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‘We Front-Loaded An Enormous Stock Market Rally’

Richard W. Fisher served as the President of the Federal Reserve Bank of Dallas for more than a decade (2005-2015). His appearance on CNBC this week offered remarkable insight into why voting members on the Federal Reserve Open Market Committee (FOMC) embraced zero percent rate policy as well as quantitative easing (QE) for so many years. One of the most controversial statements? Fisher candidly admitted, “What the Fed did, and I was part of it, was front-loaded an enormous market rally in order to create a wealth effect.” He did not say that the Fed sought to achieve maximum employment. He did not bring up inflation targeting or stable prices either. Rather, one of the world’s most influential people in any room acknowledged that the Fed wanted to push stocks higher to make participants feel wealthier. How was this wealth effect supposed to benefit workers? Or promote stable rates of inflation? Presumably, when people feel wealthy, they spend more. When they spend more, corporations see more revenue from the goods and services that they provide. When companies achieve better top-line and bottom-line results, executives express greater confidence by adding new employees. When an increasing number of workers find jobs, unemployment falls to lower and lower levels until, eventually, maximum employment spurs wage growth and desirable levels of inflation. That was the plan. However, there have been several problems with the Fed’s wealth effect ambitions. For one thing, keeping borrowing costs so low for so long primarily benefited those who were already in decent shape. Wealthier folks have super-sized stakes in the stock market and were able to increase the value of their portfolios substantially; less wealthy folks have seen erosion in real (inflation-adjusted) household income – money that most live month-to-month on. Those in the highest marginal tax brackets were able to add to their real estate holdings. In contrast, very few families in the middle or lower-middle class had the resources to acquire short sales or foreclosures. Another problem with the Fed’s wealth effect agenda? Corporations leveraged themselves to the hilt. Borrowing money on the “ultra-cheap” allowed them to buy back copious amounts of stock shares. That helped shareholders of those stocks, but it did not bring back labor participation rates to pre-recession levels. The all-important 25-54 year-old demographic is still hemorrhaging workers. Corporations never really went on the anticipated hiring binge. Instead, they went on a seven-year stock buying spree with the Fed’s easy money. Total debt levels have doubled since 2007. And while the average interest rate paid on corporate debt has declined, interest expense has risen dramatically. Do we even want to ruminate about what will happen if the Fed pushes borrowing costs up appreciably in 2016 and 2017? As it stands, corporations already need to allocate significantly more net income toward servicing the interest on existing loans. So Richard Fisher acknowledged what many people believed all along. Specifically, the Fed’s primary goal since the banking crisis in 2008 has been to push stock and real estate markets to new heights. In doing so, they hoped that the wealth effect would indirectly achieve its dual mandate of stable prices and maximum employment. Of course, when you front-load an enormous stock market rally, won’t stock prices reach exorbitant valuation levels? Is there a painful period of reckoning on the back side? Did anyone at the Fed consider what history teaches us about overvalued stock markets and overvalued real estate markets? Mr. Fisher may not have given the questions much thought during his tenure his tenure on the FOMC. However, he revealed his current thinking to CNBC: These markets are heavily priced. They are trading at 19.5x earnings without having the top-line growth you would like to have. We are late in the cycle. These [markets] are richly priced. They are not cheap. I could see a significant downside. I could also see a flat market for quite some time, digesting that enormous return the Fed engineered for six years. Obviously, the former President of the Dallas Fed cannot predict market direction. Nobody can. And one might argue that a monetary policy wonk does not a valuation guru make. On the other hand, Fisher’s valuation concerns may have merit. For S&P 500 operating earnings of $106.4 (12/31/15) to reach current year-end estimates of $125.6, they would need to grow 18%. At $125.6 and the S&P 500 at 1950, the Forward P/E becomes 15.5. Yet analysts have been ratcheting down expectations from 10% earnings growth to 7.5%. (And in 2015, growth flat-lined entirely). If one generously accepts the wisdom of analysts at 7.5% operating earnings growth, and the S&P 500 at 1950, the Forward P/E on a year-end estimate of $114.4 becomes 17. The 35-year average Forward P/E is 13.2. That’s right. Even after January’s stock carnage that has seen the S&P 500 crater 100 points from 2043 to 1943, the stock market is still pricey. Reverting to the average Forward P/E would require operating earnings to reach $114.4 at year-end AND the S&P 500 to sink to roughly 1515. That would be in line with a typical bear market descent of 28.9% from the peak (2130). Valuation concerns notwithstanding, there’s little doubt that the Fed did indeed front-load an enormous market rally. Here’s how easy it is to tell. Take a peek at how the Vanguard Total Market ETF (NYSEARCA: VTI ) fared as it relates to the Fed’s acquisition of bond assets with electronic dollar credits (a.k.a. “QE”). Specifically, in mid-December of 2012, the U.S. Federal Reserve upped its QE3 program to $85 billion per month in the acquisition of U.S. treasuries and mortgage-backed securities. The program began winding down in 2014 during the “Great Taper,” though the final day of the last asset purchase actually occurred in mid-December of 2014. The 2-year performance for VTI? Approximately 52%. Now visualize what transpired when the Fed officially removed its QE3 stimulus. Through 1/7/16, there has been a whole lot of risk and volatility. There hasn’t been a whole lot of reward. Surprising? Not particularly. In fact, “risk-off” treasury bonds via the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) have outperformed “risk-on”stocks since the end of the Fed’s QE. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Do Historical Comparisons Matter? Strong Similarities Between 1937 And 2015

The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. Market participants might want to consider a similar period in history – a time when the 10-year Treasury offered paltry yields, GDP grew at a reasonable clip and the Fed tightened monetary policy. The case for the continuation of the U.S. bull market heavily rests on the shoulders of steady economic growth and low interest rates (on an absolute basis). Many believe that, as long as these circumstances exist, stocks will provide venerable results. However, market participants might want to consider a similar period in history – a time span when the 10-year Treasury offered paltry yields, gross domestic product (GDP) grew at a reasonable clip and the Federal Reserve tightened monetary policy. In late 1936, GDP had been growing steadily and the 10-year yield averaged 2.6%. The Fed chose to modestly compress the money supply after years of extraordinary stimulus. Indeed, the 1929-1932 “Great Depression” seemed as though it had been been vanquished. Unfortunately, by the second quarter of 1937, investors became alerted to signs of economic deceleration. Risky assets began to falter. The Fed quickly reversed course from tightening to easing, even engaging in market-based asset purchases. To no avail. An insipid recession occurred in spite of the central bank’s rapid policy reversal. Before all was said or done – by the time the 1937-1938 bear had finally ended – stocks had already plummeted 51.5%. Here in 2015, we have experienced steady economic growth for six-plus years with GDP expanding at approximately 2.2% per year. It has been an anemic recovery, but an expansion nonetheless. ( Indications of economic deceleration abound .) Meanwhile, the U.S. stock bull has been remarkably robust, both in duration and magnitude. One researcher estimates that the current bull market period has been more powerful (since 3/09) than 90% of the preceding rallies since 1900. (See chart below.) Similar to the circumstances in late 1936, when the economy appeared relatively healthy, stocks performed admirably, and the Fed started to tighten monetary policy after a long hiatus, the 2015 Fed recently embarked on its first overnight lending rate hike. Those who ignore the similarities say that it is only 25 basis points; they believe that members of today’s Federal Reserve are smarter than their predecessors and that they would not endeavor to normalize borrowing costs unless the economy were strong enough to withstand the shift. Me? I am skeptical. Here are three additional similarities between 1937 and right this moment: 1. The Last Time Stocks, Bonds, And Cash Did Not Work . Asset allocation is not working . Granted, the iShares S&P 500 (NYSEARCA: IVV ) is up 3% through December 2009, with 1% coming on today’s (12/29) price jump and the rest of it coming from dividends. Yet the iShares Mid-Cap ETF (NYSEARCA: IJH ) that tracks mid-sized corporations in the S&P 400 logged -0.5% through 12/29 and the iShares Russell 2000 (NYSEARCA: IWM ) that tracks small-cap stocks registered -2.3% through 12/29. The more that one diversifies, the worse things get. Add foreign stocks via iShares All-World excluding U.S (NASDAQ: ACWX ) for -4.0%. Inject iShares High Yield Corporate Bond (NYSEARCA: HYG ) for -5.2%. Dare to emerge with Vanguard FTSE Emerging Markets (NYSEARCA: VWO ) for -14.7%. In fact, Bloomberg tracked 35 ETFs that invest in different asset types to uncover a median loss (-5.0%). Even the all-in-one solution via iShares Core Growth Allocation (NYSEARCA: AOR ), which offers 60% in stocks and 40% in bonds, served up a negative result (-0.7%). According to research compiled by Bianco Research LLC in conjunction with Bloomberg, you have to go back to 1937 to find a 12-month run where asset allocation performed as poorly. Coincidence? Could be. Or perhaps investors in 1937 struggled with the same concerns about a return OF capital as opposed to a return ON capital. 2. Overvaluation Then, Overvaluation Now . Nobel laureate in economics, James Tobin, proposed that the combined market value of all companies listed on the exchanges should be roughly equal to their replacement costs. He then developed the “Q Ratio,” which divides the total price of U.S. stocks by those replacement costs of corporate assets. Tobin’s Q hit 1.1 earlier this year, suggesting that stocks traded 10% above the value of companies’ assets. Not so bad? That reading has only been surpassed by the year 2000. Moreover, if one assumes the year 2000 was a moment of ridiculous dot-com euphoria, you’d have to go back to 1937 to find a reading that suggests similar overvaluation. Keep in mind, this ratio has only surpassed the 1.0 threshold on one-tenth of trading sessions, most of which occurred in the late 1990s. The average (mean) Q ratio is approximately 0.68. 3. “Spread Spike” For High Yield Bonds . Back in May of 1937, the high-yield bond spread rocketed 85 basis points. Here in 2015? We have two occasions where high-yield bond spreads have spiked by more than 1%. Normal market fluctuations? Hardly. When investors abandon the credit markets, they are concerned about a wave of corporate defaults. And they’re not just worried about energy defaults either. High yield corporate credit is struggling clear across all sectors of the economy. (See Bloomberg chart below.) Are the circumstances in 2015 identical to those in 1937? Of course not. Every well-read market participant recognizes that history has a habit of rhyming, not repeating. Nevertheless, keeping a higher allocation to cash than you might otherwise keep is sensible in this late-stage stock bull. Disclosure : Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Has The ‘Smart Money’ Or The ‘Dumb Money’ Been Reducing Risk?

Riskier assets have been buckling clear across the asset board. Comfort seeking in treasury bonds over low-level investment grade bonds and higher-yielding junk bonds? A preference for recession-proof staples over the wider large-cap asset class? These are signs that momentum currently favors less risky alternatives. History has rarely been kind to those who ignore common sense warning signs. Is it the “smart money” or the “dumb money” that has been seeking safer portfolio pastures throughout 2015? Time itself will tell. That said, riskier assets have been buckling clear across the asset board. Consider the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ): iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) price ratio. A rising IEF:HYG price ratio signals an increasing desire for the perceived safety of U.S. treasuries over the higher yield-producing income of comparable corporates. The ratio has not been this high since mid-2014. Another relationship that typically offers insight into investor risk preferences is the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ):SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) price ratio. When there is skittishness about the economy, cigarette makers, soda pop providers and toothpaste purveyors tend to outperform the broader large-cap market of U.S. stocks. As it stands, momentum for XLP relative to SPY is near 52-week highs. Comfort seeking in treasury bonds over low-level investment grade bonds and higher-yielding junk bonds? A preference for recession-proof staples over the wider large-cap asset class? These are signs that momentum currently favors less risky alternatives. Indeed, there are plenty of additional examples where the less risky asset is outperforming the riskier selection. Compare the perceived safer world of large-company stocks versus the perceived riskiness of owning small-company stocks via the iShares Core S&P 500 ETF (NYSEARCA: IVV ):iShares Russell 2000 ETF (NYSEARCA: IWM ). Like most price ratio comparisons today, the lower risk option is experiencing far greater demand than the higher risk option. There are exceptions to the rule. For example, in foreign markets, large caps are underperforming small caps. This can be seen in the Vanguard FTSE All-World ex-US ETF (NYSEARCA: VEU ): Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA: VSS ) price ratio. One possible reason for the trend toward the perceived riskier asset? Large foreign corporations are exceptionally dependent on international trade; lackluster world demand has put enormous pressure on exporters. In contrast, smaller companies around the globe are more dependent on their local economies as opposed to global trade. Another possible explanation? International small-caps have been beaten down so far that some may perceive them as more attractive from a valuation standpoint. However, relative strength in small-cap international stocks relative to larger-company brethren is not an indication of greater demand for riskier international holdings. In fact, like the overwhelming majority of “risk-on” asset classes, small-cap international stocks via VSS have been faltering since May. In particular, VSS is more than 10% below its 52-week high and remains well below its long-term 200-day moving average. With the U.S. economy showing signs of deceleration and U.S. stocks exhibiting unrestrained overvaluation , few should be caught off guard by waning enthusiasm for risk taking. One fact that looms particularly large? Year-to-date, more stocks in the U.S. have been declining than advancing for the first time since 2009. In sum, history has rarely been kind to those who ignore common sense warning signs. If you have long-term winners in your portfolio, restore those assets or asset classifications back to your original allocation. The cash that you raise from “pruning” will help you buy desirable assets at bargain prices in the future. If you have been holding onto losing vehicles, consider taking a small loss on each. The dollars that you raise from “cutting bait” will help you buy the best fish in the sea when those fish are attractively priced. For Gary’s latest podcast, click here . Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.