Equity market volatility over the past two days is largely due to worries that the U.S. Federal Reserve will lessen its purchases of longer-dated Treasuries, thereby reducing the flow of fresh cash into the risk markets. ConvergEx's Nick Colas notes the analogy of stocks - and other investments - being “addicted” to Fed money holds some resonance (as we noted here most recently ), given the pains of withdrawal we’re seeing ripple through equities worldwide since the FOMC minutes hit the tape. Then again, the fact that the US financial system is terminally hooked to zero-cost liquidity is well-known to our readers, since our initial profiling of this core problem nearly four years ago in "Bailoutspotting (Or The Search For The Great Financial Methadone Clinic )." Needless to say, so far nobody is actually doing any actual searching as the alternative is too painful for anyone to even contemplate.
Either way, it got Colas wondering: what are the methods and success rates of modern drug rehab programs? And what can they tell us about the potential pathways markets might travel on their road to recovery from that “Addiction” to monetary policy? Good news first: rehab works – people can and do change behaviors and dependencies. The bad news: any real rehab is likely years ago. And a word of caution: it takes time, needs to be flexible, and lapses happen. If the first step to recovery is admitting there is a problem, maybe the Fed just made that first, critical, admission. Or maybe it simply floated a trial balloon to see test how fast the S&P500 would drop upon the admission that the Fed does, in fact, have a problem, only to be talked up by the Fed's doves the next day.
Sadly, in the codependency between dealer and user, in this case the Fed and the market, it is most likely that as with the vast majority of cases of narcotic addiction, this one too will end in tragedy, and with the death of one, or more likely both participants.
From ConvergEx's Nick Colas: Rehab? No, No, No...
Every year over 1.5 million Americans go through some form of drug and alcohol abuse treatment, according to the last large survey done by the Substance Abuse and Mental Health Services Administration, an agency of the Federal government. Only about half – 47%, to be precise – complete their treatment. One quarter drop out, and the remaining 25% either transfer facilities or end treatment for some other reason. In general, the more intensive the treatment – inpatient hospital care, for example – the more successful the outcome. The length of treatment varies, as one might imagine, based on what addiction is being treated. Heroin and other opioids take over 150 days, but the median is anywhere from 90 – 121 days. Needless to say, these are long days for anyone who goes through them as well as the family and friends who support them.
Somewhere over the past few years, the serious term ‘Addiction’ has entered the lexicon of capital markets watchers as it relates to how central bank policies enable and distort the price of debt and equity securities. Essentially, the analogy is that markets have become dependent on both artificially low interest rates and the cash provided by liquidity programs such as “Quantitative Easing” in much the same way that a person can become addicted to a dangerous drug or alcohol. If you’ve ever seen addiction first hand, you know this is a spurious anthropomorphizing of financial markets. If you haven’t, well, just trust me.
But I get why market observers make the comparison – just consider the twitch in U.S. equity markets over the last two days. The release of the minutes from the Jan 29-30 Federal Open Market Committee meeting highlighted that ‘Many participants (members of the FOMC) also expressed some concerns about potential costs and risks arising from further asset purchases.’ There was also commentary to the effect that more QE could “Foster market behavior that could undermine financial stability.” The minutes go on to say that one participant argued for varying the amount of stimulus month-by-month, depending on incoming economic data. Pretty innocuous stuff, you might say, but it created the first significant market volatility of the year and took the CBOE VIX Index to a close today of over 15, its high for 2013.
“Withdrawal pains” are a part of drug and alcohol rehabilitation, and if one is so inclined to view market behavior through this lens then the last 2 days clearly resemble a market “Tell” that Fed liquidity is ingrained in equity market psychology. I would not put it past the Federal Reserve to have written the minutes in such a way as to tease out what response the capital markets would have to a proposed change in their asset purchasing plans. That is a common communication strategy in Washington, after all. It is called a “Trial balloon,” meant to gauge a reaction more than actually policy direction. I don’t think equity markets much like or even understand this approach. Too much of how the Street communicates is heavily regulated for the concept of a “Trial balloon” to be a common feature of the landscape.
If, however, the Fed is seriously thinking about changing its tack, then the “Addiction” paradigm does hold some information about how markets may react during what would be a very different world from the one many investors saw just a few days ago. A few points here:
- Drug and alcohol “Rehab” is essentially a medical and psychological treatment to change behavior. There are medications like methadone which treat heroin addicts and disulfiram for alcoholics, but any effective treatment also works on the mental processes which enabled the person to become addicted in the first place. No two cases are exactly the same, and the National Institutes of Health note in their online guide that, “Addiction is a complex but treatable disease.”
- Unhooking the capital markets from the Federal Reserve’s liquidity spigot is certainly easier than actual rehab, but the process is similar. Let’s not lose sight of why the Federal Reserve felt the need to pursue so many unconventional policies in the first place: the U.S. economy remains mired in a very slow climb out of a very big hole. Corporate profits have recovered to near-record levels, yes, but unemployment is still high and GDP growth remains near zero. Ordinarily that would have meant equity markets would apply a lackluster multiple to those high earnings, fearing a relapse to recession and declining corporate profitability. But with incremental liquidity and low interest rates, stock market valuations resemble something approaching a “Normal” mid-cycle recovery. Add to this the presumptive benefits of increased business confidence and consumer wealth effect, and you can see what the Fed had in mind.
- So here’s the “Rehab” – real investors have to take the place of the Federal Reserve and provide liquidity and buying power in equity markets. The tricky bit is that private investors using ‘Real’ capital have distinctly higher required rates of return than leveraged institutions which take advantage of low interest rates to opportunistically speculate on stocks. But the transition is not impossible, and the pathway is clear. And there is every possibility that those real investors will accept that challenge, once they know that the Fed really is clearing out. But we won’t know until they do.
- Treatment takes time. As mentioned above, the typical stay at an in-hospital program is measured in months. There are no shortcuts. The number one cause – by a wide margin – of a failed course of rehab is the patient quitting part way through.
I think this point is what troubles equity markets at the moment. No one knows how much time it will take to clear market psychology of the last few years’ presumption of a “Fed put” on stocks.
The other analog to recovery from addiction is the need for consistency. The NIH guidelines I mentioned above highlight the need for continuous monitoring of the patient because lapses back to drug and alcohol abuse occur frequently. Once the Fed decides to seriously cut back or eliminate its long-dated Treasury buying program, there’s really no going back. If you buy the notion that “Real” investors are waiting for the Federal Reserve to leave the scene before they step in, then it makes sense that they will want to be sure the market is cured of its “Addiction” before they return.
One final thought: as I read through this before pushing ‘Send,’ it strikes me just how difficult the transition to a less-aggressive Federal Reserve asset buying program will be for U.S. stocks. So much of the baseline assumptions for equities are anchored on a highly accommodative U.S. central bank that it is hard to imagine how this transition would work. But, as the saying goes, the first step to curing addiction is to admit you have a problem. And maybe that’s what the Fed just did.