Is The Fed Still In Control Of The Market?
Kitco Commentaries | Opinions, Ideas and Markets Talk
Featuring views and opinions written by market professionals, not staff journalists.
This week, I read an article on Seeking Alpha by Jeffrey Saut entitled “Stock Market Timing?”
While I have much respect for Mr. Saut’s experience and knowledge in the industry, I do not agree with his recent missive, as it is replete with market fallacies and circular logic.
Within this article, Mr. Saut takes market participants to task for not understanding the market:
"As mentioned on numerous occasions, if nothing else, if investors only understand and appreciate the following, they will always be on the right side of the market and will never be influenced by others' opinions or news headlines:
Investors must understand the role of the U.S. central bank (the Fed). The U.S. Federal Reserve System was created in 1913 to perform all roles monetary, but one of their key statutory (written in law) mandates is to "To maintain orderly economic growth and price stability." This agency has more and better information on the economy than anyone in the world. It was not created to promote hyperinflation or to create depressions. The Fed's key mandate must be clearly understood and appreciated.
The stock market is a leading economic indicator. The economy does not lead the stock market. Hence, once these two points are clearly understood and remembered, the market's logic becomes apparent. Hence, when the economy slows and heads into a recession, the Fed will ease and will keep easing until the economy responds (remember, that's their mandate). The stock market, being a leading economic indicator, will have bottomed 6-9 months before the recovery begins, not after. For example, "the market" bottomed in October, 2008 and the recession ended at the end of June, 2009 and a [market] recovery commenced, eight months ahead of the [economic] recovery. Conversely, when the economy overheats; inflation surges; and speculation is rampant, the Fed will tighten by draining liquidity from the system and raise interest rates in an attempt to cool the economy. The stock market, being a leading economic indicator, will head south long before the onset of a slowdown or recession, not after. This chain of logic is so simple that anyone with an IQ slightly above room temperature would understand it. Yet, most on Wall Street with umpteen degrees and decades of experience can't figure it out."
However, it seems Mr. Saut is guilty of some of the same errors for which he calls out others.
Let’s start with his first premise. He suggests that in order to understand the market we must understand that it is the Fed’s responsibility to “maintain orderly economic growth and price stability.” I have recently penned an article regarding my perspective on the Fed’s control of our market, and have explained why the common view of the Fed is based more upon fallacies than fact. But, the gist of that article is summarized in the following paragraphs:
"When the Fed began to change course on its quantitative easing process, almost any market participant and analyst you spoke with expected it to have a dramatically negative impact upon the stock market. I mean, since it is “clear” to everyone that the market rallied due to the Fed, then it was equally clear that the market would now react in the opposite manner when the Fed began reversing course.
However, the fact is that the stock market has gained 1100 points, which is a 61% rally, from the point at which the Fed began to change course. Yes, you heard me right.
So, I will ask you again: Do you think everyone’s expectations about the Fed’s reversal of course causing a similar impact upon the stock market was correct? And, if not, shouldn’t we then question whether the Fed is really controlling the stock market and was the true cause of the rally to begin with?"
Moreover, in prior articles, I have also explained why I think the Fed and the Plunge Protection Team, with which it is involved in “maintaining price stability” within our markets, is either asleep at the wheel or simply does not control the market to the extent that so many are led to believe:
"As another example of this perspective, many believe that there is something called the Plunge Protection Team, created as a response to the 1987 crash, which supposedly prevents the market from crashing anymore. And, again, analysts . . . point to this "Team" as the reason they are wrong when they expect a major drop in the markets which does not occur.
If there really is such a team hard at work, with their ever-present finger on the "buy" trigger, then we should not have had any stock market "plunges" since 1987. Rather, the stock market should have only experienced "orderly" declines since that time, and not plunges of 10%, and certainly not over 20%, within a period of a day to a couple of weeks in the same manner as that experienced in 1987. So, the question we now have to look at is if the facts within our markets actually support the existence of such a "Plunge Protection Team" actively at work in protecting us from significant stock market "plunges."
Since 1987, I don't think that anyone can fool themselves into believing that we have not experienced periods of significant volatility. In fact, the following instances are just some of the highlights of volatility since the supposed inception of the Plunge Protection Team:
•February of 2001: Equity markets declined of 22% within seven weeks;
•September of 2001: Equity markets declined 17% within three weeks;
•July of 2002: Equity markets declined 22% within three weeks;
•September of 2008: Equity markets declined 12% within one week;
•October of 2008: Equity markets declined 30% within two weeks;
•November of 2008: Equity markets declined 25% within three weeks;
•February of 2009: Equity markets declined 23% within three weeks.
•May of 2010: Equity markets experienced a "Flash Crash." Specifically, the market started out the day down over 30 points in the S&P500 and proceeded to lose another 70 points within minutes. That is a loss of 9% in one day, but the market did manage to close down only 3.1% in one day!
•July of 2011: Equity markets declined 18% within two weeks
•August 2015: Equity markets decline 11% within one week
•January 2016: Equity markets decline 13% within three weeks
Based upon these facts, you can even argue that significant stock market "plunges" have become more common events since the advent of the Plunge Protection Team, especially since we have experienced more significant "plunges" within the 20 years after the supposed creation of the "Team" than in the 20 year period before."
So, while the Fed is charged with the responsibility of “price stability,” does it sound to you like it is effectively fulfilling its responsibility? I certainly do not and it is simply because I do not believe the Fed has anywhere near as much control as many believe. And, history has proven this to be the case.
Now, let’s move onto to Mr. Saut’s second premise: “The stock market is a leading economic indicator.”
I have always found this to be a fascinating perspective, which seems to be a belief held by a significant amount of market participants. Yet, I never understood the basis behind this premise from the perspective of the masses. Does the stock market have a crystal ball? Is it omniscient?
While Mr. Saut accepts it as “fact” that the stock market seems to be omniscient relative to the economy, he does not offer any reasoning as to why this is the case. While I think many agree with Mr. Saut that the stock market may seem as a leading indicator, why is the stock market price action always leading the economy by as much as a year? Until you understand why the stock market is a leading indicator, I think any analysis based upon this premise will be clearly lacking.
I have addressed this causation chain in prior articles, so I will simply present the heart of my perspective here:
"During his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Greenspan noted that markets are driven by "human psychology" and "waves of optimism and pessimism." Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain.
During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course after reaching an extreme level, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive. You see, once you hit a wall, it becomes clear it is time to look in another direction. Some may question how sentiment simply turns on its own at an extreme, and I will explain to you that many studies have been published to explain how it occurs naturally within the limbic system within our brains.
When people begin to turn positive about their future, they are willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned. In fact, historically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why R.N. Elliott, whose work led to Elliott Wave theory, believed that the stock market is the best barometer of public sentiment.
Let's look at the same change in positive sentiment and what it takes to have an effect on the fundamentals. When the general public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which takes time to secure.
They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow - after more time has passed.
When the news of such improved earnings finally hits the market, most market participants have already seen the stock of the company move up strongly because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals are evident within the market. This is why so many believe that stock prices present a discounted valuation of future earnings.
Clearly, there is a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the same causative underlying sentiment change."
Lastly, while Mr. Saut recognizes that the stock market price action can lead the economy by as much as a year, he still views the Fed as controlling the market. This makes me scratch my head. If the stock market is omniscient, then would it not already know what the Fed will do and will react before the Fed does it? Does this not make the Fed action, in effect, irrelevant? Does anyone else see the circular logic here?
Moreover, Mr. Saut’s logic seems to present us with the following chain of events: The stock market leads the economy. Yet, when the economy gets to hot, the Fed supposedly steps in to act. This places the chain of events as the stock market being the first actor as it the leading indicator, the economy the second actor as it follows the stock market, with the Fed being the third actor as it reacts to the economy. Does this not place the Fed at the end of the causation chain and not at the forefront as so many seem to believe? So, is the Fed “leading from behind” when it supposedly manages the stock market over a year after the stock market moves? Is this lending to “price stability?”
While these perspectives presented by Mr. Saut are viewed as truisms by most market participants, have any of you actually taken the time to analyze these perspectives?