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April 2nd, 2013 
Peter Nolan Recently
by Peter Schiff: The
Stimulus Trap
After selling
off an astounding 56% between October of 2007 and March 2009, the
S&P 500 has staged a rally for the ages, surging 120% and recovering
all of its lost ground too. This stunning turnaround certainly qualifies
as one of the more memorable, and unusual, stock market rallies
in history. The problem is that the rally has been underwritten
by the Federal Reserve’s unconventional monetary policies But for
some reason, this belief has not weakened the celebration.
Although the
Fed has been tinkering with interest rates and liquidity for a century,
nothing in its history could prepare the markets for its activities
over the last four years. (See
‘The Stimulus Trap’ article in my latest newsletter). And while
most market analysts give credit to Ben Bernanke for saving the
economy and sparking the rally, they have not fully grasped that
market performance is now almost completely correlated to Fed activism.
A detailed look at stock market movements over the past four years
reveals a clear pattern: upward movements are directly tied to the
delivery of fresh stimulants from the Fed. Downward movements occur
when markets perceive that the deliveries will stop. In other words,
the rally is really just a bender. The rest is commentary.
Since 2008,
the Fed has injected fresh cash into the economy with four distinct
shots of quantitative easing and has added two kickers of Operation
Twist. In recent months, the Fed has dispensed with the pretense
of designing, announcing, and serving new rounds of stimulus and
is now continuously monetizing over $85 billion per month of Treasury
and mortgage-backed debt. The new cash needs a place to go, and
stocks, which now often provide higher yields than long term Treasury
bonds, and which offer much better protections against inflation,
provide the best outlet.
But the four
year rally has been punctuated by several sharp and brief drops.
It is no coincidence that these episodes occurred during periods
in which the delivery of fresh stimulus was in doubt. If the Fed
were ever to follow through on its promise to exit the bond market,
we believe the current rally would come to an immediate halt. This
provides yet another reason to believe that stimulus is now permanent.
A close look
at the performance of the S&P 500 over the past four years tells
the story.
Source: Yahoo!
Finance, Euro Pacific Capital. Past performance is no guarantee
of future results. (Click
here to enlarge)
In May 2007,
with the “Goldilocks” economy of 2005 and 2006 still in control,
the S&P finally eclipsed the March 2000 high of the dotcom era.
It ultimately hit an all-time high of 1565 in October 2007. But
later in the year, things began to unravel when bankruptcies of
premier subprime lenders signaled real trouble. A blood bath, though,
did not materialize. As late as August 2008, the S&P was trading
at nearly 1300, down a less-than-tragic 16% from its high. But when
Lehman Brothers, Fannie Mae and Freddie Mac, and AIG imploded almost
simultaneously in September 2008, the markets panicked. Hundreds
of billions of dollars of potentially worthless debt now sat on
the books of the nation’s financial system. No one knew where the
next bomb would explode. A stampede thus ensued. (A minor replay
of this dynamic just occurred in Cyprus. See
my recent commentary for more on this).
Less than a
month later the index fell below 900, a fall of more than 30%. By
November 21, the S&P had lost another 100 points. Four days
later, the Fed introduced the first round of what would come to
be commonly known as “quantitative easing”. This consisted of purchasing
$600 billion of government-sponsored enterprises debt and mortgage-backed
securities. By the day of the announcement (even though nothing
had yet been done), the S&P rallied almost 50 points to 851.
Still encouraged by the Fed, the S&P was at 931 on January 6,
2009, significantly higher than in late November.
Despite the
first round of asset purchases, the market was still in chaos and
had not yet stabilized. By early March, the S&P had lost an
additional 25%, bringing total “peak-to-trough” losses at more than
50%. On March 18, 2009, the Fed announced that it was going to expand
the size of its stimulus program. This time it really got the stock
market’s attention. The new guidelines called for a total purchase
of $1.25 trillion of MBS and $300 billion of Treasury debt. On the
day of the announcement, the S&P opened at 776 and by the time
the asset purchases were complete a year later, in March 2010, the
S&P was trading at 1171, an increase of 50%.
When the spigots
of quantitative easing shut down in the second quarter of 2010 the
S&P turned south, declining to a low of 1022 in July (a 13%
decline from March). In late August, just before Bernanke delivered
his 2010 Jackson Hole speech, in which he would hint at the next
round of stimulus (to be later dubbed “QE2”), the S&P was still
hovering a full 10% below its post QE1 high. But the expectation
of another shot was enough to ignite a rally. When the formal announcement
of QE2 came in November, the index had already advanced to 1193.
When the program expired at the end of the 2nd quarter of 2011,
the S&P stood at 1307, a 25% increase from before Bernanke jawboned
the markets at Jackson Hole.
The market
response to QE2 was in many ways similar, if less spectacular, than
its prior response to QE1. And like the first go-round, the rally
ended with the withdrawal of stimulus. In addition, after the cessation
of QE2, the markets had to contend with the farce of the U.S. debt
ceiling drama. As a result, the S&P declined from a high of
1343 on July 22 to 1123 by August 19, a drop of 16%. This is also
the same time period when the U.S. received its downgrade by Standard
and Poor’s. Ironically, the U.S. eventually got a temporary reprieve
from the spotlight when its problems became overshadowed by funding
tensions in Greece and Southern Europe, causing the market to once
again flock to the so-called “safe haven” of U.S. assets.
The cover from
Europe could only go so far. Pressure soon began to build on the
Fed to deliver once again. It acted in September 2011 with its “Operation
Twist”, a program that consisted of buying longer-term treasuries
while selling an equal amount of shorter dated paper. Although Twist
was advertised as being balance sheet neutral, the short-term sales
the Fed made were somewhat offset by the extension of credit lines
to Europe and an extended commitment to the 0% interest rate policy
that at the time called for an end date of mid-2013. The day the
Fed announced Operation Twist, the S&P opened at 1203. By the
following April it had reached 1400, a return of 16%.
But once again
the stimulus began to fade. In the second quarter of 2012, a sell
off took hold, and by June 5, the S&P traded as low as 1277,
a decline of 9% since April. Cue the Fed! On June 20, the Fed announced
the extension of Operation Twist, sparking a new rally which has
continued into 2013. This buoyancy has been maintained, in part,
by the announcement of QE3 on September 13, 2012, which also included
another extension of the zero interest rate policy until at least
mid-2015. By October, Fed governors were already mentioning inflation
targets and when QE4 was launched on December 12, they clarified
that zero interest rate policies would be in place until unemployment
fell below 6.5%. The current leg of the rally has been somewhat
non-linear as the election, the Fiscal Cliff, and the endless empty
headlines out of Europe have continued to put pressure on the markets.
Despite these obstacles, the S&P has rallied past 1500 and on
March 5, 2013, it closed at 1538, within shouting distance of its
all-time high of 1576 on October 11, 2007.
When the Fed
made the first round of asset purchases in November of 2008, the
market was still in a state of flux. However, since the system stabilized
in mid 2009, there has been a reliable correlation between the timing
of the programs and the performance of the markets. This intention
was stated explicitly in Ben Bernanke’s November 4,2010, Washington
Times Op-ed in which he provided the rationale for QE2:
“This approach
eased financial conditions in the past and, so far, looks to be
effective again. Stock prices rose and long-term interest rates
fell when investors began to anticipate the most recent action.
Easier financial conditions will promote economic growth. For example,
lower mortgage rates will make housing more affordable and allow
more homeowners to refinance. Lower corporate bond rates will encourage
investment. And higher stock prices will boost consumer wealth and
help increase confidence, which can also spur spending.”
With the Fed
on pace to expand its balance sheet by over $1 trillion in 2013,
there can be little doubt that much of that money is headed straight
into the stock market. Treasury bonds are still offering negative
real yields and so there is less incentive than ever to own government
paper.
Recently, the
New York Post’s Jonathan Trugman pointed out that Citigroup could
be considered the poster child of the dubious rally. Since the crisis
began, he reports that the Bank has received $45 billion in TARP
funding, an additional $45 billion line of credit from the Treasury,
and a government guarantee of $300 billion for its own troubled
assets. At the same time, its cost of capital (the money it borrows
from the Fed) is near zero, while it earns 3% to 5% on mortgages
and 12% to 18% on credit cards. But from an operational standpoint,
those gifts have failed to create a flourishing, self-sustaining,
business. The company had shed almost 100,000 employees from its
period of peak employment a few years ago (down to 260,000 employees)
and it announced three months ago that an additional 11,000 cuts
are to come. But Citi’s share price has risen more than 85 percent
since June of 2012, despite scant evidence that the company has
turned itself around.
But look what
all the Fed intervention has wrought. Each time they have intervened
the resulting rally has diminished in intensity, and a sell-off
has always ensued when the drug wore off. Through the years, the
cycle of stimulus administration has quickened pace and has now
arrived at a stage where it is continuous. Currently, the Fed is
talking about a potential exit strategy, but as we have argued in
the past, and as the chart above surely indicates, any withdrawal
of stimulus could likely have dire implications for stocks which
will not be tolerated by Washington.
Japan has been
unsuccessfully trying to inflate its way out of these problems for
the past 20 years (see
‘Japan’s Dangerous Game’ in my latest newsletter). Now many
of the indebted nations of the developed world seem intent to follow
that example. But the monetary experiment of unending stimulus has,
up to now, never been tried on a global scale. No one knows when
or how it will end, but I believe it will end badly.
Investing in
stocks is supposed to be a way to harness real economic growth,
not a way to front run stimulus. Our advice for stock investors
is to recognize that and to get as far away from artificially induced
highs as possible. More fundamentally sound markets exist. We just
have to find them.
April
2, 2013
Peter
Schiff is president of Euro Pacific Capital and author of The
Little Book of Bull Moves in Bear Markets and Crash
Proof: How to Profit from the Coming Economic Collapse. His
latest book is The
Real Crash: America’s Coming Bankruptcy, How to Save Yourself and
Your Country.
Copyright
© 2012 Euro Pacific Capital
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