Sunday, October 28, 2018
Enormous Federal Reserve Board Power
“Whenever the Federal Reserve raises either the federal funds target rate, margin requirements or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback” Edison Gould (Schade, 2004). Translated – whenever the Federal Reserve raises rates 3 times, stocks will stumble (3 Steps and a Stumble Rule).
“Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major direction.” Marty Zweig
“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.” Stan Druckenmiller.
We have a Hawkish Fed
Here’s a nice chart of the Fed cycles from raising rates to lowering them – note what happens with a Hawkish Fed.
Current Hawkish Fed
Below you can see that the Fed has raised rates 8 times, starting with the 12/16/2015 hike.
Odds are (per CME) that the Fed rates will stay unchanged at the next meeting in November, but there is right now a 66% chance of a 0.25% hike at the December 2018 meeting.
The Fed’s Stated 2% Inflation Target is WRONG
The following is a must read article written by Paul Volcker. Volcker explains why the Fed is WRONG in using a 2% Inflation target. Great read.
Yet, starting with the Yellen Fed, the Fed has adopted this 2% inflation target.
Inverted Yield Curve
Below is a chart of the 10-year US Treasury yields minus the 2-year US Treasury yields. A positive yield curve is when the 10-year yields are higher than the 2-year yields.
An inverted yield curve (2-year higher than the 10-year) has predicted the past 7 recessions – as you can see by the chart below, when the yield spread went negative a recession occurred shortly thereafter.
Right now that spread is only 0.28%.
Will the Fed continue to raise rates and cause an inverted yield curve?
Prime Interest Rate
Below is a 20-year chart of the Federal Reserve Target Rate (green), along with the Prime Interest Rate (red), they move lockstep together.
A look at stocks
Stocks have been the best performing asset for the past 3 years – as you can see from the table below.
I would expect that Stocks will be the best performing asset in the next market cycle (the next 3 to 5 years).
NOTE: At Jackson Wealth Management, LLC we have avoided investing in small companies, foreign companies and emerging markets companies for the past several years. We like US High Quality Large Companies. That’s contrary to the advice of most advisors, who insist that you have moneys in all the pie slices. We may start to like those foreign companies in the future, since they are down a lot.
We know this:
The Fed FOMC’s monetary policy is a powerful force for stock prices
Interest rates matter to stock prices. "The most important item over time in valuation is obviously interest rates. Any investment is worth all the cash you're going to get out between now and judgment day discounted back. The bogey is always what government bonds yield, you can pick your maturity. And you see it in real estate. Real estate yields adapt quite quickly and fairly directly with interest rates. It's the same principle [with stocks]." Warren Buffett
On October 3, 2018 Federal Reserve Chairman Jerome Powell said: "The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don't need those anymore. They're not appropriate anymore, Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral, we may go past neutral, but we're a long way from neutral at this point, probably.”
The slope of the long-term trend line has flattened
The Fed holds all the cards
We have expansionary fiscal policy (tax cuts) and restrictive Fed monetary policy (raising interest rates).
I don’t think the Fed will rescue stocks at this time by becoming more accommodative. But, clearly I have no idea what the Fed will do.
Investors have 3 choices:
Do nothing (that is a choice)
Get aggressive and dial up your equity %, stocks are on sale
Get defensive and dial down on your equity %, you are retired and you want to preserve capital
Choice #4 Get some Doves on the Fed FOMC