US Stock Markets Reach Record Highs as Fed Remains Accommodative

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The US Stock Market as defined by the Dow Industrials and S&P 500 achieved record closes Thursday afternoon.  European stocks markets are at 5 year highs, and emerging markets such as Shanghai and Bombay have rebounded 10% from the summer's lows.  The technology stock laden NASDAQ needs to rally about 32% to eclipse the dot com bubble levels of 2000.

Leading into yesterday's Federal Reserve Meeting, most economists were expecting that the Federal Reserve would reduce, or even reverse the policy of recent years of buying long dated treasury bonds.  Historically, the Federal Reserve controlled the throttle of short term interest rates by setting the Fed Funds or overnight rate.  During the last expansion (2003-2007) Fed Funds averaged 3.2% and peaked at 5.25%.  However, the financial crisis of 2008-9 was so damaging to the economy that keeping Fed Funds at an average of 0.15% over the last 5 years failed to produce the usual robust recovery.  With no leverage left at the short end of the yield curve, the Fed bought longer dated bonds, driving up the price and therefore driving down yields at the longer end of the curve.  For example, yields in the ten year range average 4.3% between 2003-2007, peaking at 5.1%, but have averaged only 1.9% over the last two years, which is good news for mortgage borrowers and corporate borrowers, hence a rebounding housing market and record corporate profits.

The problem is: every bond investor KNOWS that the current environment is an artificial environment.  When the Fed stops buying long dated bonds, or worse, starts selling its inventory back into the market, yields will pop and prices will fall.  We already saw a taste of that in June & July, when the Fed hinted that it might scale back on bond purchases.

Coming into yesterday's Federal Reserve meeting, most economists expected the Fed to "taper" the bond program because the Fed Chair Ben Bernanke had hinted as much several times this earlier.  Instead Bernanke commented yesterday, "We have been overoptimistic.  The Fed avoiding a tightening until we can be comfortable that the economy is in fact growing the way that we want it to be growing."  The Federal Reserve has two mandates:

  1. Promote Full Employment, which might be defined in the current economy as 5% or less (in the late 1990's 3.5% was considered full employment - remember those happy days?)  At present unemployment is still 7.3%, but in truth much higher given how many workers have dropped out of the workforce.
  2. Control Inflation, generally a target of 2%/year or less.  Over the last year, inflation ranged from 2.1% to 1.1%, most recently 1.5%.

In this context, the Fed can continue to hold down rates, because inflation realistically in not a worry.  Between the sequester earlier this year, which reduced economic growth in the first half of 2013 and the pending federal budget impasse over Obamacare, US economic growth remains depressed by 0.75% (currently 2.5% when it should be 3.25% or higher.)

What does this mean for stock prices?

US stocks prices are set by expectations of future earnings, discounted by expected long term interest rates, for example the 10 year treasury.  Even with conservative assumptions about both parameters, US stocks remain fairly valued to under-valued - there is not much risk in buying stocks right now IF you maintain a 5 year time horizon.  So we can continue to put our clients' funds to work even though the S&P 500's gain of over 21% totally crushed our January forecast of 8%.