First and Foremost …

By early October, 2018, the S&P 500 had more than quadrupled off its 666, 2009 secular bear market low (up over 300%). This was capped off by a spectacular 24 month run that saw the S&P 500 increase more than 50% to a new all-time-high of 2951.81 (10/3/18). I would say a correction of some magnitude (-10% or better) or even a cyclical bear market (-20% or better) would have been in order and to have been expected. This is entirely normal. 

The Dow Jones Industrial Average and S&P 500 both came very close to the arbitrary official bear market level but did not breech it during the December rout. The tech-laden Nasdaq composite made it, down 24% from its August 30, peak … the Russell 2000, ditto, down 24%.  Could it continue? Sure. Some are suggesting a retest of the December 24, lows is needed. However, during the collapse, we worked off a tremendous amount of market enthusiasm for stocks and turned it into palpable fear and historically, 20% of the time those retests don’t happen.

From here, a look backward I feel would be useful … getting our bearings, shall we say.

The Origin Of The Collapse Was The September 26  Fed Fund Rate Increase

That move, IMHO, was the trigger event. According to the punditry, including the likes of Jim Cramer, this was too aggressive a move and would likely cause the beginning of an economic contraction that could lead to a recession (defined, two consecutive quarterly declines in GDP). Stop and think about this definition for a moment–a recession, two consecutive quarters of GDP declines! It is stunning that the prospect of a RECESSION, a normal and very survivable economic event, could cause investors (not sure why we use this descriptor) to literally throw away their stocks. But they did just that in the few days leading up to Christmas Eve. I lay this squarely at the feet of a media that consistently makes the “R” word look like the worst thing that could happen without giving any perspective on what the effects of a normal recession might be.

Adding fuel to the fire the Fed, in its statement raising rates, said that it would likely go again in December giving us a four-month total increase of 1/2 of 1 percent by year-end to 2.5%. This sent the market into a precipitous decline with the so-called experts screaming this would lead to much higher interest rates which would strangle the economy. Now, there were other issue (trade, a China slowdown, Brexit, etc.) but the Fed and rates was the trigger, exacerbated by the 1/4 point hike in December.

So, Rates Must have really spiked … WRONG!

Before I get into the rate spike that did not happen, a little perspective might be in order. To clear the record on ‘rate spikes,’ the last one we had started in 2013 when the rate on the 10-year US Treasury note moved from 1.75% (4/22/13) to 3.01% (12/23/13). In the 8 months from May thru December 2013, the 10-year rate almost doubled on the back of a change in Fed policy, the end of quantitative easing — the Fed stopped buying bonds. This was the “Taper Tantrum,” not an actual increase in the Fed funds rate. The S&P 500 had opened 2014 at 1874.

Another interesting fact with regard to the first increase (off the low of 0-.25%) in the Fed funds rate in December of 2015  investors were so fearful that the economy would tank they bought treasuries (Flight to Safety), driving the rate down to a low 1.87% by January 2016. The highest the rate the 10-year had attained in 2015 was 2.50%. By July of 2016, the rate had fallen to a low of 1.37%, even though the Fed had only moved to raise the funds rate to a range of .50%-.75% … a total of only 50 basis points off the low. Again the pundits told us this, too, would be the end. It was not. The S&P 500 had opened 2016 at 2028. 

After all this sturm und drang the S&P 500 went on to record an all-time record closing high of 2930 (up over 50% since the 2013 taper tantrum), September 21, 2018.

What’s been the result since September?

The September increase in the Fed funds rate caused the yield on the 10-year to rally (spike) to a level of 3.24% in early October. It then collapsed to 2.56% (the January 3, 2019 close). This was despite the fact that the Fed, enduring massive media and pundit protests that this would be the end of us, raised the fed funds range again in December to 2.25%-2.5%.

But wait! There’s more!

There is shrinking the Fed Balance Sheet … another econ. killer.  

That balance sheet, as a result of the bond-buying program known as quantitative easing (QE), had swelled by 2015 to $4.5 trillion. The right-sizing of that balance sheet began in the 4th quarter of 2017. To date $500 billion worth of that balance sheet has been sold off, taking liquidity out of the economy. The Fed will continue liquidations (at a rate of $50 billion per month) until they feel right-sizing has been accomplished. The Fed has not said exactly what that size is estimated to be. This sucking of liquidity out of the economy is also deemed by the so-called experts to be the end of us. 

I have to ask, “Where’s the beef?”

With this barrage of negative expert opinion and a 50 basis point increase in the Fed funds rate, the rate on the 10-year Treasury is up only 33 basis points from where the started 2018 (down 45 bps from the 3.24% peak –1/18/19 close 2.79%). Apparently, there is no “beef,” no spike and no disaster, AGAIN.

But wait, wait! There’s even more! (this time positive… I think)

Remember, what triggered the slide, in the beginning, was a move by the Fed to raise rates and some hawkish language to reinforce that posture. On January 4, as part of the American Economic Association conference in Atlanta, there was a panel discussion featuring the three horsemen (actually two horsemen and a horsewoman) of this apocalypse, Jerome Powell, Janet Yellen, and Ben Bernanke. They went out of their way to reinforce the message that everything the Fed did or would do would be ‘data dependent’ and that they were going to be very careful not to exacerbate a weakening economy. This would include careful monitoring of the withdrawal of QE, shrinking the balance sheet. Sakes alive! They wouldn’t want to do anything to derail the gravy train. The so-called ‘Bernanke put‘ is back.

The second concern the pundits were obsessing about, pre the December 24 panic, was trade. The Chinese have presented a new proposal. Whether or not this is the real deal I cannot say. But, with a White House continually under siege on other fronts, the president would, I’m sure, like to declare victory about something. Diffusing trade issues would be good for stocks … another thing that he benchmarks his success with.

How did we get to the fear level manifested in the ‘Christmas Eve Massacre’?

It is very simple: The media, fishing for eyeballs, knows that in times of crisis the audience is more likely to be engaged and that the worse the picture looks, the better for their ratings. Entertainer Jim Cramer provided a perfect example of this in the run-up to the panic; “Cramer feels ‘powerless after Fed hike, tells investors to buy gold.” Now he didn’t say SELL but his headline tells you all you need to know. His timing could not have been better in terms of maximum impact on an already-spooked investor population on the Thursday night before a 4-day weekend for many (December 20). Friday would not be a well-attended trading session and Monday, the 24th, there was to be an early close (2PM EST). Ergo, liquidity would be limited. This was a perfect set up for a panic and we got it … some really stupid selling, people throwing stocks away. Cramer was not the only one singing this tune. There was a whole choir. And, nowhere did you get the perspective that I presented above — essentially that five years of Fed policy was supposed to be disastrous when, in fact, the rate on the 10-yr. US Treasury Note was virtually unchanged and the S&P was up over 50%. 

In conclusion: I can’t predict when the next recession will occur. Importantly, you need to remember recessions are normal and, according to the definition commonly attributed to them (two consecutive down quarters of GDP reports), not the end of the world. Stocks are not expensive because earnings have been good (organic growth + the impact of the tax cut). At current writing, the S&P 500 is trading a little over 15 x estimated earnings with at 2% yield. This is not excessive in an environment where the current yield on the 10yr Treasury is only 2.8% with the Fed on a more cautionary dovish stance. It is certainly not euphoric. The S&P 500 traded at a euphoric 30 multiple and 1% yield in March of 2000 … the 10-year was yielding over 6% (S&P 500 — 1550). That represented the peak of the last secular bull market … something to think about.

What’s your take?