- The biggest investor of them all just said that he will start cashing out. Hopefully, this won’t lead to a bear market, but it will certainly put the brakes on further growth.
- Economic signals are mixed, the outlook is uncertain and as much as the low unemployment rate is positive, historically, that isn’t a good sign for the future.
- As always, we’ll discuss what to do in this environment.
It seems that the S&P 500 peaked on March 1, 2017.
Figure 1: S&P 500 in the last 6 months. Source: Yahoo Finance.
Since then, the market has been slowly declining. It isn’t much, but the 2.5% decline in a month and a half could be an indication of a new trend as it seems the market lacks the fuel for reaching new highs. Apart the notorious overvaluation in the market that we’ve discussed before, there are other factors that will slowly but surely chip off the potential for further growth.
What’s Going On?
Many expected miracles from the new presidency, but if tax breaks and improved exchange policies ever materialize it will take a bit of time as these things usually move very slowly. However, positive news will give some fuel to the stock market, especially if it is in the form of lower taxes.
Unfortunately, the negative catalysts outweigh the positive ones, not so much because of their significance but because when a market is as stretched as the S&P 500 is, every little pebble in the market’s shoes has an impact.
The FED Is About To Start Cashing Out
The first pebbles are the hints that the FED is not only going to raise rates, but also trim its balance sheet. All of this has been announced very carefully, sending warnings way ahead of an actual move, but the medium-term message is clear: interest rates are going to go up and the FED will not buy new bonds as the ones it holds mature. There’s nothing that can be done against it, interest rates are like gravity for stocks. The higher the risk-free interest rate, the higher the expected return from stocks is which will inevitably push stocks down, or, if the rate changes are gradual, keep them level. The same principle applies to all other assets.
Figure 2: As interest rates went down (blue) real estate and stock prices went up (red). Source: FRED.
On top of the clear benefit coming from low interest rates, to save the economy, the FED had started with huge asset purchases in the open market in order to provide extra liquidity to further stimulate economic growth. This action has added $3.6 trillion to the FED’s balance sheet and injected the same amount of money into the system. With more money on the table, the first thing that increases in value are liquid assets like stocks.
Figure 3: FED’s balance sheet (blue) and the S&P 500 (red) have been going hand in hand. Source: FRED.
The impact of the FED’s balance sheet and low interest rates is pretty straightforward. Therefore, the reversal in the FED’s policy will have a negative impact on real estate prices and stocks. I hope it isn’t going to drag down asset values, but it is going to put heavy pressure on future potential growth.
The Economy Is And Isn’t Strong
Economic data that comes in is constantly mixed. The Federal Reserve Bank of Atlanta (FRBA) has been trimming GDP growth projections as new data has been coming in. GDP growth for Q1 2017 is expected to be around 0.5% which is much lower than the 4% many were hoping for.
Figure 4: Lower economic growth is never a good thing. Source: FRBA.
Gallup’s economic confidence index also indicates that positivity for the economy may have peaked.
Figure 5: Economic confidence in the last 12 months. Source: Gallup.
On the strong side, the unemployment level is at 4.5% which is a healthy level. However, the question remains whether the FED has artificially pumped up the economy as it has done with stocks and real estate. Higher interest rates and less liquidity will hit inefficient companies and weigh on economic growth.
Unfortunately, the U.S. economy has never been able to operate at its full potential for a longer period of time. It’s either growing or contracting. I highly doubt the FED will manage to keep things stable as we are probably well beyond that point where economic stability could have been managed. The U.S. economy prefers to grow as long as it can and then enter into a recession than to grow at a slower pace for a longer period of time. A clear indication is the unemployment rate which has never remained stable.
Figure 6: The unemployment rate is a good indicator that a recession is close. Source: FRED.
As the FED is pulling back, it’s time to get cautious. If you have been invested in the S&P 500 for the last 8 years and have done extremely well, don’t fool yourself that the reason behind the great performance are your exceptional investing skills and make sure to send flowers to Janet Yellen.
In such an environment, the most important thing to do is to compare the risks with the rewards. If the economy continues to do well, the FED will increase rates and trim its balance sheet pulling down asset prices. This means that in the good case scenario, stocks will be flat or grow at very low rates.
On the other hand, if a recession comes around, which is very likely given that economic sentiment isn’t that positive anymore and GDP growth is at 0.5%, the downside is huge.
Owning the S&P 500 is crazy at this point in time. What can be done now is to own assets that are cheaper and have better fundamentals as in the long run, fundamentals always prevail.