The last time the S&P 500 rallied in such a serene manner as the current trend was March 1987 - a few months before monetary imbalances came undone and crashed in October 1987. Further, JPMorgan's Michael Cembalest notes that prior to WWII, the previous rally as calm and uninterrupted as this was in November 1928 - a year before the crash. The JPM CIO points out how the Fed's ZIRP has created a 'Portfolio Rebalancing Channel' (PRC) transmission mechanism from cheap credit to wealth effect through spending and profits (that has worked as planned) but the last leg on this mechanism has not functioned so well. Payroll growth has been underwhelming and the housing market remains stunted - leaving the real economy remaining fragile despite the market's appearance. The Fed remains committed to driving this 'channel' but, as Cembalest points out this could easily be derailed by inflation, a bond market revolt towards funding our 'Ecuadorean' deficits, or the pending fiscal cliff legislated for 2013. "So the PRC keeps chugging along, until the Fed's job is done (and Goldilocks continues), or something breaks."
The S&P 500 has gone up in almost a straight line since November 25th, propelled by unlimited ECB lending and some positive US economic surprises. I looked for other periods when the S&P went up like this, with almost no volatility (defined as a rally whose stats match/beat those in the chart).
In the post-war era, there were none. The last time this kind of rally happened: April 1943, after Germany was first defeated at Stalingrad. History does not rhyme; ninety years ago, money-printing led to calamity in Germany, and eventually, to disaster in Europe. Today, money-printing is designed to save it. Its impact led Mario Monti to declare this week that the European debt crisis was “almost over”.
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In the US, the rally has been sustained by the view that Fed policy is working. A zero-cost-of-money is supposed to create a “Portfolio Rebalancing Channel (PRC)”. As shown in the charts below, the channel is now playing out presumably as the Fed expected after lowering the cost of money to zero in 2008:
- A flood of money goes into credit funds, lowering the cost of credit and more importantly, increasing its availability
- Rising credit and equity markets create a positive wealth effect
- The wealth effect leads to a rebound in spending, driven by the top 10% who account for ~30% of discretionary spending
- Industrial production picks up, leading to…
- A sharp rebound in S&P profits…
- And a similar rebound in capital spending…
- Eventually, accumulated profits and demand for goods and services leads to a rebound in payrolls…
- And eventually, home prices, although this cycle is clearly quite different given the supply overhang
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But, it hasn’t worked perfectly, of course. Payroll growth is still too low, home prices haven’t rebounded, and trend growth is less than 3%.
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The Fed committed again this week to keeping its zero cost of money policy in place until the recovery is on stronger footing. Fiscal policy needs to be easy as well, so that it does not get in the way. What could derail this one-way rally? Inflation, or a bond market revolt. Core inflation has risen close to its pre-crisis average but shows no signs of accelerating, and wage growth is weak. On fiscal policy and the Federal debt, a combination of the Fed (which bought 66% of net Treasury issuance last year), non-US central banks and US banks appear ready to finance America’s Ecuadorean deficits. Will the massive fiscal tightening legislated for 2013 happen if it can be postponed? There are bipartisan proposals, but the prospects appear dim. So, the PRC keeps chugging along, until the Fed’s job is done, or something breaks.