About this time each year we make resolutions regarding our future goals. We sign up for gym memberships, and swear off those unbreakable habits. We promise to eat salads for lunch, spend more time with family, and read a book a month. All of these things take time, and a lot of it, but require a paradigm shift.
In the back of our minds--and on the cover of the major newspapers and TV outlets each day--are our investments. What are they doing? How will the latest news blurb impact my retirement portfolio? Should I react? If you're like me, you can't help but check your brokerage statement a couple times a week (day?). The gyrations are maddening, particularly on days like today. Such is the nature of capital markets. Many argue that markets follow a random walk--a drunk person walking out of a bar at 3 AM. Some argue markets have a purposeful walk--an early morning stroll to walk the dog. The reality, however, is that eventually, that drunk guy sobers up, and despite our most diligent efforts, we sometimes step in shit. The markets are highly unpredictable.
Though the markets really stepped in it in 2008, U.S. stocks have appreciated at a brisk clip--14.4% annualized for the S&P 500 Index from March 2009 through November 2015. That is nearly 4% greater than the index's average since 1926. Astonishingly, the S&P 500 has outperformed its developed international and emerging market counterparts by 9.0% and 16.6% annualized over the last five years! In short, it's been a great run for U.S. stocks. What has made the run even sweeter is that stock market volatility had been relatively low.
In the last 12-18 months, we have seen extreme volatility in the currency, commodity and junk bond markets. The dollar appreciated by over 20% from July 2014 to March 2015, oil crashed from greater than $100, there are now runs on liquidity constrained distressed debt funds, and extreme moves in the VIX Index (a proxy for volatility) were high by historical standards.
From my vantage point, these major moves are likely all the result of significant shifts in monetary policy, which could continue to impact investor portfolios in the coming years.
Monetary Policy Divergence
At its December 2015 policy meeting, the FOMC finally raised the discount rate by 0.25% to 0.50%. This was largely a non-event. The true event occurred in December 2013 when the the gradual expiration of Quantitative Easing 3 (QE3) was officially announced via the "taper" program. It was at that point that the Monetary Base flattened out at about $4 trillion from its initial $850 billion level at the outset of 2008. You can see in the chart below that the rapid ascent of the monetary base (blue line, left axis) stalls after peaking in September 2014. Similarly, the S&P 500 Index's rise ran out of steam (red line, right axis).
While the pundits continue to parse each Fed statement to the individual letter, the writing has been on the wall for some time. The Fed's various monetary policy tools outlasted their effectiveness some time ago.
The chart above shows the same information as the first chart, however, it shows the rolling one-year percentage change. You can see the massive spike in the blue line, the monetary base, in late 2009. That was when the Fed first started pumping money into the economic machine. Following the red line, we can see the rapid rise of the equity markets through March 2010--arguably in response to the stimulus. Mission accomplished! Business sentiment tends to rise with appreciating stock markets, which lends itself to capital investment and employment growth. No doubt FOMC members were high-fiving each other in early 2010.
The most interesting component of the chart, though, is on the right hand side. In December 2013 "taper" was announced. This gradual reduction of monthly purchases by the Fed corresponds almost perfectly with the gradual deceleration in the year over year appreciation of the S&P 500 Index. As the market came to rely on continued and increasing stimulus, the positive effects wore off with each successive decline in monthly purchases as part of taper. This despite the fact that the overall Fed balance sheet sits at a level 4.7x greater than before the crisis. Far from being thankful for all of that extra cash sloshing around the economy, investors are asking the Fed, "what have you done for me lately?"
As I've written about here, the FOMC is in the difficult position of needing to reign in monetary stimulus so that it has policy tools at its disposal in the next crisis. While the Fed continues tightening "at a measured pace", other monetary authorities will be going in the other direction in attempts to stimulate their own economies. The ECB will do "whatever it takes" and, in fact, its monetary base has been on the rise. The People's Bank of China (PBOC) is loosening its peg on the dollar and remixing the Yuan's reference basket away from the U.S. dollar, thereby, reducing demand for dollars by one of its largest creditors. The Bank of Japan will likely continue to ease in attempts to spur inflation since the third leg of "Abenomics"--economic reform--has not come to fruition.
With stimulus no longer supporting the U.S. stock market in the way it has over the last several years, the metaphorical rising monetary tide that was raising all stocks, regardless of quality or valuation, is changing directions. As it begins to recede, markets may just well return to assessing stocks on the basis of underlying fundamentals. That may be a great thing for active value managers.
In future posts, I'll discuss the implications for stock selection, volatility, currency movements, energy and foreign stocks.