In November of last year, I wrote that unless the Federal Reserve returned to a policy of monetary easing, the U.S. stock market was likely in for a crash. By the end of December, the S&P 500 had tumbled by almost exactly 20% from its previous high. By January, it had become apparent that the Federal Reserve had lost its stomach for rate hikes; although, the Fed’s balance sheet normalization seemed to be proceeding as planned.
The Fed’s signaling that it was no longer interested in directly increasing rates was enough to return calm to the stock market, and, by late April of this year, the S&P 500 was tickling the highs established during the previous fall. These levels were short lived, though. Simply not raising rates was no longer enough to keep the market afloat. By June, the stock market was already expecting a Fed delivered rate cut. This expectation led to brand new highs in the S&P 500. With such high hopes being baked into the proverbial cake, the Fed couldn’t possibly risk another market tumble by disappointing, so it didn’t. In July, the Federal Reserve cut rates for the first time since the heart of the financial crisis in 2008. Except, this time, instead of cutting rates while the stock market was racing towards catastrophe, the Federal Reserve was cutting rates as the S&P 500 was establishing new all-time highs.
Unfortunately, even this was not enough to keep the stock market at its lofty heights. For about a month after the July rate cut, the S&P 500 bounced around in a range between approximately seven and three percent below the most recent highs of the index. Hopes of another rate cut in September ended up pulling the index higher leading into the next Fed meeting. The Federal Reserve once again delivered on expectations, and the stock market once again began to sell off on the news. It was also around this time that something more troubling began to happen.
The week of the Fed’s September Open Market Committee meeting was met with an unpleasant surprise. The overnight repurchase agreement rate was spiking.
A repurchase agreement is, basically, a very short-term loan collateralized by securities, typically Treasury securities. To satisfy short-term cash needs, the owner of a Treasury security will sell their security to another party while also entering into an agreement to buy it back at a slightly higher price in the very near future. The rate that translates into the price at which the security is repurchased is the repurchase agreement rate, or Repo Rate. This rate is usually in-line with the Fed Funds rate. Except, by the time the Fed had made its September meeting statement, this rate had increased to levels that exceeded three times the then current Fed Funds rate range. This means that the typical participants in this specific market – often banks, credit unions, or large asset managers – were unwilling or unable to provide cash in exchange for some of the most salable and highly rated securities on the planet for anything less than what would be considered exorbitant rates if such an increase had occurred in any other financial market. Such a move is typically indicative of an extreme lack of liquidity.
To provide the liquidity that the market demanded, the Federal Reserve stepped in. In doing so, as of the most recent tally on October 23rd, the Fed has effectively stopped the process it was calling the normalization of its balance sheet and has, since its recent low recorded on August 28th, added approximately $208.75 billion in assets to its balance sheet. For reference, the 2019 budget for Military Retirement is $60.45 billion. The 2019 budget request for NASA was $19.89 billion. In other words, in eight weeks, the Federal Reserve added assets to its balance sheet totaling more than two-and-a-half times the annual budget for NASA and Military Retirement combined. The casual observer might be excused for confusing such actions as panic-like intervention. To be clear, though, this occurred while the S&P 500 was within 6% of the most recently established all-time high values.
Tomorrow, the expectation is that the Fed will further reduce rates, just as the S&P 500 scratches out even fresher all-time highs.
It should also be added that these most recent all-time high levels – established yesterday – are about 5.79% higher than where the S&P 500 peaked at the end of January in 2018. At one point this month, the index was actually below the levels it obtained in January, 2018. All of this monetary firepower has been expended to maintain a market that has gone effectively nowhere for about 21 months.
I have been saying for a while that the end was near. This is what the very end looks like.
S&P 500 GAAP (Generally Accepted Accounting Principles) earnings have increased by approximately 60% since they peaked in 2007. On the other hand, the S&P 500 has increased by almost exactly 100%. There was a time, namely from 2015 to 2016, that earnings seemed entirely irrelevant. Amazingly, the market then survived many blows that, by all means, should have proven fatal. But our market now is exhibiting its stress in other ways. Just as with so many previous market cycles, investors eventually realize that fundamental multiple expansion cannot drive market prices infinitely higher. If earnings don’t catch up, eventually, the market catches down.
Our market appears very tired and very sick. The Fed is presently applying what looks a lot like palliative care. Soon, as soon as tomorrow, the effect might look more like life support. It is now apparent that this market is incapable of standing on its own legs. It requires more and more stimulus, and just enough does not appear to be enough anymore. To survive, this market needs more stimulus and earnings growth; but earnings appear to be rolling over and the amount of stimulus required to make a dent moving forward will be hard to stomach and, therefore, late in the coming, I believe.
I would not be surprised to see the S&P 500 take a 100-150 point celebratory victory lap after convincingly crossing the 3,000 mark, aided by some trade optimism, of course. However, unless the Fed is willing to burn our financial house down to resolve the current kitchen fire, it seems implausible to me that the index makes new highs beyond that for, perhaps, years to come, given all other available information.
In reality, unlike many, I do believe that the Fed is doing the best that it can. It is in a nearly impossible spot. If the Fed removes support here, the market quite probably crashes. If the Fed continues support here, eventually it won’t be enough, the market still crashes, and the Fed will have less ammunition to deal with the next real crisis, and potentially causes an entirely new crises in trying to prevent the one on its radar. In the history of financial markets, few, if any, have wanted to be the closest proximate cause to popped asset bubbles. I get that. Unfortunately, so far, it hasn’t made the eventuality any less likely to occur. Of course, as they say, this time could be different.