Lowered Expectations

Just like the FOMC, analysts have consistently underestimated the power of foreign buyers, demographics and low-productivity on long-term interest rates.  10-year yield forecasts have changed dramatically from the beginning of the year:

                                Previous:          New:  
Bank of America:       2.65%          1.50%
Citigroup:                   2.30%          1.60%
Goldman Sachs:        3.00%          2.00%
JP Morgan:                2.75%         1.55%
Morgan Stanley:         2.70%         1.25%


A Tumultuous Year Ahead

Wall Street’s S&P 500 Year-end Forecasts:

  • Federated Investors: 2350
  • RBC: 2325
  • Morgan Stanley: 2275
  • J.P Morgan: 2250
  • BTIG: 2200
  • Blackrock: 2160
  • Barclays: 2100
  • Goldman Sachs: 2100

Wall street firms polled by Birinyi Associates see the S&P 500 rising an average 8.2% this year as accelerating economic expansion and corporate earnings growth outweigh the detrimental effects from increasing rates. This comes after the S&P 500’s 11.4% gain and 53 record highs last year, extending the US bull market toward its 6th year anniversary this March.

Not one firm polled sees equities declining despite the Fed’s warnings of increasing volatility as they normalize rates. The Fed’s proclamation has already come true with VIX averaging 19.3 so far this year compared to last year’s average of 14.3. Despite higher volatility, stocks so far remain flat.

Studies show that stocks can continue to climb during the early stages of a tightening cycle (WSJ). Ben Carlson provides more detail in his Wealth & Common Sense blog, revealing that out of the 14 tightening cycles since 1950, in only 2 instances stocks lost value (bonds lost value half of these times). Furthermore in no instance was the rest of the globe embarking on massive QE while the US was normalizing rates, a situation that will offset any Fed effect (other than a strong dollar).

The dollar will continue to rally, fueled by the widening monetary divergence between the US and the rest of the world. Nevertheless any currency pressure on exports (13% of GDP) will be offset by low interest rates and oil prices. Depressed by an influx of foreign capital from the ECB ($68 billion/ month QE starting March) and BOJ ($60 billion/ month QE), lower interest rates will help US consumers (71% of GDP) in the form of lower borrowing rates, and corporation in the form of higher margins.

While the Fed has fixated on a June rate increase, international demand for higher yielding US assets will dampen the effect of the Fed’s rate hikes, holding interest rates low while boosting stock higher. TIC flow data (November: +$53.5 billion) already showed a record $6.112 trillion in Treasury bond held by foreign investors. Their insatiable demand will nearly create a bubble in US assets as long as their central banks keep printing money.

Equities are already pricey with the S&P 500 trading at 16.3 times forecasted earnings at the end of 2014 versus a historical average of 13.9 (WSJ & Factset). Similarly the index trades at 1.7x its expected sales this year, 31% higher than its 10-year average of 1.3. Nevertheless stocks will find momentum in earnings growth, forecasted at +6.3% for the full year which would be the best yearly performance since 2011 (WSJ).

Already pricey US assets temper Goldman Sachs PWM’s forecast to a 4.7% to 8.4% gain for the S&P 500 this year. Instead they recommend 2 foreign markets: Japan and Spain. Similarly Blackrock suggests cheaper Asian stocks like China and Japan (beware China’s margin levels).

Unfortunately strong economics correlates into stock performance worse than rainfall (Vanguard). While the US is a positive outlier economically, Barons reminds us of “the much heralded initial jobless claims numbers that hit a 14-year low last fall. That number also hit lows in June 1987, March 2000, and June 2007, which were all close to major market highs.” Beware for a precipitous decline in US stocks once the rest of the world stops printing money.

This just about sums it up.

An illuminating income and spending report last week:

August Personal Income & Spending: +0.3% & +0.5%. Both gauges rise as expected, given the strong August retail sales report (8/16/14 showing a +0.6% gain). Compared to last year, income (+4.1%) is outpacing spending (+4.4%), resulting in a little savings. Consumer prices were unchanged in August, leaving a very calm (+1.5%) annual gain that gives the Fed room to keep rates low. Core consumer prices gained (+0.1%) in August but also remained at a subdued (+1.5%) rate. Expansionary monetary policies in Europe and Japan will keep interest rates low, strengthen the dollar and keep inflation at bay.

March 19-20 FOMC Meeting

FOMC GDP forecasts

WSJ 3/21/13 

            FOMC Meeting:  The committee voted 11-1, holding policy at 0-0.25% and continuing QE programs.  Ester George dissented, as expected.  While continuing the $85bn ($40bn LT treasuries & $45bn MBS purchases) Bernanke warned these purchases would adjust as economic activity improved.  Such orchestration will nevertheless begin once the job market shows fundamental improvements.  “I think an important criterion would be not just the improvement that we’ve seen, but is it going to be sustained for a number of months?” Bernanke wondered aloud.  While unimpressed with the extent of employment recovery so far, he also holds little excitement for stock’s recent rally, pointing out that inflation weighted indexes are nowhere near record highs.

            FOMC members agreed that moderate economic growth would resume after the 4th quarter slowdown, as consumers and businesses increase spending, housing grows and employment expands.  Amidst this growth longer-term inflation expectations remain anchored under 2% for the next 3 years, enabling the Fed’s expansionary policy to remain focused on its employment target.  Bernanke noted that fiscal policy has become more restrictive to growth in 2013, estimating a total fiscal impact of -1.5% to this year’s growth.  Consequently their 2013 GDP estimate dropped to 2.6% from 2.7% despite becoming more bullish on employment, forecasting a 2013 unemployment rate of 7.4%, down from 7.6%.  The text “easing financial conditions” was removed from the statement, perhaps indicating FOMC members see little US fallout from the Cyprus credit-crisis.

Bernanke addresses Ester George’s worries that the QE program proposes “risks to financial stability, if persistently low rates lead some market participants to take on excessive risk in a reach for yield.”  Nevertheless he did not mention if such bubbles were forming (see Higher Yield).

Bernanke’s term as chairman expires in January 2014 and expectations foresee no third term for the recession weary combatant.  History suggests Bernanke will not change policy before his successor takes over, suggesting no QE adjustments until 2014.  He admits, “I don’t think I am the only person in the world who can manage the exit.”

GDP: March Change from December
2013: 2.55% -0.1%
2014: 3.15% -0.1%
2015: 3.3% -0.05%

Secular Bull Market

The Fed cautiously removes the crutches and the economy begins to stand.  Employment gains and consumers start to spend, encouraged by their growing stock accounts and rising home values.  The economy has mended, standing at the forefront of a powerful and long-term bull market.  For too long have prices moved sideways while stock valuations steadily improved.  The economy is now larger and stronger than it was in 2007 or 2000 – peaks where stocks markets have languished under for the past 13 years.   A secular bull market awaits, with any correction offering an ideal buying opportunity in this new phase of economic growth.

Twin Peaks

2007 Today
10 Year Yield: 4.64% 1.90%
High Yield: 8.5% 6.6%
VIX: 17.5 14
Gold: $748 $1575
Dollar / Yen: 117 93
Unemployment: 4.8% 7.9%
Size of Fed Balance Sheet: 0.89T $3T
Consumer Confidence: 99.5 69.6
Gas: $2.76 $3.74
Mortgage Rates: 6.38% 3.53%
Student Loans: $590B 1.074T



The 8 men and 4 women crouched around the massive oak table, concerned.  They knew not what awaited them.  The future rested in their hands in these most uncertain times.  They debated whether to tell the masses in their brief statement, alerting them to unresolved fiscal issues or the need to curtail their expansionary programs.  Ultimately the space in the statement was limited, this news would have to be revealed in the meeting’s minutes compiled 3 weeks later.

And so it was discovered last Tuesday and markets were caught off-guard. Sellers capitulated and sent prices down in a flurry.   Everyone was shocked, sending volatility through the roof.  Stocks gyrated for a week before markets finally calmed and returned to their previous levels.  

FOMC Minutes: When drafting the statement on January 30th, “members discussed whether to include a reference to unresolved fiscal issues, but decided to refrain.”  Also the “likely efficacy and costs in its asset purchase decisions, but the committee decided to maintain the current language pending a review, planned for the March meeting, of its asset purchases.”  It was certainly these two withheld topics on January 30 that surprised the market today, with the March reviews of the FOMC’s asset purchases ultimately the most important.

In short, The production of motor vehicles increased considerably in the 4th quarter, while manufacturing was not discussed other than exports, seeing increases in activity going out to China and Mexico but certainly not Europe.  GDP growth is also expected to pick up in China.  Home prices gained as sales of existing and new homes increased, noted several times throughout.  There were no worries over any type of inflation.  Financial market conditions improved on whole.  Also included, “The outstanding amount of unsecured commercial paper issued by European financial institutions increased notably.”  Center stage was the discussion over the ending of their asset purchase program, which many regard as risky and laden with unintended consequences.  Suggesting that they might end this program before they heal the labor market to their ideals, a sector where they see improvement in the coming months and a normal rate of 5.2 – 6% unemployment.  It could be unusual to take the patient off life support before they fully recover, threatening this recovery, however and sign that the market can stand on its own is a very good sign.

  • Market expectations for first increase of fed funds rate:                 3rd  Quarter,   2015
  • Most Likely time to end the asset purchases:                                  1st  Quarter,   2014