September 2017 Tactical Market Update

October 18, 2017

L&S Risk Pulse™ Score

Medium +

Core economic indicators are healthy, but markets indicate potential near-term volatility and/or mild correction. Valuations are trending high.

L&S Risk Pulse™ Insights – “Fed Policy Risks Increasing”

General Comments

Following an unprecedented 7 years with the Fed funds rate near zero, in December of 2015, the Fed finally raised interest rates for the first time since the end of the Great Recession.  At that time, they indicated their expectations that rates would move continually higher.  Despite their forecasts, the next interest rate hike came a full year later in December of 2016.  At that time the Fed again announced their intentions for higher interest rates as 2017 progressed.  This year the Fed has raised interest rates twice more, although the Fed Funds rate continues to be significantly below the rate that the Fed governors had expected.

Let’s take a step back in time to review how we got in this position in the first place.  As the impacts of the Great Recession remained tangible in the economy, the Fed attempted to do whatever it could to push the economy to a level of self-sustaining growth.  Historically, the Fed has cut interest rates to spur economic growth, but the impact of the recession was so severe that, even with interest rates near zero, the economy continued to sputter.

The Fed resorted to untried tools to continue to spur the economy.  These were referred to as “quantitative easing,” and the Fed decided that one way it could increase the amount of money in the system was to purchase bonds.  The thought process goes something like this:  The Fed purchases bonds from a seller.  The seller, now flush with cash, does not like the very low interest rates available on other bond investments, so that capital is deployed to build a plant or make an investment that will have a higher return.  Some of that money found its way into the stock and property markets, pushing up the price of assets.  With higher asset prices and with more investment, the idea was that consumers would feel richer and would have more confidence to spend, helping the economy regain its strength.

As the Fed undertook several rounds of quantitative easing (or QE for those acronym-loving Wall Street types), the Fed ended up buying trillions of dollars worth of bonds.  (Yes, we did say trillions.)  The assets owned by the Fed grew from roughly $900 billion to $4.5 trillion.

Now that the economy is on very solid footing, the Fed is looking at its swollen balance sheet and has decided that it needs to start reducing those holdings. It recently announced that it would begin this process by reducing its holdings by about $10 billion per month, increasing that amount quarterly until it was reducing its holdings by $50 billion per month.

This is a very good sign that the Fed has enough confidence in the health of the economy to begin this process.  The risk comes from the fact that like QE to begin with, the reversal of QE has never been done before.  We simply do not know what the impact on the economy will be.  If QE helps spur the economy to grow, is it not logical that the reversal of QE would slow the economy somewhat?  In some regards, this is what the Fed is trying to do — they want to see the economy continue on its growth path, but they do not want the economy to get too hot which would cause an unwanted increase in inflation, and would require further action from the Fed.

So we are embarking on a new and untried tool to control the economy.  This certainly suggests increased risk, even as we acknowledge that the Fed could easily cease or reverse its operations if it felt that the impact of this policy was deleterious.  The stock market was able to shrug off the Fed’s announcement and continued to march ever-higher.  As of this writing, it is very difficult to suggest that the Fed’s policies will have a meaningful impact on the economy or on corporate profits.  While that may change in the near future, the market has spoken that it is willing to accept those risks.

Data Points and Global Economic Indicators

A telling sign that problems are brewing occurs when there are credit problems in the financial system.  Banking, and a free flow of capital, is like the oil in an internal combustion engine.  Without it the system freezes.  We look at several indicators to determine whether credit problems are bubbling up.  To begin, we look at the interest rate demanded by banks for loans to higher risk borrowers.  When lending standards get tighter, the lower quality borrowers are the first to suffer.  We can also see this in increasing default rates and in increasing charge-offs for non-performing loans.  All of these data points remain at or near recent lows, and do not give us any indication that credit issues are mounting.

Another tool we look at to help us evaluate the risks within the market are how the market is behaving itself.  Warning signs of trouble occur when there are fewer and fewer stocks participating in the market’s advance, or when the number of stocks at 52-week highs is declining even as the market is making new record highs.  Over the past several weeks the opposite has been occurring.  The number of stocks participating and making new highs has been expanding, suggesting the market is on solid footing.

We also look for signs of excess speculation as a sign that markets are near a peak.  The psychology of investors tells us that investors are euphoric at market tops and are despondent at market bottoms.  This can also be seen in the volume of mergers and acquisitions occurring.  When corporate managers are worried they are going to miss out on an opportunity, they frequently engage in merger activity.  We do not see signs of speculation, and we do not see signs of heavy merger and acquisition activity.

Conclusion

Take note when your friends are telling you that it is easy to make money in the stock market.  It is never easy to make money, and a sign of speculation is when everyone is a maven.  One strategist we followed suggested that when the taxi driver gave him stock tips it was time to pare risk back.

We spend time every day and every week looking for signs that risks are rising, even as they may be unseen by many.  This is one factor that differentiates us.  At this time, we can say that the signs of risk remain modest, although we acknowledge that as John Maynard Keynes said, “when the facts change, I change my mind.  What do you do, Sir?”