Ever since the 1980s, when Alan Greenspan was Federal Reserve chairman, investors have accepted the idea that the Fed acts to increase market liquidity during significant market downturns. NY Fed president John Williams recently announced that:
If economic conditions dictate a policy change to lower rates to zero or even negative rates, we will do what is appropriate.
This response to challenging market conditions by the Fed has benefited both borrowers and those investors who are prepared to reach out and take a risk. With the Fed prepared to intervene in the market both businesses and families have been emboldened to take on more debt as the 10-year yield has gone down 3.24% to 2.62%. At the same time stocks levels have continued to trend upward, climbing towards the record heights that were seen at the time of the September-October peak.
While the actions of the Federal Reserve have proven effective so far the question in the mind of investors now is "will the ‘Fed-Put' prove so efficacious next time?" That question is not so simple to answer and will probably depend on the Federal Reserve but on if the U.S. economy is experiencing recession-inducing pressures.
In the past, it has been common for the Federal Reserve to respond to financial crises by offering bailouts. Long Term Capital Management, the world’s biggest hedge fund was the recipient of a bailout in 1998 and more recently the Federal Reserve contributed along with other financial authorities and central banks in the bailouts offered to numerous European countries, such as Italy, Spain, and Greece.
Looking at the other side of the coin for a moment, the actions of the Fed have not always been so successful. In the last 20 years alone the Federal Reserve has tried unsuccessfully to halt the growth of a couple of 50%-plus bear market disasters. Business leaders saw stock prices halve and no amount of jawboning, or interest rate manipulation had any appreciable effect. To explain this simply we could say that when a fall in the markets is combined with recessionary pressures, as we saw around 2000-2001 and 2008-2009, the actions taken by the Fed are frequently ineffective. If this premise is accurate it means that when the next downtown comes around it is likely that there will be a significant stock mauling.
Another concerning issue is the way the Fed has kept the overnight lending rate at only 2.25%. In present circumstances, this is not a problem but during past recessions such as those in 1990, 2001, and 2008 the Federal Reserve be able to stimulate the economy by cutting the overnight lending rate by 5%. A similar 5% cut today would result in negative interest rates. Is that desirable? What about a $10 trillion in quantitative easing program?
It must be admitted that no-one at the Federal Reserve is yet publicly speaking about a U.S. recession coming any time soon, yet these are the same people who used global economic weakness to justify their recent change of direction.
Looking outside the U.S., China has established a growth target for 2019 of 6-6.5%. Their slowest growth rate since 1990, although still large by global standards. In the Eurozone and Japan, PMI economic output appears to be trending toward contraction.
As a largely service-oriented, consumer-based economy the U.S. does not rely excessively on exports or manufacturing and this has led some to believe that the economy will not face the same degree of pressure being seen elsewhere but is that the case?
Durable goods data from December recorded an unexpected slowdown in business spending. The manufacturing survey produced by the Philadelphia Fed dropped to minus 4.1, recording the first negative amount since May 2016 and the greatest single drop since August 2011.
February saw more jobs being cut than at any time since July 2015, and the Atlanta Fed issued a GDP forecast with a measly Q1 growth rate of 0.4 %. J.P. Morgan has reduced their overall growth forecast for the first quarter of 2019 to 1.5%. This follows on from a lowered 1.4% for the last quarter of 2018. One factor which has not helped the economy is the 35-day government shutdown. it is impossible to say whether it will prove to be more than a temporary economic drag, but it is certain that it has held up the release of economic reports, meaning that there is less economic data available that would normally be expected.
Does that mean that this is the right time for the Fed to be accommodating and to be purchasing equities? There are a lot of people who are speculating along those lines but to do so ignores the negative guidance coming from 75% of S&P 500 corporations.
As Michael Wilson, Morgan Stanley (NYSE:MS)'s chief equity strategist says:
Earnings revision breadth has been some of the worst we have ever witnessed with both sales and margin guidance coming down across all sectors.
If Wilson is describing the situation accurately then it follows that extreme valuation levels will be correspondingly even further out of line. Indeed, numerous valuation models indicate that at no time have stocks been more oversubscribed. It is quite possible that the stock recovery we are seeing today may not indicate a long-term trend at all. History tells us that during the 2000-2002 bear market there were three occasions when stocks rose 20% off a bottom before being pushed back lower than before.
At the present time, investors seem to have opted to look past growing signs of global economic weakness, clear-cut overvaluation measures and the historical performance of the Fed during past collapses. It would be wise for them to think about the degree of leverage remaining in the system. Today leverage is greater than at the pinnacle of both the real estate bubble and the tech bubble. this situation is potentially problematic since when lowering prices start to trigger margin calls we could see excess leverage begin to violently unwind. If it happens that the "Fed-Put" is unsuccessful on the next cycle then it is not likely that a 19.9% S&P 500 decline will be succeeded by a "V-shaped" recovery.