I don’t know how many more times I can write that “this is a really tough market” before my head explodes. There’s only so many times we can hash out the bear market buzzwords — oil, China, emerging markets, the Fed, earnings, high-yield bonds — before the message starts to get a little stale.
And I figure if I’m sick of writing it, you’re probably getting sick of reading it. So maybe we try to take it from a little bit different angle today…
We can take those bear market buzzwords, analyze the dynamics that characterize each one, and come to an understanding of why they are important. American oil companies invested heavily in shale oil production. Now that the Saudis have committed to driving oil prices lower, these companies are vulnerable.
China invested heavily in infrastructure and exports to fuel economic growth. With both global demand and global growth weak, its export economy isn’t thriving. And as its infrastructure build-out slows, it’s using fewer commodities like copper, iron ore, cement, etc.
Commodity prices have been crushed, putting a major squeeze on emerging market economies that invested heavily in expanding commodity production to feed the China beast.
U.S. companies are seeing earnings growth slow. Demand remains tepid, and companies see better opportunities to invest their cash in share buybacks and dividends than in CAPEX spending.
And then there are high-yield bonds. Because interest rates have been so low, companies have made the conscious decision to raise cash by selling bonds. But of course, bonds are loans and have to be paid back out of future earnings.
Now, before I get to the Fed, I want point out that each of the bear market buzzwords share a common theme: investment. China, oil companies, emerging markets — they’ve each invested money based on assumptions that are proving to be, if not outright false, at least misguided.
And we’ve really only got one source for the misguided notion that growth and demand would be enough to justify massive investment: the Fed.
Yep, It’s the Fed’s Fault… Again
I guess you could call it hubris. Starting with Bernanke, the Fed was adamant that it could foster real economic growth by making money cheaper and encouraging borrowing and investment. So it left interest rates at zero and tried to pump liquidity into the system via quantitative easing.
And really, there was some reason to think that the plan would work. Because economies recover, growth returns, inflation picks up, etc…
That’s just how the business cycle works. And when we’re sitting at the bottom of a business cycle like we were in 2009, it’s a pretty good bet that things will get better at some point. I’m sure the Fed governors thought they’d be declaring victory by now…
But unfortunately for all of us, this business cycle hasn’t been as strong as the Fed thought. Demand hasn’t picked up enough. And now, we’re seeing a global economy that’s struggling because of poorly invested money.
We could certainly argue that the Fed could have seen this coming. This is exactly the scenario that market guru Mohamed el-Erian was describing when he coined the term “New Normal” five years ago. He was describing a scenario where growth and demand would be subpar for several years as the global economy worked off the excess of the last business cycle.
El-Erian has been 100% right. And it makes you wonder why the Fed misread the signs and tried to pump up the economy artificially…
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Economy on Steroids
You may have seen people compare the effect of quantitative easing on the economy to the effect of steroids on an athlete’s body. I find this to be a very apt comparison.
Steroids can give an athlete stronger muscles and better performance in the short run. But over the long haul, the body breaks down because the effect of steroids is artificial. The body simply wasn’t meant for that kind of growth.
We’ve gotten the effects of quantitative easing steroid injections. The stock market was very strong for years. Unemployment improved, and consumer demand picked up in spots like car sales and restaurant spending. I guess it doesn’t make much sense to ponder how the economy would have done without the steroid injections. Because we are now seeing the breakdown, as the effects of quantitative easing can no longer push the economy.
Now, I will give current Fed chief Janet Yellen a little credit here. I think she is well aware of the problems quantitative easing has caused. I think she sees that there’s a bit of an asset bubble out there, and I can see why she’d want to ease off the throttle. To me, that’s why she hiked rates a quarter-point back in December.
Still, that doesn’t change the fact that it was the wrong move. It’s all well and good to acknowledge that there’s a problem. But she’d better be very careful about how she manages things going forward. The patient is not well. And the risks are so high right now that a misstep could do some serious damage.
Yellen’s Next Step
I tell ya, I would not want to be in Yellen’s shoes today. She and her minions wrap up their January meeting and have to address the interest rate thing this afternoon.
What can she say? That they made a mistake in December? The market will not like that.
So does she say the economy has underlying strength and that they anticipate better growth ahead? Investors will think she’s insane.
Maybe she points to China and says the U.S. is fine, but the Fed has stood pat while China and the emerging markets get their acts together.
That’s probably her best bet, even though it still doesn’t fill one with confidence that China can drive U.S. monetary policy.
But don’t miss the fact that what is happening in the stock market needs to happen. Stock prices need to come down to reflect a more realistic view of the economy. Yeah, it’s painful, but it’s a necessary adjustment. And it will set the stage for better times ahead.
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
