Kass: The Default Bull Market

This content originally appeared on Real Money Pro on Sept. 19.

NEW YORK ( Real Money) -- Yesterday's decision by the FOMC not to taper was a big surprise relative to market expectations.

Above all, the Fed appears to believe that the economy is too weak to taper -- the Fed downgraded its erroneous domestic growth expectations for 2013-2014 -- and would be unable to survive without the continuation of excessive monetary stimulation.

The Fed calls the June-September bond market selloff "the rapid tightening of financial conditions." It is clear that the Fed is concerned when even a 10-year yield rise to only 3% is enough to jeopardize the trajectory of growth in the U.S. The housing market is (and has been) especially vulnerable.

Jobs data are still weak. As I have continually emphasized, the employment picture remains poor. Labor participation is low and the jobs that have been added are low-paying.

A budget showdown and possible government shutdown loom. Constructive fiscal policy is plagued by political divisiveness and inertia. The burden of growth lies on the shoulders of monetary policy.

I, too, have been fearful of our addiction to interest rates and felt most observers were too optimistic regarding domestic growth (my growth slowing thesis/endorsement) within the framework of failed fiscal policy.

Unfortunately for my shorts, my attention to weak economic growth, tepid corporate sales and profit growth (excluding financials) was wrong in focus.

I thought after four-plus years of quantitative easing investors would get the point -- QE is losing its effectiveness, and we are likely in an extended period of subpar growth that might be accompanied by less-than-average P/E multiples.

What surprises me is that by certain members of the Fed's own admission, the benefits of quantitative easing are increasingly called into question. But that did not keep the Fed from the surprising decision not to taper. I suppose its rationale is that the economy would be even worse without more cowbell. This ignores the downside to this policy -- namely, wealth/income inequality, a depreciating currency and a further abolishing of fiscal responsibilities from our leaders in Washington, D.C.

As mentioned previously, perhaps the Fed is concerned about the upcoming budget negotiations. Perhaps the Fed was surprised to the degree that interest rates rose (and housing stalled) in the face of a mere mention of tapering four months ago.

Or perhaps it has to do with Summers being out for the Fed chairmanship and the move is a handoff to Yellen, the likely new Fed chairman. (Isn't it interesting that the Summers announcement came before the FOMC report? I strongly suspect purposefully. Part of the reason for tapering in first place is that the Fed knew that Summers wanted QE killed. The Fed thought he was going to get the chairman position and had to clear the decks for him. Now that is not an issue.)

For now, the Fed has decided to try to continue to borrow from the future in order to stimulate the present.

The downside is that the Fed is ignoring the dangerous ramifications and unintended consequences (that are multiplying) when the policy changes. Just look at the prices of commodities (namely, gold and crude oil) on Wednesday after the FOMC announcement. (We should continue to monitor the risk of higher commodities into the balance of the year.) As we saw in June, the adjustment process (once the subsidy is taken away) comes quickly and painfully.

Though it has failed to stimulate growth recently, the Fed still believes that higher asset prices will trickle down and lift activity. By contrast, it remains my view that the average Joe will suffer from the Fed's policy. Financial repression serves to inequitably redistribute wealth and puts a further wedge between the haves and have-nots. Finally, I have no idea why the Fed is ignoring that QE3 has failed to stimulate activity and, instead, has decided to put ever more accommodation into the system.

The Fed is pressing a losing bet, further undermining its credibility (policy and forecasting). Come to think of it, maybe my domestic growth expectations are too optimistic!

I would make several additional observations:

  • The Fed didn't understand the market implications of its own policy expressed in late May.
  • Despite knowing how bad the addiction to interest rates is, the Fed wants to continue to feed the addiction.
  • Most have clearly misinterpreted the rise in home and stock prices as indicative of a material improvement in the real economy.
  • When the policy changes (as I said previously), the Fed is trapping itself by making it far more difficult to exit.
  • More monetary easing could encourage our political leaders to shirk their fiscal responsibilities in the months ahead.
  • What happens if the bond market fails to play ball with the Fed?
  • Due to the uncertainty of monetary policy -- the Fed's game plan is now more confusing -- the stock market will likely exhibit more volatility.

Yesterday stocks celebrated bad news -- namely, a weak economy that cannot withstand even a small amount of tapering.

It cheered because the Fed wants to make alternatives to the U.S. stock market even more unattractive.

As such, we are in a default equity bull market.

To be straightforward and honest, this is not a comfortable type of bull market and backdrop for a fundamental investor like myself -- it is, quite simply, a market that rewards subpar growth.

In my view, there is no way out for the Fed once it started the process of printing. Getting in was easy. Getting out -- not so much. The Fed is trapped and can't end tapering or else the bond and stock markets will blow up. The longer this continues the bigger the inevitable burst.

The only question is how long will the pump priming persist and whether it even matters that the economy's foundation of growth is unstable (over four years after the financial/economic crisis ended).

To be honest, I clearly have no clue, but waiting for the U.S. economy to come roaring back may be like waiting for Godot.

Meanwhile, the gap between valuations and the real economy grows ever wider.

Buying credit default swaps on the Fed might now begin to make sense.

Looking at Potential Outcomes

If you look at the range of fed funds forecasts for year-end 2016, the high is 4.25% (Fisher?), the low is 0.5% (Evans?) and Bernanke falls seemingly right in the middle at 2%. The dovish view on the unemployment rate for the same point in time is 6%, while the hawkish view is that it will be down to 5.2%. The median is 5.6%, and that seems to be where Bernanke resides.

If you look at the interquartile range (kick out the top 25% and bottom 25%), the fed funds views still range from as low as 1.75% (7 hikes if you start at zero) to as high as 2.75% (11 hikes up from zero). Note it is widely believed that Yellen is currently in the most dovish quartile, clearly outside the middle 50%, whereas Bernanke seems to lay claim to the median.

The difference of 4 hikes between the somewhat hawkish and somewhat dovish is about 6 months' time, which implies half the members believe the initial hike might occur as early as 24 months from now and 30 months from now, with 25% thinking it would need to occur sooner and 25% later. (This, of course, assumes that the future FOMC will follow a monotonic, 25-basis-point-per-meeting schedule, which is by no means guaranteed.)

The interquartile range for the unemployment rate is 5.4% to 5.8%. No doubt some members believe that this number will not fall as much as the increase in payroll jobs they are forecasting, as many seem to believe that improving conditions will draw in re-entrants from the ranks of the discouraged. My own sense is that the decline in participation we have seen is mostly structural and not very much cyclical -- that is, fewer of the long-term unemployed/marginally attached/claim-they-want-a-job-but-can't-find-work group will find their way back into the workforce than Bernanke seems to think). ISI group seems to disagree even more vehemently with Bernanke's view that the real unemployment rate may be closer to the 13.7% U-6 than the 7.3% U-3 rate as officially defined.

Based on the latest decision to continue to "jam credit into the economy," the question becomes whether that credit is capable of continuing at a pace fast enough to further lift asset markets (equities and residential real estate) to levels that may not be sustainable in a normalized interest rate environment (i.e., at a 4% fed funds rate, which is the Fed's own median longer-term forecast).

I wish I knew what that level was.

In other words, stay tuned.
At the time of publication, Kass and/or his funds had no positions in any stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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