What’s Driving the Markets?

X-factor Report 20 July 2014

by Lance Roberts, StreetTalk Live

“Last week the market finished up 0.54% marking the 15th week of gains which has pushed the year-to-date return of the S&P 500 to 7%.”

If I worked in the media, this would be how I spun the market action last week. However, such bullish spin would miss some important facts such as:

1. On Thursday, there was a 1% plunge in the index as geopolitical tensions spiked with the downing of a Malaysian Airlines passenger jet and an invasion of the Gaza Strip by Israel. (Note to self: Do not travel on Malaysian Airlines. Two entire planeloads of passengers lost since the beginning of the year is more than just coincidence.)
2. The other 14 weeks of the year have been negative, and;
3. All of the gains for the year have occurred since April 1st.

The third point is most important. All of the gains have occurred during a period that has historically been some of the weakest return months of the year.

These gains have also come at a time when corporate profits are slowing; economic growth is weak and geopolitical tensions have been on the rise. UBS published a research piece last week entitled “We are worried” which stated:

“Firstly we are concerned about valuations. We show that equity markets are stretched (e.g., more than 80% of the S&P rally since last year is due to re-rating), but we also find that the fixed income market has become quite rich (we have been overweight European peripherals for more than a year on valuation grounds, we show that this argument no longer holds), and the same is true of the credit market.

Second, because capital has been flowing rapidly into risky assets, we document that argument and here too find evidence that the market might be ahead of itself. We read the market reaction last week to the Portuguese news as a sign that the market is indeed too complacent and could correct rapidly.”

The reason for the rise, of course, has been almost solely due to the Federal Reserve’s ongoing, but currently declining, liquidity injections into the financial markets. The chart below shows three things from the beginning of 2014:

1. The S&P 500
2. The monthly NET changes to the Fed’s balance sheet
3. The cumulative changes to the Fed’s balance sheet.

As you can see, there is a very high correlation between the Fed’s balance sheet increases and the financial markets. With the Fed now “tapering” those purchases and ending them theoretically by October, this support will fade.

Just in case you think that this has only been a recently anomaly, I assure you it is not. The next chart shows the Fed balance sheet prior to the financial crisis to present. The correlation remains intact.

Importantly, as the chart shows below, as the Fed’s balance sheet approaches $4.5 Trillion it has required $1.89 of purchases to create $1 of growth in financial assets.

This is not by happenstance. The Federal Reserve specifically targeted “asset inflation” in order to boost consumer confidence. In turn, it was hoped that increased “confidence” would ultimately translate into stronger economic growth. Unfortunately, that failed to happen, not only domestically, but worldwide.

At nearly $20 for every $1 of economic growth it is clear that the transmission system failed. For investors, however, the problem, is that eventually reality will collide with weak, and deteriorating, underlying fundamentals. This will most likely occur next year as the Federal Reserve becoming less “accommodative” with monetary policy and begin raising overnight lending rates.

Fed Rate Hikes And Stock Market Performance

I wrote an analysis earlier this past week on what happens when the Federal Reserve begins raising interest rates. While the media currently dismisses the impact of rising Fed Funds rates, it is only due to very short memories. Leon Cooperman tweeted this past week that:

“One-quarter of fund managers today were playing little league baseball the last time the Fed raised rates in 2006.”

While humorous, he is correct. People have a short memory. More importantly, many of the individuals doing investment analysis, managing money, etc. weren’t even in the business in 2006, much less so in 1999 when Alan Greenspan was hiking interest rates.

If we take a trip back in time to 1954, we will find that the number of times either the markets or economy was able to weather increases in the Fed Funds rate was exactly ZERO.

“It should come as no surprise that rising interest rates, Fed Funds or otherwise, eventually has a negative impact on the financial markets. As interest rates rise, so does the costs of operations which ultimately leads to a decline in corporate profitability. As corporate profitability is reduced by higher borrowing costs, market excesses in price are eventually unwound.”

As I wrote in “Why Market Bulls Should Hope Rates Don’t Rise:”

“The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus.The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter.”

The table below shows the history of Federal Reserve rate hikes. Beginning from the month of the first increase in the 3-month average of the effective Fed Funds rate to the onset of either a recession, market correction or both.

“There are two important points to take away from this analysis. First, as I discussed previously, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near peaks of cyclical bull market cycles. While the analysis above suggests that the current bull market could certainly last some time longer, it is important to remember that it is ‘only like this, until it is like that.‘”

Current Rally Still Intact

While the sharp Thursday selloff certainly got the attention of many individuals, it did not change any of the underlying technical market trends.

The next chart tells us several things about the shorter term conditions of the market.

First, the bullish trend channel, as defined by the two solid upward sloping blue lines, remains firmly intact. The market has been unable to break out above this channel while the bottom has provided consistent support.

Secondly, the market is extremely overbought. At the current time, the market is “stretched” to the upside quite extensively. It will require a correction, most likely to 1900, to relax the markets enough to continue its advance in the near term.

Lastly, as denoted by the vertical red dashed lines, when both of the overbought/oversold indicators have turned down the markets have suffered a modest to more severe decline.

One important note, the markets have currently gone an extremely long amount of time without a correction of 10% or more. While no one likes market corrections, they are necessary for the “health” of a long term sustainable bull market. The current market advance is more reminiscent of the late “90’s” exuberance.

As I wrote last week:

“While Ryan argues the ‘fundamental’ underpinnings of the financial markets; the problem is that market ‘bubbles’ are ‘behavioral’ in nature.

Stock market bubbles have NOTHING to do with valuations or fundamentals.

If stock market bubbles are driven by speculation, greed and emotional biases – the valuations and fundamentals are simply a reflection of those emotions.

In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you a very basic example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.”

“Only with the exception of only 1929, 2000 and 2007, every other major market crash occurred with valuations at levels equal to, or lower, than they are currently. Secondly, all of these crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, rising interest rates, recessions or inflationary spikes. However, those events were only a catalyst, or trigger, that started the ‘panic for the exits’ by investors.

Market crashes are an ’emotionally’ driven imbalance in supply and demand.”

While there is currently no “technical” reason to become more negative on the financial markets, it is important to remember that we should NOT BE CONCERNED WITH RISING MARKETS. When we are allocated to the financial markets, and markets are rising, that is not the issue we should be focused on. It is much like trying to drive by looking in the rearview mirror. We are already where we need to be for where we have been. We need to be paying attention to the road ahead for the unexpected dangers that could suddenly arise that could lead to a catastrophic accident.

It was in 1996 that Alan Greenspan first uttered the words “irrational exuberance” but it was four more years before the “bull mania” was completed. The “mania” of crowds can last far longer than logic would dictate and especially when that mania is supported by artificial supports.

With the Fed’s artificial interventions suppressing interest rates and inflation, it is likely that the bullish mania will continue into 2015 as the “herd” mentality is sucked into the bullish vortex. This is already underway as shown recently in “Charts All Market Bulls Should Consider”‘ which showed individuals are once again piling into stocks and depleting cash reserves in the hopes of “getting rich quick.”

The current low-volume market, combined with excessive bullish sentiment, sets up a potential for asset prices to be inflated further. As stated, the risks in the markets have clearly risen, but the next significant reversion could be many months away. The problem for most, particularly those touting “investing for the long term,” is when the“dip” turns into a full-fledged “decline” the panic to exit the markets will become overwhelming.

Our memories tend to be much shorter than the damage done to portfolios by failing to recognize the risk and to manage accordingly.

Have a great week.