Market fear and loathing
Author's Note: The full analysis was originally published on Rohr-Blog.com Tuesday evening in anticipation of equities potential problems if Fed Chair Yellen did not change her tune from further rate hikes being likely. Please review it in that context.
We have referred to the Federal Reserve’s desire to raise rates in spite of weak conditions as its "normalcy bias" for some time. Much of what we have noted about a broad range of problems is also not news to our regular readers. We have been over those other influences many times as well. Yet that doesn’t make them any less relevant, as many of the market impacts foreshadowed by previous analysis are only just hitting the broad financial market psychology.
Most important is a key idea that many analysts and portfolio managers could not even begin to fathom from the early part of last year right through the end of 2015. Yet it is finally making its way into the market perspective because recent activity has left it an unavoidable possibility:
The next financial crisis will occur when the investment and portfolio management community (and ultimately the investing public) realizes that the central banks alone cannot restore the robust growth from prior to the 2008-2009 financial crisis.
Any crisis will certainly not occur due to the sort of credit bubble seen into 2008. And that central bank impotence is finally working its way into market psychology after so many months of most of the financial community waiting for a more robust recovery based on micro-analyzing central bankers’ every move.
How many billions of Quantitative Easing (QE) can you balance on the head of a pin? As we mentioned at many points in our past year of analysis, it is rather the case on this cycle that the political class has failed. It accepted all of the central bank QE as a giant gift to help them avoid any of the heavy lifting involved in meaningful structural reform.
While it has evolved in many ways since then, our www.Rohr-Blog.com January 2015 posts It’s Lack of Reform, Stupid! (Parts 1 & 2 on the 19th and 24th) basically summed up the reasons trouble was brewing if there was no change to quite a bit of the old order. [Thursday brought some interesting discussion with quite a few Senators finally acknowledging that wage growth and productivity are not the Fed’s burden, but rather are the responsibility of the political class. Too little too late for the current economy and market, but maybe hopeful for 2017.]
The reason that lack of structural reform is back to being so important now is the looming Congressional testimony from Fed Chair Yellen over the next two days. And whether the Fed’s "normalcy bias" is maintained in the face of obviously deteriorating global and US economic conditions will likely determine the near-term fate of already struggling equities.
The failure of central banks’ ability to restore growth did not become apparent simply due to equities struggling since last May (as we had warned in a major May 2 post.) It was only truly obvious again last August in the wake of the release of the previous month’s FOMC meeting minutes on the 19th. Our post later that day led off with the (very rhetorical) question, Tail Risk Now Mainstream?
That was the day before the September S&P 500 future cracked key 2,040-35 support, which culminated in the Chinese currency crunch two trading days later (Aug. 24) temporarily dropping it down to 1,831.
And other than the timeliness of our understanding that the Fed was already suffering from its substantial "normalcy bias," and how pernicious that overly upbeat perspective might be for equities, that was also the beginning of the current bear market.
That’s right: An equities bear market
Now we must clarify two points on that. In the first instance we have always been big believers in the ‘Rule of Three.’ That is the number of factors necessary to sufficiently upset the equities to foment a sustainable reversal of any well-established bull market.
No one factor can reverse an equities bull market. We have seen many temporary disruptions along the way. That includes sporadic political disruptions that flare up in Eastern Europe and the Middle East, and the October 2014 Ebola epidemic scare. Yet no single influence tends to create a lasting selloff in the equities.
The reason the current underlying weakness has been so well masked is that the very cure so many folks felt was going to restore growth and inflation was actually a key contributing factor to disinflation. That was the degree to which all of that QE was actually encouraging companies that produce goods or materials to expand their operations. Of course, the political class liked that insofar as it appeared to be creating employment.