Newsletters 2010 Newsletters Unintended Consequences
Monday, 12 April 2010 22:38
Since the mid-January through early February slide that saw stocks fall roughly 10%, the market has resumed its gravitational ascent back to levels not seen since the collapse of Lehman Brothers in September 2008. The Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite rose 5.15%, 5.88% and 7.14% respectively in March and are now up 4.11%, 4.87% and 5.68% respectively for the year.
The S&P 500 first crossed 1,200 during the Fall of 1998. After the technology or dot-com bubble burst in March 2000, the S&P Composite fell precipitously and crossed back below 1,200 in early 2001. It wasn’t until the Fall of 2004 that the S&P 500 would again recapture the 1,200 threshold. The markets remained stable for most of 2005, 2006 and 2007 and ultimately reached a high of 1,561 in October 2007. From that peak, the S&P 500 Composite drifted steadily lower for most of 2008, hitting a full 20% correction in July as energy prices surged in the wake of $150 oil. The stock market attempted to gain its footing, as the oil bubble collapsed, but everything changed on September 15th when Lehman Brothers announced its bankruptcy. Just prior to Lehman’s demise, the S&P 500 stood at 1,255. By early October, the S&P 500 had broken below 900 before making an even feeble attempt to rally. While the market lows were not ultimately set until March of 2009, the initial waterfall decline or “Lehman gap” in September 2008 marked the period of maximum uncertainty during the financial crisis. Because of this gap, S&P 1,200 is an important technical and emotional barrier for the stock market.
So, with Spring in the air and a new whiff of economic optimism, the S&P 500 Composite seems poised, even destined, to once again recapture 1,200, an amazing 12 years after first crossing that milestone. While filling the so-called “Lehman gap” should inspire confidence that the recovery underway is perhaps gaining momentum, there remains a distinct possibility that we may be testing the higher end of a trading range. After all, our 2010 year-end target for the S&P 500 is for a range of 1,200 to 1,280. With the lower end of our year-end target range rapidly approaching, we are finding far less bargains available and have made gradual, tactical allocation shifts out of stocks and into short-term corporate bonds for our more income-oriented clients.
While we remain confident, even after the impressive 70% increase from the lows set last March, that stocks offer superior long-term value over bonds, we also remain concerned about the nagging uncertainties that may result from a world of higher deficits, higher taxes and higher interest rates. While the data increasingly points to a sustainable economic recovery, we worry about how long-lived the recovery will be in the face of increasing government entitlements, the expiration of the Bush tax cuts and a Federal Reserve on the cusp of its next rate-hike cycle. This tug-of-war is currently being played out within the Fed as they debate their pledge to keep rates low for an “extended period”. With recent inflation reports still benign, it is clear that the Fed is erring on the Greenspan side of caution by maintaining excessively easy monetary policy. We wonder what the unintended consequences of this excessively easy policy will be.
In a recent letter to the Wall Street Journal, Charles Schwab, founder and Chairman of the Charles Schwab Corporation, beckoned “those in Washington” to consider the plight of retirees as they “consider Fed monetary policies going forward”. Schwab argues that “retirees feel the consequences (of the Fed’s easy monetary policy) disproportionately” since “more than $7.5 trillion of American household wealth is held today in short-term, interest bearing products such as checking and savings accounts, retail money funds and CDs”. Schwab points out that “at today’s low interest rates, the return on those savings is hundreds of billions less than it would have been at 2006 interest rates”. From the perspective of this highly regarded financial services pioneer, the consequences of very-low interest rates have been both direct and “painful”. He goes so far as to say that “ultra-low interest rates are a potential disaster striking at core American principles of self-reliance, individual responsibility and fairness”. How’s that for unintended consequences?
Schwab does acknowledge that “historically low fed-funds target rates pulled many banks from the precipice of collapse” and “by that measure the action by the Fed has been a resounding success”. Reading between the lines of Schwab’s letter, he applauds the intended consequences and lambasts the unintended. We doubt that Fed Chair Bernanke intended to deprive retirees of their safety net and an important source of income, but that is precisely what has occurred. We doubt that Bernanke intended for seniors to trade in their CDs for riskier bond funds, but that is exactly what they have felt compelled to do.
Recent market history is littered with the impact of unintended consequences, particularly as it relates to Fed policy. In the months leading up to the new millennium and much-feared “Y2K bug”, the Fed pumped liquidity into the system, helping ignite the final wave of the technology bubble, itself fueled by unprecedented, massive spending on technology upgrades to prevent the Y2K bug. The Fed was surely not a willing accomplice in helping create the dot-com bubble, but that in fact was an unintended consequence of their actions. After the dot-com bubble burst, Fed Chairman Greenspan maintained an extended period of easy monetary policy that helped create the housing bubble. With the extraordinary economic damage caused by housing’s collapse, we are quite certain that the Fed did not set out to inspire such wild speculation in keeping rates low for such a long period. And while many, including us, predicted the increasing likelihood of a housing bubble, very few predicted the unintended consequences such as the failure of Lehman Brothers and Washington Mutual, bailout of AIG, nationalization of Fannie and Freddie and a 50%+ drop in the stock market.
Perhaps the most likely unintended consequence of the Fed’s current ultra-low interest rate campaign, as suggested by Charles Schwab’s letter to the Wall Street Journal, is the inability to invest “safely” in today’s market. Not long ago, we would often hear the mantra “cash is king” as investors considered potential allocation strategies. Today, we are more likely to hear that “cash is trash”. And the conundrum faced by investors due to the lack of any real yield on “safe” short-term instruments is compounded by the fact that longer-term instruments will suffer when the Fed begins raising rates. Even Bill Gross, bond guru, manager of the world’s largest mutual fund at Pimco and arguably the most highly regarded bond investor of all-time, seems to be challenged by the current environment. Gross recently told CNBC “that risk assets, whether its high yield bonds or whether its stocks, have a decent return relative to the potential of declining bond prices” and that he’ll “go with the stock market”.
Interest rates have already begun to rise even as the Fed continues to telegraph exceptionally low rates for an extended period. The 10-year Treasury bond is rapidly approaching 4%, its highest level since last June and well above the 2% crisis lows set in the Fall of 2008. Rates may very well be rising because the economic data has been stronger than expected and investors, such as Bill Gross, feel more comfortable getting out of Treasuries and into stocks. Or rates may be rising to reflect growing fears of rising deficits and the long-term fiscal health of the United States. We suspect that the longer the Fed keeps rates at such unprecedented low levels, the risks will rise for policy error and unintended consequences that today cannot be predicted with precision. In the meantime, as the S&P 500 prepares to once again pierce through 1,200, investors that share Charles Schwab’s disgust for the high price of “safety” may find the wait for Fed action too difficult to bear. When these investors ultimately choose to join the ranks of bond gurus now “going for stocks”, as reluctant a choice as it may be, the unintended consequence of that choice may be the marking of an intermediate high in the stock market.
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