Market Intervention Has Left Investors Confused

May 28, 2014

Investors “Lack Direction”

We have covered the topic of investor indecisiveness numerous times in recent months. This week, bank executives cited investor uncertainty as an ongoing drag on trading revenues. From The Wall Street Journal:

Executives from some of the biggest U.S. financial firms said a slump in trading that has hammered bank results for more than a year is likely to continue to weigh on profits. Large investors are retreating from the market, big trades are rare and price swings are shrinking, executives told investors at an industry conference in New York on Tuesday. Citigroup Inc. C -0.02% Chief Financial Officer John Gerspach told investors the bank expects the slide it has reported in markets revenue to deepen in the second quarter. “People lack direction,” Mr. Gerspach said, speaking about investor behavior at the conference sponsored by Deutsche Bank AG. “People are uncertain. There just isn’t a lot of movement.”

2008-2010: Free Markets Were Not Free

Why are investors confused? Markets have an almost infinite number of moving parts, which makes isolated cause and effect analysis difficult. However, common sense tells us the recent “lack of direction” from investors stems from a logical question they have been asking themselves:

“Is the stock market higher based primarily on an improving economy or market intervention?”

Investors, large and small, are accustomed to making financial decisions based on easy to understand economic concepts, such as the law of supply and demand. Market intervention from policymakers and central banks has muddied the free market waters. The current bull market was kicked off by a series of bailouts back in 2008-2009. Below is a small sample of the steps taken during the financial crisis to boost free markets:

  1. The Troubled Asset Relief Program (TARP) was a program of the United States government to purchase assets and equity from financial institutions to strengthen its financial sector. The TARP program originally authorized expenditures of $700 billion.
  2. Fannie Mae and Freddie Mac were placed into conservatorship (bailed out).
  3. IndyMac Bank, America’s leading Alt-A originator in 2006 with approximately $32 billion in deposits was placed into conservatorship by the Federal Deposit Insurance Corporation.
  4. AIG received an $85 billion emergency loan in September 2008 from the Federal Reserve.

ECB Continued Trend Of ‘Non-Standard Measures’

Even though the pace of non-standard measures slowed in the United States, government intervention was prevalent in Europe between 2009 and 2011. For example, in Q4 2011 European banks were encouraged to take unlimited amounts of cash in the form of three-year loans from the European Central Bank (ECB). From the ECB’s December 8, 2011 statement:

In its continued efforts to support the liquidity situation of euro area banks, and following the coordinated central bank action on 30 November 2011 to provide liquidity to the global financial system, the Governing Council today also decided to adopt further non-standard measures. These measures should ensure enhanced access of the banking sector to liquidity and facilitate the functioning of the euro area money market. They are expected to support the provision of credit to households and non-financial corporations.

ECB Dispensed Billions To Banks

How much money did European banks take from the ECB? The answer is billions. From The Wall Street Journal (March 2012):

The European Central Bank handed out €529.5 billion ($712.81 billion) in cheap, three-year loans to 800 lenders, the central bank’s latest effort to arrest a financial crisis now entering its third year. Wednesday’s loans were on top of the €489.2 billion of similar loans the ECB dispensed to 523 banks in late December. The ECB’s goal is to help struggling banks pay off maturing debts and to coax them to lend to strained governments and customers.

Investors Prudent To Question Economic Sustainability

You might think injecting billions into the European banking system would have resulted in higher inflation and a more stable track for economic growth, at least for a time. Despite all the non-standard measures, Europe continues to battle low inflation and tepid economic growth. The blurb from The Wall Street Journal below was published on May 27, 2014:

The European Central Bank is aware of the risks associated with too long a period of ultralow inflation, the bank’s president Mario Draghi said Tuesday, though he said he was confident that the ECB has the tools to push consumer-price growth higher. “We are confident we will deliver the close to 2%, but below 2%, objective,” Mr. Draghi said, referring to the ECB’s medium-term target. Annual euro-zone inflation was just 0.7% in April, far below that target. The persistent weakness of inflation, combined with a sluggish economy and weak credit dynamics, has prompted speculation in financial markets that the ECB will cut interest rates and take other stimulus measures when it meets on June. He spoke at the conclusion of the ECB’s two-day conference in Sintra, near Portugal’s capital.

The Fed Has Skewed Market’s Pricing Mechanism

The Fed was criticized for “keeping interest rates too low for too long” between 2002 and 2006. Interest rates are lower today than they were in the often-criticized 2002-2006 period, which is shown inside the orange box below.

Investor are concerned that as the Fed tries to take a step back, the economy may not be strong enough to stand on its own.

Investment Implications – Is It Real Or Just A Juiced Market?

Our market model, which allocates based on observable evidence, continues to recommend a mix of stocks (SPY) and bonds (TLT). With the S&P 500 recently making a new closing high, the model’s stock allocation is not surprising; it is the bond allocation that continues to align with investor concerns about “juiced” asset prices. Have stocks recently made a new high relative to bonds? As shown in the chart below, the answer is no. In fact, stocks have not made a significant new high relative to bonds in almost five months.

In terms of what we can learn from the stock/bond ratio above going forward, a breakout toward the green A would increase the odds that the recent highs in the S&P 500 are sustainable; a breakdown toward the orange B would increase the odds of a equity reversal.

Intervention Calls For Risk Controls

In addition to flooding the system with greenbacks, the Fed’s ongoing low interest rate policy distorts financial markets by forcing investors to gravitate toward riskier assets in search of returns. Distorted markets call for tighter risk management controls. Investors can profit from rising stock prices, but it is prudent to have plans in place for the next inevitable bear market.

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