The sharp and sudden rise in long-term interest rates in response to the perception that the Fed will taper down its bond-buying program is coming close to placing the stock market in a lose-lose situation. If you believe, as we do, that economic growth will remain tepid at best and that the Fed, therefore, will not slow down its purchasing program anytime soon, S&P 500 earnings will fall far short of the big second-half increases that the “Street” is forecasting. If, on the other hand, you think that organic economic growth will be strong enough to enable the Fed to reduce its purchases, long-term rates will climb by enough to stop the economy in its tracks and result in the same negative outlook.
The bullish case for the market rests on continuing massive easing by the Fed, supposedly reasonable valuation for stocks, big increases in second half earnings and a more rapidly growing economy. The result has been a market that is overbought and overvalued.
While history indicates that Fed monetary policy is an important factor in the market, it is not everything. The market declined substantially in 2001 and 2002 despite major monetary easing, and the same happened in 2008. In a period such as now where excessive household debt is holding back consumer spending, the economy has been unable to sustain any traction despite massive easing over the last few years.
The Fed will keep its current level of bond purchases going indefinitely only if the economy continues to look anemic. In that case, second half earnings will be highly disappointing. Bernanke continues to believe that Japan tightened too soon in the previous decade and that the Fed tightened too soon in 1937, causing another recession. He has constantly made it clear that he would rather err on the side of staying easy too long than in tightening at a point he considers premature.
On the other hand, if we are wrong about our tepid outlook for the economy, and it grows fast enough for the Fed to taper off its bond-buying program, we have only to look at the rapid rise in long-term rates over the past week, when even a hint of slowing down the purchase program caused a 50 basis point rise in rates and a drop in stocks. It seems almost a no-brainer that an actual tapering of the bond-buying program would send rates soaring. In that case, an economy that has become overly dependent on low interest rates and abundant liquidity would be stopped in its tracks, and the market would likely undergo a substantial decline.
In our view the Fed has stretched the rubber band as far as it can go in the face of major fiscal restraint, and is facing the dilemma that whatever it does from this point, it cannot save the economy or the stock market. That is why economists and strategists, after Bernanke’s congressional testimony, have been complaining about the seeming fuzziness of the Fed’s goals and its perceived lack of transparency. The Fed simply cannot tell investors what it is going to do and when because it just doesn’t know. Overall, it’s not a situation that is conducive to continuing strength in the market, and we therefore reiterate our view that it will all end badly.