Photo: Wikimedia Commons
It’s a common way of framing things: Bull vs. Bear.TV has these segments all the time.
Some guy comes on and talks about how stocks are really cheap to bonds, and how there’s tons of cash sitting on the sidelines.
The other guy responds by pointing out that margins are unsustainable, and that earnings forecasts are already rolling over.
It should be obvious how tired this debate is.
The new debate is between two camps: Those who think that the market is totally driven by liquidity and cheap money, and those who think that economic fundamentals are the main driver of the market.
We’ll call this liquidistas vs. fundamentalistas.
We touched on this this morning in our post about the new conventional wisdom regarding the market. The new conventional wisdom is that the liquidistas are right, and that when the Fed signaling no or delayed QE, and the ECB showing no hints of a QE3, that things are going to plunge.
They point to charts like this one, from Reuters’ Scotty Barber, showing how nicely the market has been driven by QEs and hints of QEs ever since the market bottom.
Photo: Scotty Barber, Reuters
Each time the Fed does something new it seems that the stock market rallies. When a QE ends, the stock market seems to fall.
There’s precedent for this in other post-bubble economies as well.
One of our favourite charts is this one: A 30-year look at the Japanese stock market, showing how it’s in large part basically reacted to this or that easing or tightening measure. You should click the chart to enlarge it to actually see what’s going on.
Photo: Morgan Stanley
Ben Bernanke’s own comments support the idea of a relationship between monetary easing and asset prices.
Right after he announced QE2 in November of 2010, Bernanke wrote an editorial in the Washington Post citing higher stock prices as evidence that easing works.
Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
More recently, in one of his lectures on how the Fed works he cited the effect of QE diminishing the pool of risk-free assets and forcing investors into riskier assets.
So due to the timing of the various QEs/LTROs, and the theoretical relationship between easing and the appeal of risk-free assets, the liquidistas conclude that when the market goes up or down, it’s basically all a function of liquidity or lack thereof.
We’ll also add that there’s sometimes a Austrian economics whiff to this view.
The analyst Sean Corrigan of Diapason Commodities Management recently — who is a well known Austrian market commenter — wrote in a February 29 note:
As regular readers of these scribblings have hope‐ fully come to appreciate, this is not the place to come to slake your thirst for mechanistic ‘models’ and fancy‐dan macro‐correlation studies (for the techni‐ cally‐minded, this is precluded by the subjectivist, methodological individualism of the Austrian School to which we adhere).
The only exception to this—if, indeed, an exception it is—is to be found in out penchant for mapping out developments in money supply and, in particular, real money supply and relating these to potential changes in the revenue stream percolating through the economic structure and, hence, to their implica‐ tions for income, returns on invested capital, and the supportability or otherwise of the accumulated debt burden.
To an Austrian, the credit cycle IS the business cycle, while, more generally, the many disruptions to the progressive delivery of greater material satisfaction we suffer —outside of those forcefully visited upon us by the political process—are almost inevitably the result of some unlooked‐for departure in the rate of provision of new money from that to which people had become accustomed.
So that’s the liquidistas view.
What then about the fundamentalistas?
They might start, as we have, with a chart like this, showing a clear inverse relationship between initial jobless claims (a real world economic sign) and the stock market.
As initial claims have ground lower, stocks have ground higher right on schedule.
Let’s go back to November 2010.
Lots of people, including Bernanke, thought it was QE2, or expectations of QE2, that caused the market to rally in late summer/early fall of that year.
But as we pointed out then, the market turned at the same time the UBS Surprise Index turned higher.
Also, there was specifically a strong move on September 1, 2010 when the ISM came in way better than expectations, causing the market to lift off.
Or go back last summer. People claimed that Operation Twist is what drove the market out of its summer slump, but a technique called “nowcasting” showed that right at the end of September, the data started projecting much stronger growth.
Fundamentalistas also point to other market realities that are not just about Fed easing.
In recent months (excluding the last few weeks), we’ve really seen signs of a turn in car and home sales.
And that famous profit margin chart that people can’t stop pointing to is thought to be more of a function of government spending rather than anything that Bernanke is doing.
Photo: GMO LLC
Stepping back and looking at the big picture, this liquidistas vs. fundamentalistas debate is important, because there can be bulls and bears on the same side.
You might think that the market is all Fed driven, but that the Fed will definitely ease more, and so it’s insane to be short. You might think that the Fed is out of bullets (if it wants to keep its credibility) and that the ECB is so obsessed with fighting inflation that it won’t dare ease more. On the fundamentals side, there are good arguments that profits have peaked, and that the market is now way overvalued.
There are two points that add some wrinkle and some annoyance to the debate.
The first is that you can’t totally separate the Fed from the real economy. You can make the argument that the Fed’s suppression of interest rates has helped housing, the car market, and any other credit-sensitive area of the economy.
Also, the timing is annoying for everyone, because not only does that first QE vs. S&P chart work very nicely, so does that later Initial Claims vs. S&P chart. We haven’t had many periods since March 2009, where the Fed was really out of step with the data. It almost seems like happenstance.
Still, this is the key debate of the market for the moment.
Right now, the liquidistas are winning a lot of people over to their side with the claim that the market is due to tank without more help.
But there is a counter-camp, which has been elucidated by Goldman’s Dominic Wilson, who wrote on April 1, that the question is all about whether or not the data keeps pointing to 2%+ GDP growth.
Having stepped aside after last month’s ISM, we recommended fresh long exposure to US equities (through the Russell 2000) following the mid-month Philly Fed release. Since then, the market has made fresh highs but has been unable to hold them and the data have continued to be mixed. The key question is what should the threshold for further market gains be? Our answer remains anchored in the data. We think that risk assets are likely to move higher as long as US data remain consistent with GDP growth of somewhat more than 2%. Given more mixed news in March, and the likelihood that weather-related boosts will fade in the month or two ahead, the stakes have been raised for the releases over the next 24 hours.
At the risk of oversimplification, if the ISM and global PMIs bounce convincingly, we think the market is likely to be able to make fresh highs. If instead we see a second month of declines, we are likely to turn more cautious. Since the start of the year, our most consistent theme has been to back better US cyclical outcomes in equity markets. Two sources of concern kept us sidelined in early March: (1) some mixed signals from US data, particularly last month’s ISM decline; and (2) mixed signals from asset markets given weakness in key cyclical areas. We felt that the early March data (claims and the first regional surveys), while unremarkable, were enough for the rally to extend. But since then, neither of the two sources of concern that worried us before have clearly faded. And our long Russell recommendation is only modestly higher than when we initiated it, having moved up and back in between.
Anyway, we eagerly anticipate the next liquidista vs. fundamentalista segment on CNBC.