Support Drops Away

Over the past few months, I’ve tempered our long-term outlook for near-zero S&P 500 total returns over the coming 10-12 year horizon, and our cyclical outlook for a 40-55% market loss over the completion of the current cycle, with a rather neutral near-term outlook. Specifically, despite wicked valuations coupled with mixed market internals, various trend-following components among those measures were constructive enough to hold us to a fairly flat near-term outlook. I’ve often described this kind of market return/risk classification with the phrase “unpleasant skew” - the most probable single outcome in any given week under these conditions is actually a small gain, but those incremental gains are typically offset by the small probability of steep, abrupt losses that can wipe out weeks or months of gains in one fell-swoop. As a result, the mode is positive, but the resulting average returns are quite negative overall (see the chart in Impermanence and Full-Cycle Thinking to see what this skewed distribution looks like in market data since 1940).

Last week, the most reliable of those trend-following components deteriorated to a negative condition. That’s not a forecast of immediate market direction, particularly with a Fed statement on Wednesday, but it’s an indication that we presently estimate both razor-thin (and even negative) equity risk premiums from a valuation standpoint, and also a uniform, if subtle, shift toward increasing risk-aversion among investors. That, historically, is the most negative combination of conditions we identify. The equity market has been dancing sideways for months on a very thin floor supported strictly by trend-following considerations. That’s kept our near-term outlook rather neutral. Last week, on the most reliable measures we identify, that floor quietly dropped away.

Importantly, we’re focused here on the joint signal we infer from market internals, not on some moving average or another. As I’ve frequently observed in a variety of “signal extraction” contexts, single indicators typically provide weak information because the true signal (whether about market conditions or economic prospects) is invariably confounded by random noise. Market action should always be analyzed in the context of multiple “sensors” that capture the behavior of a broad range of individual securities, industries, sectors, and security types. The information isn’t just in the obvious trends; it’s also in the less obvious divergences. When we’re asked “what are you looking at when you talk about market internals?” the answer is that we’re looking at the joint behavior of all of these sensors in combination.

On the subject of Federal Reserve policy, I’ve regularly emphasized that much of the variation in output, employment, and inflation over time can be explained by prior values of those same non-monetary variables (output, employment, inflation) and that adding monetary variables provides virtually no useful additional information (see Failed Transmission - Evidence on the Futility of Activist Fed Policy). We can’t quite conclude that monetary policy is useless, but we can confidently say that any predictable impact on the real economy is wholly contained in the “systematic” component of monetary policy; the component that can itself be predicted by lagged output, employment and inflation. By contrast, “activist”deviations of monetary policy from those measured and statistically-defined responses to output, employment, and inflation have no correlation or beneficial effect at all on later economic outcomes, except to the extent that they contribute to speculative bubbles and crashes, which exert their effects over a longer horizon than the Fed seems to consider.

The chart below shows the actual Federal Funds rate across history, along with the “systematic” component that could have been predicted using only data on output, employment and inflation that was available at each point in time. The difference between those two lines is what I’m calling “activist” Fed policy. Notice that the admirable thing about Paul Volcker’s tenure at the Fed in the late-1970’s and 1980’s was not his activism, but rather the courage to follow what actually reflected a disciplined rules-based policy (aside from very temporary deviations that probably exerted most of their effect on the financial markets). In my view, the massive activist deviations from rules-based policy by Greenspan, Bernanke, and Yellen have served only to enable a sequence of financial bubbles and collapses.

As for Wednesday’s decision, two things are clear from the chart above. One is that our own estimate of the appropriate Federal Funds rate here is certainly above 1% at present. But the other is that we’ve seen significant and progressive deterioration in underlying economic conditions recently, so it’s not clear that this is a pressing moment to normalize policy, except to rein in a financial bubble that already has “market crash” written all over it. Whatever policy error the Fed might make by raising, or not raising, interest rates here pales in comparison to what activist Fed policy has already baked in the cake. As I noted last year The Fed’s Real Policy Error Was to Provoke Years of Speculation, “when the Fed holds interest rates down for so long that investors begin reaching for yield by speculating in the financial markets and making low-quality loans, the entire financial system becomes dangerously prone to future crises.”