In response to the 2008 Financial Crisis, governments around the world led by the U.S. Federal Reserve developed a series of monetary policy tools to try to stabilize the financial system. The two primary policy tools they have employed are a zero interest rate policy (ZIRP) and quantitative easing (QE). We believe that these policies have created a high-risk paradigm for investors who have come to believe that easy monetary policy can drive asset prices higher, forever. We fear that investors who fail to understand the growing gap between fundamental value and current market prices are at risk of buying high and selling low once again.
Why “ZIRP and QE”?
The main ideas behind these policies were to provide excess liquidity to the banking system to foster loan growth and to encourage investors to move into riskier assets, including corporate bonds, high-yield bonds, and stocks with higher yields. The Fed has argued that these policies would create a “wealth effect,” increasing asset prices which would increase consumption and economic growth. Many investors bought in on each positive ZIRP and QE announcement, believing the Fed provided a backstop to asset prices and piled into risky assets blindly. With the Fed considering reversing course on monetary policy for the first time since December of 2008, we believe investors need a reality check. We suggest taking a quick inventory of where we are so investors can review their assumptions about stock and bond prices before the bubbles start bursting.
What’s the Objective? How Have We Done?
With “ZIRP and QE” monetary policy prescriptions the Fed has been trying to spur inflation, promote full employment, and generate sustained economic activity. So far the results seem mixed at best. It is tough to find inflation, and we seem to be getting farther away from achieving the Fed’s 2% inflation target. While the headline employment statistics have improved dramatically and the “unemployment rate” has fallen nicely, workforce participation statistics and the low quality of employment continue to create concern. Economic growth, as measured by growth in GDP, has yet to achieve the 3% threshold that many economists believe is the minimum growth rate required to promote sustained recovery. Already the weakest recovery since WWII, growth in GDP has failed to eclipse 2.5% in any calendar year.1 GDP stats for 2015 seem to suggest that GDP growth may be getting weaker, not stronger.
Even with tepid economic growth the U.S. economy is posting the best performance among developed economies, indicating the economic picture outside the U.S. is far less sanguine. Euro economies are struggling to find growth, and for the first time Germany, the main driver of growth in Europe, seems to be faltering. China, once the global driver of growth, has slipped badly causing a commodity price collapse - creating negative growth rates among many emerging market, commodity-producing countries. Japan launched a massive QE program they coined “Abenomics” to lift the country from deflation into inflation, but has not yet turned the corner.
A Fundamental Disconnect?
We are highly concerned that the disconnect between corporate earnings performance and stock price fundamentals may shortly be reconciled by a significant market correction. Much of the media discussion on earnings reports has focused on companies meeting or beating earnings expectations, leading investors to think corporate performance is better than it is. We believe analyst earnings expectations are so fungible and fast changing that they are poor indicators of earning quality or trends for corporations. Just beating expectations can be immaterial if earnings are negative. We believe earning trends quarter-over-prior-year-quarter are material. According to Dow Jones S&P 500 Index data, with 88% of the S&P 500 having reported 3rd quarter results through 11/4/15, 68% have lower operating earnings year-over-year. And this is the 4th quarter in a row for a decline in quarter-over-prior-year quarterly operating earnings. Yet equity prices remain elevated with the S&P 500 Index trading at a P/E of 20 times trailing earnings. In our review of historical measures, it seems this high P/E is counterintuitive against a backdrop of falling earnings, falling corporate revenue, weakening economic performance, and a potential monetary policy reversal that removes the Fed’s backstop to asset prices.2
Summing It Up
The long run economic benefits of ZIRP and QE seem questionable at best. We feel more QE is unlikely to solve today’s economic issues any more effectively than it has in the past. A definition of insanity is doing the same thing over and over again but expecting different results. We believe it is time to stop the insanity of blindly believing that asset prices are going to move ever higher on more QE. Sooner or later investors may come to their senses and see that monetary policy by itself is not a panacea. Sometimes the markets make investing look easy and that fundamentals do not really matter. At WBI, we believe that disciplined investing requires strict attention to the fundamental value of the markets and securities you invest in so you do not get caught up in the insanity of emotionally-biased decision makers. We strongly feel that now is the time for investors to reevaluate how much risk they are taking and how willing they are to take another significant loss. Successful investing is never easy and that is why WBI’s first priority is to protect your capital from large losses.
Important Information
Past performance does not guarantee future results.
The views presented are those of Don Schreiber, Jr. and should not be construed as investment advice.
All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this document, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI does not guarantee its reliability.
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Quantitative Easing is when a central bank purchases government securities from the market as an effort to lower interest rates and increase the supply of money. Zero Interest Rate Policy is when the central bank sets the interest rate at base rate (0%) as an attempt to increase demand in the economy, thus, making the supply of money cheaper. The S&P 500 Index includes a representative sample of large-cap U.S. companies in leading industries where all cash payouts (dividends) are reinvested automatically.
1 Lim, Diane. "Health Care Distortions Hurt America's Businesses and Patients." Committee for Economic Development of The Conference Board. N.p., 03 Feb. 2015. Web. 16 Nov. 2015.
1 Rainey, Michael. "The Weakest Economic Recovery Since World War II Putters Along." The Fiscal Times. N.p., 30 June 2015. Web. 16 Nov. 2015.
2 “Markets." Bloomberg.com/Markets. Bloomberg, Web. 16 Nov. 2015.
