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Everyone Has A Plan Until...

Via ConvergEx's Nick Colas,

Every Federal Reserve Chair since 1979 has faced a notable challenge in the first 12-20 months of their tenure – something akin to capital markets “Bullies” hazing the new kid at school.  Paul Volcker had the 1979-1980 Iranian oil shock/recession, Alan Greenspan the 1987 Stock Market Crash, and Ben Bernanke the 2007 Financial Crisis.


Their responses shaped market perceptions about Federal Reserve priorities and set the stage for the remainder of their tenures, from Inflation-Fighting Volcker to Save-the-World Bernanke.


Now, it is Chair Yellen’s turn, with today’s selloff throwing down the gauntlet in front of the Federal Reserve. At stake is the Federal Reserve’s relationship with equity markets not just now, but for years to come. Paul Volcker famously pushed the country into recession in 1981-1982 to dampen inflation, but both Greenspan and Bernanke were much more equity-friendly during their tenures.


How will Chair Yellen’s Fed face the market’s challenge?  It will likely take months to find out, so today we update our “Have U.S. stocks bottomed” checklist. The answer: not yet. 

Former heavyweight champ Mike Tyson is a man of few words, but he does have one great saying: “Everyone has a plan until they get punched in the mouth.” Less well known is his second line: “Then, like a rat, they stop in fear and freeze”. My own father, a man of about as many words as Iron Mike, had his own version: “Never trust a man who hasn’t been punched in the face.” Either way, the sense is the same. Everyone faces adversity, and how you respond to it both reveals and helps build your character. 

The same, albeit less pugilistic, lesson holds true for Federal Reserve Chairs.  Ever since Paul Volcker took the top job at the Fed in 1979, markets and geopolitical events have conspired to challenge new U.S. central bank heads almost right out of the box. Here are the case studies:

Paul Volcker got the big office at the Marriner Eccles Building on August 6th, 1979.  The Iranian revolution was underway at the time, spiking oil prices to $40/barrel (yep, right around where they sit today). The country was in recession, the hostage crisis that demoralized the nation began in November, and despite all that Volcker pushed interest rates to 20% in June 1981 to dampen runaway inflation. That lead to a second recession in the early 1980s, but inflation has been low and generally contained for the last 30 years.  No one has seriously doubted the Fed’s inflation fighting playbook since Volcker’s tenure.


Alan Greenspan took over on August 11, 1987. Two months later, the U.S. equity market crashed with Dow Jones Industrial Average falling 508 points (22.6%) on Monday, October 19th.  This was back when small specialist operations dominated floor trading for stocks, and market participants worried that market losses might bankrupt some of these players. Before the open on Tuesday, Greenspan’s Fed issues a short statement: “The Federal Reserve consistent with its responsibilities as the Nation’s central bank affirmed today its readiness to serve as a source of liquidity to support the economic and financial system”. It also cut Fed Funds to 7.0% from 7.5% and NY Fed President E. Gerald Corrigan personally calls Citicorp chairman John Reed and others to encourage them to lend freely to the securities industry. The message was clear: the markets and the economy were intertwined, and the Fed understood that linkage in the context of its Congressional mandate. No one has doubted the importance of equity market performance to Fed policy since Greenspan’s time in office.


On February 1, 2006, it was Ben Bernanke’s turn at the helm. His honeymoon was a relatively long one; U.S. equity markets rallied until October 2007. The rest of the story you know well, for that 20 month quiet spell quickly morphed into the disaster that was the Financial Crisis. During the interregnum between Bush and Obama presidencies, it was the Federal Reserve that kept the lights on for the U.S. financial system. After that, he worked to expand the Fed’s balance sheet from its pre-Crisis $890 billion to its current $4.5 trillion in the hopes of sparking economic growth. Ever since then, there has been little doubt that the Federal Reserve will do whatever it takes to hold the financial system together.

And now, it seems to be Chair Janet Yellen’s turn to face her first critical challenge.  She has been in office since February 3, 2014 and the S&P 500 peaked in May 2015, so her market honeymoon was almost as long as former Chair Bernanke. Still, the 10% move lower for the S&P 500 and 11% for the NASDAQ in just the last 5 days is a clear sign that markets have grown disenchanted. But why? Three reasons fall to hand:

Issue #1: Low interest rates have juiced equity valuations to levels more consistent with a rapidly growing global economy than one still stuck in first gear. Assuming that the S&P 500 can still do $120/share, the U.S. stock market’s valuation is 16x earnings with today’s pullback. That should be low enough to hold markets together, save one critical problem: analysts expect revenues for U.S. companies to decline for the next 2 quarters. That makes U.S. stocks more of a “Value” play than “Growth”, and the historical valuation range for value is more like 12-14x earnings – not 16x.


Issue #2: The persistent decline in oil and other commodity prices threatens to reintroduce the specter of deflation into global economies.  In a world that still fears a Japan-style round of declining prices, that is a meaningful concern.


Issue #3: And yes… China.  Stock market declines there are worrisome, of course, but more meaningful is that the Chinese government is having so much trouble containing the fallout and stabilizing financial markets. Western fund managers and analysts tend to think of this economy as a ‘Black box’, but when that container starts to sputter they are not in a position to know if it is a minor problem or something larger and more foreboding. Add to that the importance of China to global commodity producers (see Issue #2) and as a growing end market (see Issue #1), and it is easy to see how the selloff there dampens investor enthusiasm elsewhere.

After today’s action, it seems pretty clear that capital markets have a disagreement with the Federal Reserve. The latter thinks things are pretty good and it is time to raise interest rates. The former begs to differ. Two weeks ago we assembled a list of various market-based indicators that outlined this squabble, and we continue to believe that this is also a good checklist for those interested in finding a near term bottom for U.S. equities.

1.    Crude oil prices.  With a close at $38, oil is well below the $40 level we think divides market sentiment on a growing versus contracting global economy.


Verdict: Oil needs to find a bottom – meaning no new low for at least a week – before equities can bottom.


2.    2 Year Treasury Yields. Two weeks ago these were 68 basis points; now they are 58 basis points. At 50 basis points, they would signal almost complete confidence that the Fed was not going to raise rates any time soon. That should be bullish for stocks.


Verdict: we’re getting close, but not there yet.


3.    10 Year Treasury Yields. With a close today at 2.01%, we are on top of our 2% target for long rates as a “Buy” signal for equities.


Verdict: Our first “Buy” signal for stocks!  With yields this low, the S&P 500 now sports a yield higher than 10 year notes: 2.1%.


4.    10-2 Treasury Spread.  At 143 basis points between 2 year and 10 year notes, the yield curve has flattened only modestly from two weeks ago when the spread was 147 basis points.  Something tighter – like the 138 average of February – April timeframe would be a clear buy signal for stocks.


Verdict: not there yet.


5.    Dollar/Euro exchange rate. Two weeks ago the euro fetched $1.104; now it is $1.159.  Ordinarily, that would be healthy for U.S. stocks as a weaker dollar translates into better offshore earnings on a USD income statement. Today, it was more a sign of fund flows out of U.S. dollar assets.


Verdict: we’ll take this one as positive for equities.


6.    S&P 500. Our near term target for the S&P 500 two weeks ago was 1956. Since then, there’s been a lot more technical damage, which simply means that investors are surprised they’ve lost more than they imagined possible.


Verdict: despite being 10% cheaper than a week ago, many investors will probably wait a week to see if current levels hold.


7.    CBOE VIX Index. Two weeks ago we said we wanted to see the CBOE VIX Index over 20 (its long run average back to 1990) for 5 consecutive days before we thought a bottom was in place.


Verdict: three more days to go, but not a Buy yet.


8.    Fed Funds Futures. If Chair Yellen came out tomorrow and said “Recent developments in global financial markets make it clear that a September rate increase would be premature”, we believe stocks would rally.  That is because Fed Funds Futures still ascribe some possibility that the Fed will move next month: 24%, to be exact.


Verdict: once Fed Funds Futures give the chance of a September hike 10% or less, stocks should bottom. We aren’t there yet.

On points, 6-2 to be precise, our indicators show that U.S. equity markets are still in for more volatility in the days ahead.  As for the larger issue of how the Fed responds to this bout of market volatility, well…  I am sure they have a plan.