Key Investment Rule: “Don’t Fight the Fed”.

November 30, 2019 | Jeff Finkelstein


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November 29, 2019

MARKET ENVIRONMENT

Key Investment Rule “Don’t Fight the Fed”.

The major US, Canadian and other global markets are performing very well in 2019 (usually 20%+ so far).

These all-times highs have been achieved despite the numerous risks carefully enumerated and repeated by the media:

     - The longest economic expansion in modern history;

     - Major trade disputes;

     - Political instability in several major countries (Hong Kong, Chile, Iraq);

     - US political cycle

     - Growing corporate, consumer and governmental debt

     - “Yield inversion” in the fixed income markets.

All of the above concerns have been completely overwhelmed by the positive impact of the great flood of low cost money created by the central banks.

Central banks, like the “Fed” create cheap money by (i) lowering short term interest rates by setting policy and (ii) lowering long term rates by buying large volumes of bonds in the open markets (this raises their price and lowers their yield).

The below 10-year chart shows the magnitude of the various major central banks in purchasing their national bonds. This reached over $US 2.5 trillion per year at its peak.

The flood of cheap money created pumped up consumer spending, reduced the cost of business and government debt and expanded the prices of financial assets such as equities and real estate.

All of this supported economic, business and market growth.

In the below chart;

     A) 2018 withdrawal of stimulus leads to market declines;

     B) 2019 return of stimulus leads to market rise.

Since 2009, these policies have worked well. Economic and market growth has entered the longest expansion in history …..

However, as a result of their success, central banks have been gradually reducing their stimulus support. At the lowest point (late 2018) the global liquidity support had shrunk to $77 billion.

This rate of withdrawal of stimulus support proved to be too deep and too fast.

In fact, this was the direct cause of the sharp market decline in Q4 2018 which almost turned into a bear market.

As a result, when the Fed, and other central banks, returned from their Christmas Breaks in January 2019, they were determined to reverse their mistake and reinstitute at least some of their financial stimulus.

As per the market performance in 2019, they were very successful.

To be more specific, in 2019, the US Federal Reserve has contributed:

     - Three interest rate cuts

     - $60 billion/month of bond purchases

The European Community Bank has contributed:

     - Another (punitive) short-term interest rate cut. The short term rate is now minus 0.5%

     - 20 billion Euros/month in quantative easing

The Bank of Japan has contributed:

     - A continuation of a punitive short-term interest rate set at minus 0.1%

     - 80 trillion yen/year (about $US 60 billion/month) in purchases of Japanese government debt. Actually the BOJ will buy whatever volume of bonds necessary to ensure that the yields of a 10-year government bond does not rise above a rate of 0%

     - To support their equity market, 6 trillion yen/year (about $US 4.5 billion/month) in purchases of Japanese corporate equities. (As a side effect, the BOJ is a significant owner of Japanese companies such as Union).

The valuation support provided by the central banks to the financial markets, will likely continue for the foreseeable future.

Final Thought #1

The return of large scale stimulus by the central banks has already been announced and is now largely reflected in broad market prices.

The early consensus annual predictions for 2020 from the professional investment strategists predict the (moderate) continuation of market gains in 2020 supported by:

     - Low interest rates and continued central bank support;

     - Growing dividends and share buybacks;

     - Reasonable growth in the GDP, corporate revenues and corporate profits.

Final Thought #2

Since 1950, the S&P 500 has had 18 years where markets gained over 20% (about 1 year in 4).

According to RBC researchers, the positive market momentum continued on for the future.

In the following year, the average 1-year S&P 500 return was 14.0%.

Over the following three years, the average annualized S&P 500 return was 13.0%.

This bears watching.