There is no doubt in my mind that what happened last Friday, as in the Dow moving above and below the zero-line no fewer than 19 times, was emblematic of this roller-coaster ride for the year as a whole. A surge in January on the back of deficit-financed tax cuts. That was followed by a February-March correction and then a rebound led by a handful of growth stocks that took the S&P 500 to fresh highs in September. And since then, it has practically been a straight line down, punctuated by sessions of huge short-covering rallies along the way as we saw right after Christmas Day.
In fact, readers may be interested to know that the worst year for the market since 2008 — after its best start in January since 1987 — just enjoyed its single best point session ever the day after Christmas (+117 points for the S&P 500). That was a 5% bounce that followed a December 24 half-session (it actually ranked 38th on the list in per cent terms) when the index sagged 2.7%, which had never happened before on this date.
Not to mention the 7.1% market plunge in the December 17 week being the worst in over seven years. Just three weeks earlier, during the week of November 26, the S&P 500 experienced its best five-day period in seven years — as if in perfect symmetry. Talk about a meat grinder of a market!
While that whippy gain on December 26 had the cheerleaders on bubble vision crowing again, we have seen rallies like this (+4.5% or more) 24 times in the past four decades; and declines of at least 4.5% no fewer than 29 times. Let's see when we last saw the S&P 500 jump anywhere close to what it did on December 26th in the past:
Four times in 2008 and six times in 2018.
What about in percent terms?
How about three times in 1987, six times in 2008 and once in 2009.
So the market is behaving as it did during the worst collapse for the market since 1929 and/or the worst recession since the Great Depression.
As an aside, the debate over whether we are in an official bear market because the S&P 500 fell 30 basis point shy of dropping 20% on a closing basis from September 20 to December 24 obscures the major point. We have had declines like this, or worse, without there being a recession like in 1987...but the Fed eased aggressively, and we were in year five of the recovery with plenty of slack, not year ten with a closed output gap and now the Fed remains bent on still tightening. We also had a sub-20% decline in the S&P 500 between July and October of 1990 and we had a recession in any event. There is nothing magical about 20% -- what matters is what the catalyst is that causes the carnage to cease.
As the folks at Bespoke Investment Group told Barron's (see page 7 of this week's edition), as of last week, investors had wiped out $5 trillion or 20% of GDP from market capitalization. "To paraphrase Warren Buffet: If this isn't a bear market, then what is it?"
Even the father of the ETF industry, Jack Bogle, has turned very cautious. Either you see this as a positive contrary development or you heed the advice of someone who has had seven decades of experience in the markets. See A Warning From Jack Bogle on page 29 of Barron's. To wit: "...trees don't grow to the sky, and I see clouds on the horizon...a little extra caution should be the watchword."
It's not too late to de-risk. If we move into recession, which I believe is a base-case by the spring, this bear market is little more than half-done, at best. These types of downdrafts do not end with P/E multiples of 14x-15x but rather closer to a 10x-12x range. So even a flat earnings backdrop can take this market down to 1,800 on the S&P 500 or even lower. Again, either heed the lesson from history or be doomed to repeat the mistakes of the past - that is the choice.
I have been accused by some of being overly bearish and this is not the first time I warned of double-dip risks. This happened in 2010 and 2011 when the economy was fragile and susceptible to shocks, but each time we had a market setback and a sputtering in growth, Ben Bernanke could be relied upon to step in and intervene with massive doses of monetary stimulus. Then after he was done, Mario Draghi picked up the mantle, and the ECB's incredible monetary accommodation acted as a valve for global risk-takers once the Fed was finished with QE.
This is when I turned bullish from 2012 to 2016, catching 50% of this bull market, which is a step up from missing the entire run from 2002 to 2007 while at Mother Merrill. Maybe in the next bull market, I'll capture 75% of it. We'll see. But I started to turn cautious once the Fed started to tighten policy in 2015 and 2016, and without trying to time when things roll over, I had a strong feeling that normalizing the abnormal was not going to be a very smooth transition.
So between the unwinding of the balance sheet and the Fed's rate hikes since late 2015, the net policy tightening has approached 350 basis points. If the Fed does all it wants next year, the cumulative tightening will be 500 basis points, and no cycle ever managed to emerge unscathed by this sort of monetary policy restraint.
The Fed actually had the temerity of raising rates on December 19 even though, since the prior tightening in late September, financial conditions in aggregate had tightened 125 basis points. So the Fed actually raised rates 25 bps after the financial markets had already raised rates 125 bps (worthy of five tightenings!) for the central bank over the prior twelve weeks.
I do expect the Fed to be cutting rates in 2019 and the futures market has priced this as one-in-ten odds at the moment. But the die is cast because the Fed has already overshot neutrality in our view and there is a risk it will not ease as quickly as we think. I think that the Powell Fed is determined to burst all the market bubbles created under the Bernanke era and then nurtured in Yellen's short tenure.
I am hearing that the President wants to have a lunch meeting soon with Jay Powell and that he is (reluctantly) willing to have the opportunity to break bread (and maybe a few vases...as if meetings like this went well for James Comey...best to have this thing taped).
The question is whether Mr. Powell will ask the president if he did any due diligence and actually read what the current Fed chairman had to say about the bubbles the Fed was generating years ago when he was Governor? Oh, I forgot, we have a President who doesn't like to read.
Here's an example of what Mr. Powell had to say (from the October 23-24, 2012 FOMC meeting - just one month after the Fed announced QE3):
"I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy."
"I have concerns about more purchases. As others have pointed out, the dealer community is now assuming close to a $4 trillion balance sheet and purchases through the first quarter of 2014. I admit that is a much stronger reaction than I anticipated, and I am uncomfortable with it for a couple of reasons."
First, the question, why stop at $4 trillion? The market in most cases will cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated. And we will be able to tell ourselves that market function is not impaired and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?
[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it's not so much the sale, the duration; it's also unloading our short volatility position.
My third concern—and others have touched on it as well—is the problems of exiting from a near $4 trillion balance sheet. We've got a set of principles from June 2011 and have done some work since then, but it just seems to me that we seem to be way too confident that exit can be managed smoothly. Markets can be much more dynamic than we appear to think.
When you turn and say to the market, "I've got $1.2 trillion of these things," it's not just $20 billion a month— it's the sight of the whole thing coming. And I think there is a pretty good chance that you could have quite a dynamic response in the market."
Well, it seems as though the Powell Fed has a new strategy, and before it eases again, let alone pauses, the market pullback will have to show definitive impairment to the central bank's relatively optimistic economic forecast. So for the here and now, take note of the historical record, every bear market or major correction did not end on their own...the Fed eased and at some point, enough to put a floor under the situation.
The fundamental low in August 1982 only took hold after Volcker massively slashed rates -- like by over 1,000 basis points!
The lows following the October 1987 collapse was after the Fed cut rates, not once or twice, but three times.
The cyclical bear market of 1990 ended once the Fed started to cut rates aggressively (by nearly 700 bps that whole cycle).
The Fed did the unthinkable and cut rates three times in the second half of 1995 to early 1996 to reverse the market jitters it created when it doubled the funds rate to 6% from early 1994 to early 1996.
The stock market almost corrected 20% in the summer and fall of 1998 and in the face of a fully-employed four-percent growth economy, the Fed again cut rates three times. Only then was a floor established under risk asset prices.
It goes without saying that the Fed was forced to slash rates more than anyone would ever have thought in the 2000-2003 cycle (to 1%) and again from 2007-09 (0% with QE) to stem not just the market slide, but also terminate (asset-based) recessions that proved difficult to emerge from.
But also look at this past ten-year cycle. The market dips in 2010, and then we get QE2. Every single market correction this cycle was met with additional policy easing — QE3 was then followed by Operation Twist to bring long-term yields down. And then Mario Draghi stepped in to act as a surrogate when the Fed was done. But for the time being, this story of central bank support is over.
And we are seeing the results of the Fed's balance sheet, the G-4 central bank balance sheet, and the global monetary base are all in contraction mode. The liquidity constraints are acute, and occurring just as the global economy has swung in the past year from synchronized expansion to synchronized slowdown. Surely it is not lost on the bulls that the OECD leading indicator has declined now for eleven months in a row.
To repeat, we have seen a significant tightening in financial conditions that will have implications for global growth, cash flows, debt-service, credit ratings and defaults/recovery rates. And central banks have not responded with anything more than a pledge to keep a close eye on things and be prepared to pause. They clearly don't want to be seen as supporting asset markets any longer -- this goes double for the Federal Reserve. At some point, the monetary authorities will have no choice but to ease, but it may take more concrete signposts that recession risks have materially risen.
We have experienced nearly 10 years of a bull market and economic expansion. The unemployment rate has gone from 10% to 3.7%. We have seen records set for stock buybacks, M&A and dividend payouts. Credit spreads tightened back towards the levels we saw in 2007.
That last bubble, which was related to housing and mortgages, lasted for five years. This bubble was related to overextended corporate balance sheets, growth stocks, private equity, and CLO's which exceeded the high yield market at the peak and with record-low investor protection, and the shadow banking system.
The Fed undertook an experiment which produced a 'sugar high' that lasted a long time, extended and accentuated by the even more aggressive ECB, but now the movie is in rewind mode. It stands to reason that if zero (or negative!) rates along with central bank asset buying would create a certain bullish environment for investor risk appetite, that the opposite will occur once this monetary policy moves in the opposite direction.
The problem, of course, is that mean-reversion means that we go through the mean -- and this is true for credit spreads as it is for the P/E multiple. When you move to one or two standard deviation events in the bull market, you do the exact same in the ensuing bear market. This is why the terms "overshoot" and "undershoot" exist in our business.
Back in August 2005, Alan Greenspan (at his last Jackson Hole symposium), in classic early fashion, saw what was coming down the pike:
"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy."
"But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."
Well, my friends, we are living through history yet again. But with a twist this time.
We experienced an abnormal recession from 2008 to mid-2009. We then incurred an abnormal policy response — unprecedented to the extent that the Fed's balance sheet expanded to a record size and Federal Government debt relative to GDP soared to all-time highs for a peacetime nonrecessionary economy.
And we still had a totally abnormal recovery — the weakest of all time. So abnormal that the tax cuts of this year produced just two-quarters of decent capex growth and all signs suggest that the relief has already been spent by consumers, with no multiplier effects on spending at all, but a debt and debt-service hangover for years to come.
This was never a normal recovery nor a normal bull market. Ben Bernanke took on the role as Grigor Potemkin who built fake cities in Crimea for Catherine the Great four centuries ago. But we are seeing first-hand that normalizing monetary policy has exposed this economy and marketplace for what it is, and has been for years — a complete façade. This remains an abnormal economy that remains chronically dependent on easy money policies and ongoing asset price inflation for its survival. Either Jay Powell reverses course to allow the economy and Mr. Market to once again suck at the central bank teat, or we have to accept more pain ahead -- asset prices that are allowed to find their intrinsic values.
Imagine that all we are seeing today is occurring with the Fed not even yet hitting its estimate neutral rate target and with the real policy rate barely above zero. This has never happened before. And here we are, with the Fed still claiming that monetary policy is still mildly accommodative, coming off a year of rampant fiscal accommodation, and the economy is sputtering and the equity, credit and commodity markets sinking. All because of the Fed's attempts to 'normalize' its policy. But maybe the economy and market are so abnormal that they can't handle the move back towards policy normalization. That is the real story here - the economy and the financial markets, a full decade after the crisis, still need the training wheels. Remember - the Fed also made an attempt at policy normalization in 1936, and then look at what happened in 1937-38. It was not a pretty picture.
The bottom line: Northing is normal about normalizing an abnormal policy setting in the context of an abnormal economic recovery. This clearly is proving to be a very difficult transition, and the risk is that the Fed has already over-reached, as it did, despite its best intentions, in 1990, 2000, and again in 2006.