End of the Road
The confluence of factors that influence market prices are vast and variable. One moment patterns and relationships are so pronounced you can set a cornerstone by them. The next moment they vanish like smoke in the wind. One thing that makes trading stocks so confounding is that the buy and sell points appear so obvious in hindsight. When examining a stock’s price chart over a multi-year duration the wave movements appear to be almost predictable.
The fascinating obviousness of hindsight – it is now perfectly clear when one should have bought AMZN. Unfortunately it wasn’t quite as clear in real time. [PT]
Trend lines matching interim highs and lows, and bounded price movements within this range, display what, in retrospect, are the precise moments to buy and sell. In practice, the stock market dishes out hefty doses of humility with impartial judgment. What’s more, being right does not always translate to success. Sometimes it is more costly to be right at the wrong time than wrong at the right time.
One fallacy that has gained popularity over the last decade is the zealot belief that the Fed disappears risk from markets. That by expanding and moderating the money supply by just the right amount, and at just the right time, markets can grow within a pleasant setting of near nonexistent volatility. Some even trust that when there is a major stock market crash, the Fed, having the courage to act, will soften the landing and quickly put things back upon a path of righteous growth.
Believers in the all-powerful controls of the Fed have a 30 year track record they can point to with conviction. Over this period, the Fed has put a lamp unto the feet and a light unto the path of the stock and bond market. But what if the Fed’s adventures in fabricating a market without risk are approaching the end of the road? Let’s explore…
Sometimes the road just ends… and you either hit a wall or fall right off a cliff. [PT]
White On Rice
When Alan Greenspan first executed the “Greenspan put” following the 1987 Black Monday crash, markets were well positioned for this centrally coordinated intervention. Interest rates, after peaking out in 1981, were still high. The yield on the 10-Year Treasury note was about 10 percent. There was plenty of room for borrowing costs to fall.
The mechanics of the Greenspan put are extraordinarily simple. When the stock market drops by about 20 percent, the Fed intervenes by lowering the federal funds rate. This typically results in a real negative yield, and an abundance of cheap credit.
This gimmick has a twofold effect of seen and observable market distortions. First, the burst of liquidity puts an elevated floor under how far the stock market falls. Hence, the put option effect. Second, the interest rate cuts inflate bond prices, as bond prices move inverse to interest rates.
Of course, Wall Street money managers took to the symbiotic forgiveness of the Greenspan put like white on rice. With this new brand of central planning firmly in place, market uncertainty was largely mitigated. The workings of the Greenspan put made markets behave in more or less predictable ways.
A portfolio manager could smile in the face of the occasional and inevitable stock market crash because it meant their bond holdings were rising. Then, after a pleasant dip buying opportunity, their stocks would be running back up to new highs. This was the story of U.S. financial markets and money management from 1987 to 2016.
The infamous crash of 1987 – when the „Greenspan put“ was born. Ten year note yields fell from more then 10.2% to 8.8% within days of the crash. The punters didn’t know it yet at the time, but yields would keep falling for years to come… [PT]
No doubt, there were several gut wrenching sell offs during this period – like 1987, 2001, and 2008. But every time, the Fed came to the rescue by cutting interest rates, bumping up bond values, and engineering an extended stock market rally. Few questioned whether this Fed intervention would ever cease to be available.
Why You Should Expect the Unexpected
Over the decades, risk management strategies were invented that advocated the virtues of a 60/40 stock-to-bond allocation portfolio. And why not? The Greenspan put brought a comforting certainty to the market. When stocks go down, bonds go up. Somewhere along the lines the flow of funds from stocks to bonds during a market panic became regarded as a flight to safety. But what if, in the year 2018, this flight is no longer to safety; but, to danger?
What may come as a great big surprise in the next market downturn is that this relationship between stocks and bonds is not set in stone. In fact, over the next decade we suspect this relationship will be revealed to have been an aberration. An artifact of a now defunct disinflationary world.
We haven’t done a thorough analysis. But we have an inkling that prior to the Greenspan put, the ‘stocks down bonds up’ relationship of the last 30 years was far less certain. What we mean is that during the prior decade, the 1970s, there were occurrences where both stocks and bonds went down in unison. Such occurrences could happen again.
Correlations between bond yields and stock prices have indeed alternated significantly over extended time periods. During the Great Depression, WW2 and the post-war recovery, interest rates and stocks were most of the time positively correlated – they fell and rose in tandem. From around 1969 to 1998 they were mostly negatively correlated, when bond yields declined, stock prices surged and vice versa. After the Russian crisis of 1998, the relationship changed once again to an increasingly positive correlation, with falling stock prices coinciding with falling bond yields and vice versa (even though the larger trend in bond yields remained down because the declining phases were stronger then the rising phases). [PT]
You see, the conditions that made the Greenspan put possible are the opposite of the conditions that exist today. Rates are low and are moving higher. The world is oversaturated with debt. Policies of mass money debasement have bubbled stocks and treasuries out to extremes well beyond what was honestly fathomable.
Yes, the doom and gloom of an epic stock and bond market meltdown are approaching. At the moment, Fed Chair Powell’s even determined to bring it on. We applaud his efforts.
Yet when push comes to shove, and the Fed lowers the federal funds rate, expect the unexpected to happen. The Greenspan put – the market savior – will be mowed over like a ground squirrel beneath a tractor rotary tiller. The market carnage left in its wake will be grotesque and unrecognizable.