By Steve Sosnick, Chief Strategist at Interactive Brokers
Old habits die hard. Throughout most of our careers, an accommodative Federal Reserve has been reason enough for buying financial assets – particularly equities.
The phrase “don’t fight the Fed” is implanted in many investors’ psyches, and following that advice has been an undisputed winner for investors since the depths of the last financial crisis. Over the longer spectrum of history, however, there is a second part of that advice that requires an occasional reminder: although it rarely makes sense to fight the Fed, there is nothing that requires one to join them.
I believe that, while central bank accommodation is a necessary condition for a rally in the stock market, it is not a sufficient condition in and of itself.
The sharp rally that has gripped the equity markets over the past few weeks is largely predicated on the massive influx of Fed liquidity. Each day seemingly brought a new form of asset purchases, from repos, to Treasury notes to mortgages and high yield corporate debt.
During the prior crisis, central bankers eventually learned that massive intervention was the key to avoiding financial distress. Ultimately, when combined with fiscal stimulus, the crisis of 2007-9 was put behind us. This time around, both central bankers and legislators were much quicker to act and many of the oversold financial markets bounced back in response.
Buy the Dip
Old habits die hard, though. Over the past decade, central banks responded to crises of all types by adding liquidity when necessary. In general, equity investors used those liquidity injections as a reason to increase their exposure. “Buy the dip” worked nearly all the time, even if not initially. If there is a signal that works really well for over a decade, investors are rightfully loath to ignore it.
The upward move that we saw from last August to February was predicated largely on Fed liquidity that came in response to generally scary news. The repo market, a crucial funding market for banks and other financial institutions, had come under significant stress. The Federal Reserve did what it needed to, intervening directly in the repo market and increasing the size of its balance sheet to avoid a financial crisis.
But rather than considering the negative implications behind the Fed’s activity, equity markets blazed to new highs in response to the increased accommodation by the central bank. Those who were concerned by that incongruity and ignored the fear of missing out (FOMO) that drove much of the rally were ultimately spared the worst of last month’s decline.
Yet again we are seeing FOMO-induced buying as the Fed adds liquidity in the face of truly dire circumstances. There was certainly a solid rationale for decisive action as asset classes of all types came under stress. In 2008, however, the crisis arose from financial excesses. That made a financial response all the more crucial. The current crisis is non-financial in origin. Rather than the financial system causing broader economic stress, in this case there is a broader crisis causing financial stress. That means that a financial response has limitations in curing the problem. While the fiscal response has been quite strong as well, it is only providing first-aid to some critically injured sectors of the economy. Many workers are seeing their livelihoods impacted in profound ways, and it is quite possible, if not likely, that the post-Covid-19 economy will not snap back as quickly as equity markets seem to reflect. The bond market is hardly reflecting robust growth, and as I’ve said before, when stock and bond markets disagree, the bond market is usually proven correct.
Last week, I viewed an enlightening discussion between Michael Milken, the former junk bond king, and Frank Luntz, the political pollster and strategist. (Disclosure: Frank and I have been friends since college.) Most of their discussion centered on the Milken Institute’s efforts toward finding treatments and a cure for COVID-19, but they had an interesting exchange regarding markets.
Milken was unconcerned about our ability to finance our deficits with our current low interest rates, and seemed to view the current Fed accommodation as a positive (though he warned against trying to profit from a global crisis).
Luntz countered that his research is showing a change in economic behavior that is likely to persist for some time, putting a drag on economic growth for some time. That divergence of opinion is likely to drive the investment landscape for the coming months. Ultimately it comes down to this – is it different this time?
Those are very dangerous words for an investor, so they better be considered carefully. If it’s not different this time, then following the Fed’s liquidity path should yet again prove sensible. If it is different this time – and there is ample evidence that it could be – then buying equities at pre-COVID valuations based strictly upon accommodative monetary conditions could prove treacherous.
This article first appeared on Traders’ Insight on April 20.
Photo Credit: Pictures of Money via Flickr Creative Commons
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