for an extended period, investors know most of the reasons why the market has been going up and expect the trend will remain their friend. Investors are repeatedly advised by the financial press and advisors that it is a mistake to sell, so they resist the urge to sell even as the stock market is falling. When the pain from a steep decline becomes too great and they simply can't take it anymore, they frequently throw the in towel not far from a bottom. Investing through the rear view mirror is why so many investors buy near a market high, and sell at market lows.
The notion that the stock market is a discounting mechanism that anticipates changes in the economy is part of Wall Street folklore and is widely accepted. It is logical, easy to understand and works most of the time, which creates the blind spot. But here's the rub. At every major top and bottom in the stock market, the market is wrong. We appreciate that this view borders on heresy, but a quick review of history should prove the point. The advent of the internet in the early 1990's brought about a technological boom that boosted productivity. After almost a decade of gains, the 'New Paradigm' resulted in extraordinary valuations, but that didn't inhibit investors from flooding technology mutual funds with money. In March 2000 when the Nasdaq Composite was above 5,000, what was the market discounting and 'telling' technology investors? Don't worry, be happy, tech stocks are still going higher!
The bull market that began in March 2003 was more than four years old when the first rumblings of the credit crisis appeared in August 2007. After the Federal Reserve cut the federal funds rate several times, and Fed Chairman, Ben Bernanke, said housing would stabilize by the end of 2007, the stock market rallied to a new all-time high in October 2007. Clearly, the stock market was telling investors that a potential credit crisis was a non-event. Wrong. By December 2008, the Federal Reserve had slashed the Federal funds rate to .25%, but the economy and stock market remained in free fall in early 2009. Certainly, the stock market was confirming that the sky was indeed falling.
What is amazing is that investment professionals are just as likely to develop a blind spot as the retail investor who follows market movements only part time. It's possible that professionals are more likely to believe that markets truly are a discounting mechanism since they know all the reasons why the current trend is happening. For instance, it is the responsibility of the rating agencies to rate and measure the amount of risk in the securities related to housing. Moodys, Standard & Poors, and Fitch Ratings all used sophisticated methodologies to evaluate mortgages, mortgage back securities, and all the derivatives they routinely rate AAA. Amazingly, the analytics used by the rating agencies presumed home prices would not decline, since they had not fallen since the 1930's. Between 1965 and 2000, the ratio of home prices to median income remained remarkably stable, fluctuating near 3.3 to 1. This was the result of mortgage lenders not allowing the monthly mortgage payment of a home buyer to exceed 33% of income. As shown in the Radio of Median Home Price to Median Household Income chart above, by 2006, the ratio of home prices to median income had risen from 3.3 to 1, to 4.7 to 1. And yet, the rating agencies believed the risk of a decline in home prices was still 0%.
In our opinion, the stock market and markets in general are almost always wrong at every major top or bottom. Despite the history and facts, the belief that the stock market is a discounting mechanism continues. In recent weeks the common theme on CNBC, Bloomberg and in the financial press is the recent strength in stock market is telling us the U.S. economy is in good shape. The expected pick up in GDP and earnings in the second half is why investors should buy if the market dips. As we noted last month, there are a number of reasons why a second half improvement is unlikely. Investors' faith that the market is a discounting mechanism may be creating another blind spot if the economy fails to accelerate as forecast.
Last year Gross Domestic Products (GDP) grew 1.7%, and that was with an improving housing market and increase in auto sales. Even if they continue to improve, the incremental addition to GDP will be small, and not likely to offset the impact of the tax increases and sequester. The Congressional Budget Office has estimated that the combined drag from the tax increases and sequester will amount to 1.75% of GDP. Our view has been that the impact from the increases in taxes and sequester was likely to be cumulative. The 2% social security payroll tax is about $20 a week for a worker with median income of $50,000. We doubted most consumers would respond with spending reductions after they received their first paycheck in January. Instead, many consumers would maintain their life style for a period by charging a bit more and dipping into savings. The cuts implemented by sequester are likely to take some time as they ripple through the economy, as down steam suppliers are increasingly affected. This suggests the drag from the tax increases and sequester are likely to intensify in the second half of this year.