The Fed launched what many are calling Quantitative Easing 3. Included in the announcement was that the pedal will be to the metal into 2015. A reader asked the following after the news;
Fed announces QE 3, buying mortgages to further push historically low rates even lower. Must be nice to own a money printing press! Where do you think this will end, Roger, and how do you think it will affect/add risk to the market. I fear that when our house-of-cards comes crashing down, 2008 will look like a picnic.
There are a few different things in there to address. The starting point for me in trying to think about these things is that we now live in a distorted world. Unprecedented action on the part of the Fed is influencing many things in my opinion. Whether you are bullish or bearish, you are so in a world that is distorted in a way that it never has been before. Two or three years from now it will still be distorted in a way that it never has been before, so we are told.
My thesis for the US before the crisis started was that growth in the economy and the stock market would generally muddle and be relatively unattractive compared to select foreign countries. Net net that is what we have gotten but stocks have been more volatile than I would have thought; down 50% and then up 100%.
The current state of the economy is not horrible it is merely well below what we expect from recoveries. Jobs have not come back the way they should have by now, likewise GDP and as far as housing there are some signs of life but for now I just think of it more humbling as no longer imploding. Regardless of whether you agree with my description in this paragraph or not the numbers and the way you look at them comes in a Fed-distorted world.
As far as when this will end, the Fed keeps extending the date so obviously they don't know when it will end. I read or heard somewhere that the various versions of QE that come have diminishing returns; number 3 will be less effective than number 2 which was less effective than number 1. This theory makes intuitive sense to me and could be important if true.
If you can accept that GDP and jobs are well behind where they should be at this point in the cycle then consider that the numbers such as they are have come from desperate Fed action but only produce weak results and further action from the Fed will yield ever weaker results and we are left to wonder where, when or if meaningful natural demand will come back.
Until it does we will continue to live in a distorted world. In terms of how it will end, I do not believe it will end in such a way that makes 2008 look like a picnic. What I think is more likely is a winding down of the easing. I think there will still be economic cycles and stock market cycles with the expansion/bull phases not going up as much as they used to and the recession/bear phases going down a little more than they used to.
This is not a catastrophic outcome it is a wildly anemic outcome. As far the stock market I doubt there will too many four year periods where stocks cut in half and then go up by 100%. I think it was John Hussman who observed that the typical bear market retraces about half of the bull market run. We might still be in the snap back from 2008, but I think we will see average annual stock market growth of 4-5% and maybe the bear markets take back a little more than half of that.
Several years ago I wrote that I thought our fundamentals called for higher interest rates (this was before QE) and while I believe that fundamental argument is still intact it is obviously no match in the markets for the Federal Reserve. One way this goes haywire would be if rates started going meaningfully higher further out on the curve. This has not happened and I am not sure what the specific catalyst would be but meaningfully higher rates would gum up the works.
One reason why I do not think the market will stop rotating on its axis is the chance for surprises has greatly diminished, as it relates to the financial crisis. The Fed is effectively printing money, anyone not know this? In the last few years anyone who did not know the possible consequence of printing money now does know or at least has an awareness of the consequences. If natural demand never comes about then it is possible that consequences like price inflation could remain relatively muted (relatively muted in the context of a 15% CPI).
Another point about equities is that I do not think they are insanely priced. The low from March 2009 was in part an overreaction as people thought the financial world might be ending. The nature of panics like that is that there is some element of fast retracement that takes back a meaningful chunk of the decline which is exactly where we are now; most of the decline has been made back but there is still a ways to go. I am not one to make a bullish argument based on PE ratios and similar metrics but while I don't necessarily think the market is cheap on a PE basis I do not think it is grossly overvalued. Markets can pull back by any amount at any time but I do not think the valuations call for a massive decline.
The above is what I think has the highest probability; muddling not imploding. Of course discipline to our strategy will will be the first priority.
DIGITAL JUICE
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