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Buckle Up:

Fed Continues Stimulus

 

 

Last week, the big event that virtually all long-term investors, short-term traders, Fortune 500 CEOs, and a vast number of small business owners across the country focused their undivided attention to was the meeting of the Federal Open Market Committee (FOMC) on Tuesday and Wednesday, June 15 & 16. At the post-meeting Press Conference, Fed Chairman Jerome Powell said that it was not reducing its stimulus measures, but it tightened its interest rate increase expectations to two in the next 2.5 years.

The reason for last week's attention to the Fed from such a diverse variety of businesspeople and investors was that in 2021, the US Federal Reserve is the most critical player in the contraction or expansion, success or failure of the US economy and the US market.

The Fed has also made itself responsible for determining whether stocks and index-based ETFs will persist in climbing higher, continuing the unprecedented rally that began in late-March 2020. It should be clear that the Federal Reserve’s control over equity prices in 2020 and 2021 has been nearly absolute. The correlation between the Fed’s Balance Sheet growth and appreciation of the S&P 500 Equity Curve is tight.

There has been an undeniably high correlation between the Fed's Balance Sheet and the S&P 500 market's reactions since the two entities became synchronized and inseparably linked last March. That’s when Fed Chairman Jerome Powell's announced virtually unlimited monetary support for the economy (and the equity market) on the morning of March 23rd, 2020, when the S&P 500 most other investments were in freefall.

The power that the core group of men and women in the FOMC—effectively the steering committee of the US Federal Reserve Bank—have in their hands is profound. As an unaudited, unelected, exclusive club of peer-selected men and women, the Federal Open Market Committee (FOMC) members are arguably some of the most influential people on the planet. As a result, this group wields incredible power over the financial prospects of their fellow Americans and businesses, large and small, throughout our land.

 

Clear Evidence of Market Manipulation

To start this discussion, let's examine the two-year, weekly charts of the Big Three Indices, represented by the SPDR S&P 500 ETF TRUST (SPY), the NASDAQ 100 Index (QQQ), and the Russell 2000 Small-Cap Index (IWM). These three ETFs represent the three most widely followed market indices, representing America's 500 largest and most successful public corporations (SPY), the 100 largest technology, biotechnology, and other large-cap growth companies (QQQ), and the 2,000 most successful, small-sized public corporations that may tomorrow be the companies populating the first two, large-company indices and ETFs (IWM).

Last Wednesday, when the Fed announced it would not (yet) be tapering the assets purchased each week, the Nasdaq 100 ETF (QQQ) set a new all-time high at its close on Friday. Meanwhile, many other segments of the market fell.

Chart 1 below shows these three indexes hitting their March 2020 Covid-Crisis low, stopping on a dime upon the late-March announcement by Fed Chairman Powell, reversing course, then beginning one of the most potent bull-market rallies ever recorded. All three major indices are at or near new all-time highs, with QQQ setting a new high at the close last Friday, with the other two ETFs dropping slightly. It’s only logical that various market segments should pull back after their incredible runs since the March 2020 low. The S&P 500 ETF (SPY) gained 93%, the Nasdaq 100 ETF (QQQ) gaining 101%, and the Russell 2000 ETF (IWM) index gaining 133%.

 

SPY, QQQ, IWN saw incredible gains.
Chart 1: SPY, QQQ, and IWM recorded enormous returns since their March 2020 low—with prices distorted higher by Fed stimulus.

 

Stock Returns Controlled by the Federal Reserve

In each case shown above, the profoundly high returns for the three indices—more than ten times the average return for each of these ETFs in any typical 14-month period—are directly correlated to the infusions of cash pumped into the financial system through asset purchases by the US Federal Reserve. The Fed’s purchases of Treasury Bonds and other interest-bearing financial assets push interest rates even lower than can be achieved by setting a 0% overnight, intra-bank lending rate. It also provides enormous liquidity from increases in the money supply, preventing the risk of a temporary financial lockup during a time of high economic stress.

The Fed directly invests in Treasury bonds, municipal bonds, private corporate stock, and even the occasional publicly traded equity, converting those assets into deposits on the bank’s balance sheets, then invested in the economy. Regulatory requirements and market forces require the nation’s banks receiving this money supply to invest those funds into qualifying economic opportunities as they see fit, usually for business loans, residential and commercial mortgages.

However, after turning over 2-3 times in the economy, ultimately, all that money finds its way into the stock market – a platform facilitating the most profitable investment vehicle available to modern civilization. In this way, the stock market—and particularly the largest publicly traded companies (represented by the S&P 500)—are controlled by the Fed’s weekly infusions and purchases. These purchases have been on the bigger side of BIG, amounting to $80-$120 billion each month since last July. As a result, the Fed’s Balance Sheet broke the $8 Trillion mark by the end of last week, after starting 2020 at slightly above $4 Trillion.

 

The Wealth Effect — Keeping Stock Prices Dangerously Climbing

Since the Alan Greenspan era as the Federal Reserve Chairman (1987-2006), the Fed has maintained a policy of supporting what he called the 'wealth effect' to instill business and consumer confidence in the economy and prompt the public to spend money whenever there was a recession or weakness in the economy. Greenspan believed in a tight connection between the Markets, the economy, and people’s Life decisions (i.e., ‘MEL’). As a result, the stock market has become a driving force in the lives of many who either trade for a living, are active, self-managed individual investors, or people who make most of their financial decisions based on the status of their 401(k) plans.

Greenspan actively promoted the wealth effect and was exceptionally active in supporting stock prices during the 19 years (1987 - 2006) he served as Federal Reserve Chairman. Investors referred to a ‘Greenspan Put’ having their backs whenever there was an increased risk in the market. Investors felt, from experience, that Greenspan would always save their bacon, so it was an ongoing ‘put’ (an option supporting shares) maintained by the Fed Chairman and his infinite money-printing policy.

Fed Chairman Greenspan created the concept of maintaining elevated stock prices as a worthy objective for the Federal Reserve—one that would contribute to the health of the US economy. Greenspan imbued this principle into his protege, the next Fed Chairman, Ben Bernanke, who also maintained a dovish policy that coddled the equity market. Subsequent Fed Chairs have continued this policy, including Fed Chairman Jerome Powell.

Chart 2 below shows a two-year chart of the SPDR S&P 500 ETF (SPY) in the top pane with a two-year chart of the Federal Reserve's Balance Sheet in the lower window. We lined up the dates on these two charts, and they clearly show the direct effect of the expansion of the Fed's balance sheet on stock prices.

After plummeting by -34% in March 2020 when the severity of the Covid Pandemic was finally realized, the S&P 500 ETF’s descent reversed course higher in late March 2020. That happened from the Fed’s announcement of extraordinary, virtually unlimited support for the market (represented by the S&P 500) and the economy. As a result, the market has been in a low volatility climb higher, in which every dip is being purchased by investors, primarily because of this extraordinary support. Market news is mostly meaningless these days. It doesn’t matter whether a company’s earnings report surprises to the upside or disappoints to the downside; the result is essentially the same—more purchases and higher prices.

 


Chart 2: We can see there is a close correlation between the Fed's Balance Sheet (lower window) and markets (SPY, upper window).

 

Because the Fed is controlling market prices so directly, the Federal Reserve's meeting last Wednesday, June 16, was closely watched for any hint that 'tapering' of the Fed's asset purchases would begin soon (as opposed to jawboning about tapering at an undisclosed day in the future).

Investors felt that a reduction in purchases was possible because of the recent rapid increase in CPI to 5% annualized set a multi-decade, record high. However, while Jerome Powell continued to reference future tapering, there was no mention of a hard date when it would take place, nor was there an increase in rates. However, the Fed pulled forward its estimate of an interest-rate increase in late 2023 to two increases before early 2023. That means there likely won't be a rate increase for more than two years!

The reason the Fed is staying dovish is that the economy – while growing rapidly from widespread reopening – is still not generating job growth at a pace fast enough to work off the remaining glut of unemployment. Also, supply-chain problems are causing the economy to fail to achieve a full-throttle reopening, and it could take six months or more to eliminate crucial supply-chain chokepoints.

However, it is also because the influential people at the Fed know that if they reduce monetary support too soon before the economy has adequately recovered enough momentum to be self-sustaining from the perspective of investors, there is likely to be a market crash that makes the March 2020, -34% Covid Crash look like a walk in the park—and the Fed would be forced to reverse itself and get right back in the support game, starting over with even larger amounts of asset purchases in a new Quantitative Easing program.

Hence, at last week's Fed announcement, the Fed Chairman Jerome Powell continued the long-time Fed tradition of jawboning the market lower by discussing future tightening—without doing anything about it. No taper, and no interest rate increase, potentially for years.

So why did the market sell-off on Wednesday and Friday if there was really no change in policy? It's likely because investors were looking for any reason to sell and take profits. After the epic runups in stock prices shown in Chart 1 above, investors wanted to sell—and sell they did in certain asset classes and individual stocks.

 

Inflation Obsession

Investors have been obsessed with fears related to predictions of out-of-control inflation for the last year, but most of those making the predictions don't realize that this isn't their father's 1970s economy. Conditions have changed significantly in the last 40-50 years since we last saw rampant inflation affecting America. Inflation depends on imbalances in supply and demand in order to occur. However, in the 21st Century, we now live in a global economy in which the supply of virtually any product or product component can potentially be supplied by experienced subcontracting/ manufacturing companies in a dozen different low-cost nations.

The recent reports of dramatic increases in the prices of specific products such as lumber and copper are very likely to be temporary. It's pretty obvious from those two examples that some commodities used in homebuilding are in short supply because the demand for housing is going through the roof after sales were suppressed for the last year. The inflation seen recently in other individual products, while there has been no inflation in the majority of products, is largely because of supply shortages and imbalances related to the significantly increased pent-up demand in the reopening trade following a year of closures and reductions in a vast number of industries.

Some things like last year's vacation plans can be shelved and fogotten, and plans to buy a home can be delayed—but it would be rare for a purchase of the magnitude of buying a house to be cancelled. There's too much planning and saving and dreaming that goes into buying a home. For this reason, a year of housing demand wants to be served NOW. As a result, certain items used extensively in the home-building sector, in this case Lumber and Copper, are currently in short supply because of heightened demand after a year of reduced demand.

It's as simple as that. We're not seeing widespread runaway inflation—so far, we only seeing isolated shortages. These supply shortages and imbalances should be resolved in the coming three to six months. After that, and product or service that has increased its costs as a means to take advantage of the opportunity to do so will likely be punished in the marketplace by the 'invisible hand,' a concept about the free market promoted by Scottish economist Adam Smith.

Chart 3 below shows the Consumer Price Index (CPI) for the last two years, with a sharp increase in the last month. In May, CPI jumped by 0.6%, ahead of the 0.4% expected. That pace set headline CPI at about 5% year-over-year, which is the highest we've seen since 2008.

Stop and think about that for a minute. Do you remember 2008 being a time when there was runaway inflation? No, me either. Do I remember 2008 as being a time when the economy crashed and people stopped spending out of fear? Yes. Then, I'm guessing, a short-term increase in some prices appeared when the economy began to recover and there were isolated shortages of certain items. It wasn't widespread inflation—it was opportunism!

Investors should avoid extrapolating the near-term anomaly in the chart below far into the future. The increase in prices will likely disappear in the next three to six months as supply-chain chokepoints and shortages are resolved.

 

 


Chart 3: Inflation, as represented by CPI, made a sharp acceleration higher recently to a pace of 5% per year. We believe this is a transitory anomaly.

 

 

The recent increase in prices is a result of the reopening trade after a year of Covid-related shutdowns, the enormous pent-up demand, and the backlog in the supply chain that reopening is creating. Another example of a shortage is in chips, which is dramatically affecting the auto market and the many aspects of our lives that today rely on semiconducting processors.

However, many of the supply issues the world is experiencing right now are likely to be worked off as hungry global manufacturers will step in to fill any supply shortfalls with a rapid response. Other shortages that are US-exclusive are likely to be worked out over the next 3-6 months.

The US and world are also experiencing dramatic changes in demographics, with falling rates of population growth and an aging society. Couples are having fewer babies and as the average age of the population gets older, that older population naturally cuts back on spending. These are just a few of the reasons why this is NOT your father's 1970's economy.

 

 



 


In the modern global economy, the mantra of "location, location, location" is now "meaningless, meaningless, meaningless."


 

 

Today, Inflation is a Global Phenomenon, Not Local

In 2021, we have thoroughly stepped into the age of globalization, in which companies all over the world bid on the opportunity to fill supply needs. Inflation is no longer a local phenomenon, caused by local or national supply and demand imbalances.

Today, inflation is largely a global phenomenon, a conclusion that was recently reached by several recent academic studies. Because of this fundamental change to the economic dynamics of your father's American economy, the world's suppliers can soak up an incredible amount of demand from their purchasers in the US and world.

This would be the equivalent of giving the high-inflation 1970s US economy an increase of 50-75% in available productivity; plant, equipment, labor, and capital investment. What would this increase have done to inflation in those years? We'll never really know, but as part of our thought experiment, consider that the authors of the above-mentioned studies says that to get off the ground, significant US inflation will now require global inflation.

Global suppliers in coming years will have the ability to absorb multiples of historical demand levels and put to productive use of far larger flows of cash than has been exchanged between buyers and suppliers ever before, investing those funds back into growing the business with purchases of plant and equipment.

The world's ample supply of inexpensive labor, abundant resources, economies of scale, and the innovation of economically hungry, emerging-market entrepreneurs who are far poorer than middle-class Americans, will continue to keep the costs for goods suppressed throughout the world—perhaps permanently...

It's likely that this low-cost globalization of the world's supply chains is the primary force that has kept inflation subdued below the Fed's target of 2% for the last 13 years. It's the reason the Fed has been saying that it will let inflation run hot for a while before it begins tightening.

However, the Fed surely knows it's fighting an uphill battle in the effort to spur moderate inflation. After all, the Fed has intimate knowledge of the enormous amount of unused capacity available from the world's low-cost work force, a workforce frequently supplied by impoverished nations where the citizenry will work diligently, giving 100% all day in exchange for a wage that is a pittance compared to the pay in developed countries, and the opportunity to build a life for themselves and provide for their families. Those who have temporarily lived and worked in emerging-market countries, as I have, know the truthfulness of these words.

For example, did you know that the average annual per-capita income in Thailand is only $1,800? That in the Philippines it is $478, and in Ghana it is just $47 per year?

And did you also know that the unemployment rate of the ten countries with the highest Unemployment Rate stands at an average of a whopping 40%? Some Americans panic over an Unemployment Rate of 6%, but in the previously mentioned ten countries, nearly half of the citizenry have no job and no income and don't know how they, their children, or their loved ones will survive without dying of starvation in the coming weeks.

Do you think these people aren't willing to do whatever it takes to scrape out an existence for themselves and their loved ones for a miniscule wage that would be considered an insult in mos of the world? They are willing. Far more than you can imagine. And at this point, there is a virtually unlimited supply of people on this planet in this dire position who will put in a 16-hour work-day without a break for the chance to earn 25¢ for the day—to eat a meal—and have the opportunity to return and do it again tomorrow.

THIS is one of the primary reasons why widespread, high inflation in the US is not likely to be an issue for the foreseeable future, or perhaps ever again. Other reasons for limited inflation are the pervasiveness of labor-reducing technologies, a reduction in birth rates and the resulting aging of the world's population, and the steadily increasing number of deaths of those in the 'Baby Boom' generation that was a result of post-WWII procreation. But we should also consider the effect that global warming will have on prices across the world as populations are displaced and a significant portion of the world becomes refugees.

Today we are living in a brave new world in which it is likely we have already witnessed the end of inflation. In the modern global economy, the old mantra of "location, location, location" ...is now replaced by "meaningless, meaningless, meaningless" when the subject at hand is inflation.

 

Asset Inflation is Today's Real Problem

If Jerome Powell and other decision-makers at the Federal Reserve need to weather the storm of transitory problems that include pent-up demand, shortages, and temporarily increased prices in select categories.— Particularly, if it can weather the loudest individuals (particularly politicians with cable-TV megaphones) claiming that these temporary problems are instead permanent problems, then its easy-money policy will work to get the economy percolating again.

Some individuals will wield scary inflation stories as a cudgel against their political enemies—but if it can get through this Summer and into the Fall without imploding and doing something stupid, then the Federal Reserve will likely survive to successfully complete its objective of spurring a return of the US economy.

The Fed's Dual Mandate

That job consists of the Dual Mandate for the Fed, amended by Congress in the 1970s, to achieve the objectives of 1) Maximum Employment of the American work force, and 2) Stable Prices (including moderate inflation and moderate interest rates). These mandates are documented in the statutes of the Federal Reserve Act of 1913. Because of those mandates, it is likely the Fed will continue its dovish monetary policy until the US returns to Full Employment at an Unemployment Rate of around 4% or lower.

The Fed said last Wednesday that it won’t taper its monthly buying of $80 billion of Treasurys and $40 billion of mortgage-backed securities until it sees “substantial further progress” in the economic recovery.

If fighting high inflation (greater than 8-10%) by raising interest rates is truly off the table, the Fed has no other purpose for its existence than to stimulate the economy to a level where 'Full Employment' is achieved.

The upshot of last week's Fed announcement was that investors can expect a continuation of the status quo (continuing financial-asset purchases by the Fed) and likely a continuation of the bull market. At the Wednesday-afternoon press conference, the FOMC decided to continue asset purchases. There was no mention of tapering.

 

A Far More Dangerous Circumstance

If conventional inflation in wages and cost of goods is a risk that has been taken off the table by globalization, technology, and aging, the world—and particularly the US—is quickly coming face-to-face with another kind of inflationand this one is far more dangerous: Asset Inflation.

The Federal Reserve is likely to continue to stimulate the economy with the only tool it has available to it (monetary policy) effectuated through 1) lowering the overnight lending rate ('Fed Funds') between banks, and 2) implementing what the Fed has—for the last 12 years—called an 'experimental' effort to stimulate the US economy—illogically—by purchasing the government's financial liabilities from the nation's banks (through Quantitative Easing, or QE).

Think about that for a minute: In hopes of attaining 'full employment,' and a benign level of CPI growth (mild inflation of 2.5%), the Federal Reserve is purchasing financial assets such as Treasury Bonds and packaged Mortgage Securities from commercial banks. While there are a couple of paths of very convoluted logic, which if they are twisted just right,might have a slight chance of prompting companies to hire workers; but this logic offers a very thin reed.

Tell Me Truly: if you owned a manufacturing company that made widgets, and the Federal Reserve was doing QE by buying Treasury Bonds held by your local commercial bank, would the Fed's purchase of those Treasury Bonds cause you to want to hire new workers? Do you think that by moving these assets from one balance sheet to another, the QE effort will stimulate your local economy?

No – me either. I've always been dubious about the effectiveness of Quantitative Easing to boost hiring. We also know that QE is ineffective at spurring a moderate level of inflation of goods and services. After all, the Fed has been using QE since 2008 and only once was their target rate of inflation (CPI growth of 2.5%) achieved.

On the other hand, it is likely that stock prices will continue rising as long as the Fed's stimulative monetary policy is in overdrive. The ample liquidity infused by the Fed's dramatic increase in money supply by $4 Trillion is—logically—working its way into Equities and ETFs.

The Fed has created an enormous asset bubble as a side-effect of its attempts to boost the economy. If (or more likely, when) that asset bubble bursts, it will surely create a horrendous crash in stock prices. The reason? Because in 2020-2021, the Fed has blown the largest, most out-of-hand bubble in history. And the carnage will be all the greater because of that when investors lose confidence in the Fed's ability to control the bubble it has created—or perhaps more likely, the Fed bursts the bubble itself by announcing that it is reducing or eliminating QE.

 

The Highest Market Valuation in History?

According to PE Ratios and other valuation measures—stock prices are already at the second-highest level ever attained, and arguably at the highest level ever if we consider the facts around the past record-holder.

Chart 5 below shows the current PE Ratio of the S&P 500 is at 45, now surpassing the high reached at the peak of the Dot-Com Bubble in 2000 and likely to go higher still before these circumstances change. The chart below, courtesy of Multpl.com, shows that there was only one time when the S&P 500 PE ratio shot higher than the current level, albeit very briefly at the nadir of the 2008 Financial Crisis.

 


Chart 5: The PE Ratio of the S&P 500 is currently at 45, arguably the highest valuation in history since 2008 deserves an asterisk. Source: Multpl.com.



The caveat of that 2008 peak, deserving of an asterisk for its anomalous existence, is that it occurred at a time when S&P 500 corporate profits briefly plummeted to near-zero in one quarter as consumer spending came to a complete halt from a widespread fear that something akin to a repeat of the 1929 crash and Great Depression was near at hand in late-2008. Yet stock prices didn't bottom until the end of the first quarter of 2009, briefly causing an extremely distorted PE Ratio near 70 for the fourth quarter of 2008.

On the other hand, the current S&P 500 PE Ratio of 45 is legitimate because stock prices (and the PE Ratio) have continued to steadily rise over the last year to accompany the new public perception of the ability of the government to create money out of thin air (while Congress can't create money without borrowing it in the form of Treasury Bonds, the Fed can create all the money it sees fit to 'print').

The current PE Ratio of 45 for the S&P 500 is not the result of a one-time 'anomaly' in the record books. It is legitimate, the result of a steady progression of rising stock prices and a floundering, pandemic-driven stagnation of profits of the benchmark S&P 500 index.

The website CurrentMarketValuations.com maintains a regularly updated assessment of multiple market-valuation techniques, and it ranks the market 'Strongly Overvalued' on the measures of the Price/Earnings Ratio, the Buffet Indicator, and S&P 500 Mean Reversion. It assesses conditions as 'Fairly Valued' based on Interest Rates and the Yield Curve, a result of the current artificially low interest rate environment, intentionally manipulated lower by the Fed to stimulate borrowing and economic growth (with the unfortunate side-effect of a bubble in asset prices).

 

Aiming for One Target but Hitting Another

Besides maintaining Full Employment, the Federal Reserve has been attempting to prompt a rise in CPI (the prices of goods and services) to a consistent level around 2% for more than a decade (since the Financial Crisis in 2008). During this entire time, it has maintained 'emergency measures' with overnight interest rates at the zero-bound – even as the economy reached and exceeded 'Full Employment' – part of a herculean effort to boost inflation a bit above 2%.

Chart 6 below shows the rate of inflation for each year from 1990 to 2020. In the first 17 years, from 1990 to 2007, inflation averaged 2.95%, even as it included a period of economic troubles (the 'Asian Contagion' currency crisis in 1997-1998) and an outright recession (the Dot-Com Bubble bursting accompanied by a slow-rolling 3.5-year bear market and a -50% decline in stock prices). Still, the pace of inflation (year-over-year CPI growth) averaged a baby-bear's porridge inflation rate of 2.95%. Not too hot and not too cold.

However, ever since the 2008-2009 Financial Crisis-driven recession that caused deflation in 2009 of -0.4%, the rate of inflation has averaged a meager 1.5%. In 2015, as US corporations experienced an earnings recession without being accompanied by an actual recession, and the pace of CPI inflation dropped as low as 0.1%. Overall, that CPI average growth of only 1.5% has not produced the kind of benevolent inflation the Fed has been determined to generate, despite its best efforts to create overheated economic conditions.

 



Chart 6:
The annual rate of inflation from 1990 to 2009 ran at 2.95%, but since the Financial Crisis the average has only been a 1.5% pace.

 


This dynamic, with inflation during the last decade averaging only about half the pace it averaged in the previous 17 years, is what the Federal Reserve is seeking to manipulate higher with its very dovish monetary policy, anchored by extremely low interest rates, even when the economy has reached full employment.

However, for the reasons established earlier (globalization of labor/resources and an aging demographic profile), it is unlikely the Fed will EVER achieve its goal of an annual inflation rate of 2% and slightly higher. While the Fed is the only game in town with any tools at its disposal, those tools are ill-fitted for their objective.

The Federal Reserve is limited to prompting the economy to run a bit hotter through the control of overnight intra-bank lending rates and manipulation of employment and stock prices by increasing the money supply. The Fed sets the overnight rates near zero, and all other interest rates usually respond sequentially to that fundamental rate.

The Fed also attempts to stimulate the economy and spur higher inflation by increasing the money supply. The Fed does this by creating dollars out of thin air and using that new money to buy Treasury Bonds and other assets from commercial banks. More dollars in circulation chasing the same amount of economic supply should, in principle, spur higher prices (inflation). But so far, it hasn't—likely for the reasons stated previously.

While the Fed could also simply deposit the new cash it creates in the participating bank's accounts, the approach of buying a bank's supply of 10-year Treasury Bonds achieves the additional objective of keeping interest rates low (by creating increased demand for Treasuries) further out on the yield curve at 10-years, and it monetizes the Federal Government's debt, which decreases the amount of debt owed by the government to borrowers. Congress writes checks, the US Treasury borrows the money to cover those checks by issuing bonds, then the Fed buys up those Treasuries with money created from nothing, eliminating the government's debt-repayment obligations. It's called Modern Monetary Theory (MMT), and it's quite a fine arrangement if you can get it.

 

Insanity 101

The problem that the Fed is facing is that it is fulfilling the definition of insanity: That is, repeating an activity over and over while expecting a different outcome. The Fed has been traveling down this same Quantitative Easing (QE) path since 2008, but so far it has had very little success in creating a beneficent level of inflation. Full employment has been achieved—in fact, even better than full employment when the Unemployment Rate stayed at levels near 3.5% for an extended period of time from 2018 to early 2020. But still, it has been unable to generate benign inflation—a result of the fundamental forces that have all but eliminated inflation across the world; globalization, technology, and an aging population demographic.

What the Fed has instead created is a dangerous level of Asset Inflation. With the only tools available to the Federal Reserve being the financial tools of interest-rate policy and control of the money supply, the result of its efforts to manipulate the economy using those tools has not been a stimulation of the prices of goods, services, and wages when the economy reaches full-steam. Instead, it has achieved a stimulation in the prices of financial assets, primarily inflation of stock prices, with several measures of valuation already at all-time highs.

The Federal Reserve has boxed itself into a gruesome mess:

The Fed could announce one of the following policy changes, and the result will be

1) If the Fed admits that the QE experiment was a failure that never could achieve its objectives, then announces that it will extricate itself from the QE process by reducing or eliminating asset purchases (the least likely scenario), investors will react by selling everything in sight. However, honesty from government (or quasi-government) officials like this is highly unusual, and you may be watching a hostage video. The music has stopped, and you better grab the nearest chair—fast.

2) If the Fed announces it is reducing ('tapering') its asset purchases, the same effect to markets will likely occur, with nobody wanting to be left without a chair when the music stops (another low-likelihood scenario) as the Fed reduces stimulus.

Or... 3) the Fed could simply start 'tapering' (i.e., reducing its stimulus) without an announcement (the most likely scenario). The same result will ultimately occur, and the market will collapse, but with a delayed reaction as investors with differing sophistication will conclude at various points that 'tapering' is what they're witnessing. Subsequently, these investors will bail out of stocks at different points and with a wide range of losses.

In response to the possibility of 3), you could 4) exit stocks now, bank your profits, and be happy you are avoiding the eventual financial disaster.

At its June 15-16 meeting, the Fed retained the staus quo. I fully expect the Fed will maintain the status quo and diligently continue the current stimulative approach for some time to come—perhaps months or even for years to come.

If you sell your positions now, you will ultimately believe that was a mistake. No matter how experienced and sophisticated an investor you believe yourself to be, these continually rising stock prices will cause you to have a classic case of FOMO (Fear of Missing Out), and there's a good chance you'll get back into the market at higher prices and at a point closer to the subsequent collapse.

The unprecedented stimulus—both fiscal (Congress) and monetary (the Federal Reserve)—has left stocks extremely overextended and priced at the highest valuation levels ever recorded. If the Fed even hints at backing off stimulus in the future, the stock market will likely collapse in a flood of sell orders with no buyers on the other side of the trade. How much could it fall, you might wonder? Well, a PE Ratio of 45 means stimulation has pushed equities to an overvalued factor of 3-to-1 or 300% above normal levels, since the average historical PE Ratio of the S&P 500 is about 15.

The Bottom Line

To interested readers of this report looking for the bottom line, Wednesday's dovish announcement meant there will be a continuation of asset purchases and a likely continuation of rising stock prices—as soon as the current correction is complete. Nobody knows the date when the Fed will actually slow or entirely cease its stimulative policy, begin tapering its asset purchases, and start interest rate increases to a more normal level. It will depend on conditions as they develop in the coming years.

However, keep in mind that there are no entrenched special interests (of which I am aware) who are anxious to see stock prices stop rising. There are no substantial rivals to that idea. Who wants to see stock prices decline, other the few investors who are on the wrong side of the trade with short positions, and perhaps a handful of prominent politicians from the Libertarian Party?

So without much of a constituency lobbying for the Fed to terminate its asset purchases, the Fed's stimulative policy is likely to continue until the economy returns to Full Employment at its early-2020 level (3.5 to 4% Unemployment). If the reopening continues to be robust—as the market has been expecting for the last year—and for which there is some evidence already, then the Unemployment Rate should quickly close that last 1.7% of Unemployed workers to reach Full Employment from the current level of 5.8%. This continuation of stimulation will likely result in a continuation of the bull market.

While we may have seen a knee-jerk reaction to the only bearish aspect of the Fed's announcement, which was that it was increasing its inflation prediction by 0.8% in 2022. It also said it now expected two rate increases (instead of one) by the end of 2023. From my view of the calendar, that's 2.5 years away.

So, it's not like the Fed has made a significant, hawkish policy shift, which seems to be the interpretation of many media types. Rather, it was a very dovish announcement because the Fed made no changes to the same policy that has nearly doubled the S&P 500 since the March low. Last Wednesday, the Fed continued its long history of jawboning the market downward from its current overextended S&P 500 PE ratio of 45, while continuing to stimulate the economy without a change. Savvy investors know to watch what the Fed DOES — not what it SAYS.

What we're seeing in the market over the last three days is the beginning of a common correction of individual stocks and ETFs from overextended conditions—probably no more than 8-10%—not the beginning of a bear market.



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