Investors should not imagine that a shift to outright easing by the Fed would necessarily be favorable for stocks. A look at valuations, market internals, and monetary policy, with notes on Modern Monetary Theory.
Bull market or bear market? Bargain or bubble? Late-cycle or new economy? Recession or continued expansion? More rate hikes or a new round of QE? Buy stocks or buy bonds? Keep reading.
While we don't presently observe conditions to look for a "buying opportunity" or a "bottom" from a cyclical standpoint, we do observe conditions that are permissive of a scorching market rebound, even if it only turns out to be the "fast, furious, prone to failure" variety.
Quantitative easing wasn’t about creating more “liquidity,” or encouraging more bank loans, or any of the other excuses tossed around for it. What quantitative easing really did was to replace interest-bearing Treasury bonds held by the public with a mountain of zero-interest money that was so uncomfortable to hold that it drove investors absolutely crazy.
Valuations are informative about long-term returns and full-cycle risks. Market internals are informative about investor psychology over shorter segments of the cycle. Presently, neither valuations nor internals are favorable, and that is what opens up a trap door under the market.
The music is fading out, and a trap-door has opened up in the floor, but they're still dancing.
Current stock market capitalization is largely an artifact of speculative psychology, not reasonably discounted cash flows. Unless investors rely on eternal sunshine of the spotless mind – the assumption that current levels of extreme cyclical optimism will be permanent – they should not expect the associated valuation extremes to be permanent either.
Market returns and economic growth have underlying drivers. At their core, extended periods of extraordinary growth and disappointing collapse reflect large moves in those drivers from one extreme to another. Extrapolation becomes a very bad idea once those extremes are reached.
Even when extreme “overvalued, overbought, overbullish” warning signs are present, we now require explicit deterioration in market internals before adopting a negative market outlook. That, however, is far different than saying that extreme conditions can be ignored altogether. With market internals negative here, underlying market risks may be expressed abruptly, and with unexpected severity.
The hallmark of an economic Ponzi scheme is that the operation of the economy relies on the constant creation of low-grade debt in order to finance consumption and income shortfalls among some members of the economy, using the massive surpluses earned by other members of the economy. The factors most responsible for today’s lopsided prosperity are exactly the seeds from which the next crisis will spring.