Published June 4, 2021
While there remain many places still struggling with Covid-19 and its myriad effects, the broad U.S. economy is, less and less, one of those places. This week, the Federal Reserve made clear they are ready to begin backing out of the unprecedented market supports they put in place a year ago. It will be a good while before the Fed takes any action on interest rates. For now, they are beginning to sell off the assets accumulated during the height of pandemic uncertainty. Those assets are the corporate bonds and ETFs purchased by the Central Bank last summer to shore up wavering market confidence. The chart below shows the doubling of Federal Reserve assets during the pandemic (from $4 to $8 trillion).
We also see in the chart that the Fed never unwound its market support after the 2008 Financial Crisis, a time when assets also doubled (then, from $1 to $2 trillion). Heavy Fed support has been a hallmark of recent markets, as the chart shows.
The Fed balance sheet action comes as the economy shows wide-ranging signs of getting back to normal, and at a pace that is unprecedented. This week’s Wall Street Journal wrote extensively on the recovery, beginning with this overview:
“New businesses are popping up at the fastest pace on record. The rate at which workers quit their jobs—a proxy for confidence in the labor market—matches the highest going back at least to 2000. American household debt-service burdens, as a share of after-tax income, are near their lowest levels since 1980, when records began. The Dow Jones Industrial Average is up nearly 18% from its pre-pandemic peak in February 2020. Home prices nationwide are nearly 14% higher since that time.
The speed of the rebound is also triggering turmoil. The shortages of goods, raw materials and labor that typically emerge toward the end of an expansion are cropping up much sooner. Many economists, along with the Federal Reserve, expect the jump in inflation to be temporary, but others worry it could persist even once reopening is complete.
“We’ve never had anything like it—a collapse and then a boom-like pickup,” said Allen Sinai, chief global economist and strategist at Decision Economics, Inc. “It is without historical parallel.”
The stock market has been well ahead of this recovery, sending stock prices sharply higher throughout the second half of last year and into 2021. Stocks have lately appeared to stall while the economic data catches up. First quarter corporate earnings were outstanding as you would expect coming out of a recession.
But the market had expected that, sending valuation measures to unusually high levels. Those high valuation levels typically portend low returns going forward. The scatterplot below tells us that once the stock market hits a price-earnings (P/E) ratio around 20, the subsequent five-year returns tend to be near zero.
That 5-year march to zero returns does not mean stocks sit still for five years. Instead, what we know is that the stock market likely bounces up and down as it makes little overall progress. This is the perfect environment for our models to outperform the market. Our models turn this up-and-down, back-and-forth market behavior into trading wins for our accounts.
With quarterly corporate earnings season mostly finished, investors looked to broad economic reports for catalysts to move stocks further. Coming back from Monday’s holiday, markets digested a positive report on manufacturing activity but failed to see much progress in stock prices. The broad market indexes closed flat. Wednesday brought more of the same, a flat day for stocks. However, both days saw energy shares break higher on a pop in oil prices. OPEC has recently raised their estimates for global oil demand as economies reopen. A Fed announcement that they plan to sell some assets dimmed investor moods Thursday leading the S&P 500 to a -0.4% slip. The Nasdaq tumbled a full -1% as growth stocks continued to underperform. But Friday delivered a less-than-anticipated monthly jobs report which sent interest rates tumbling and growth stocks barreling higher. The +500k pickup in jobs was twice April’s gain. However, economists had expected a markedly bigger number. The lesser jobs pickup gave investors reason to believe the Fed will remain on the sidelines.
For the week, the S&P 500 lifted +0.61%. The Nasdaq 100 (QQQ) added +0.50%. The smallcap Russell 2000 (IWM) gained +0.84%.
Warm wishes and until next week.