Wednesday, March 13, 2013

Have cycles been killed by the Fed?

Have cycles have been overpowered by central bank intervention?  This is a question that many investors have been asking in view of the stock market's relentless strength since November.

Some of the short- and intermediate-term cycles that have been historically reliable for predicting periods of strength or weakness in equity markets have undoubtedly been muted – or in some cases cancelled out completely – by the Fed’s ultra-loose money policy of the last couple of years.  Are we therefore to assume that the longer-term yearly cycles will also be annulled by the Fed?

One of the first things I learned when I began studying financial markets was that “liquidity is everything.”  Liquidity is in fact the single most important factor in determining the health of a market and it can trump all other considerations, be it fundamental, technical or cyclical. 

Consider that the present bull market has continued despite numerous metrics which suggest the rally should have ended long ago.  For instance, corporate earnings growth was lower in the fourth quarter of 2012 than in the previous year.  Yet equities ignored this and continue to rally in the first quarter of 2013.  Fundamental analysts have tried to rationalize this but probably the best explanation I’ve heard was summarized by David Kotok of Cumberland Advisors.  He writes, “We continue to argue that classic and typical methods have to be set aside in an era in which the short-term interest rate is near zero; hence, the equity risk premium determined on the short-term interest rate is near infinity.”  Kotok expressed concern over the eventual unwinding of the Fed’s policy, but for now is committed to being fully invested – a sensible response to unlimited central bank support.

Another respected analyst, Bert Dohmen of Dohmen Capital Research, points out the technical flaws that have emerged in the stock market in the last few months.  Yet despite these flaws, the market continues to rally.  “The massive monetary creation by the Fed is producing the fuel for the rally,” he writes.  “Unless you think that will stop, the market should rise until Bernanke leaves, though with periodic market corrections.  We all know that this cannot end well.  But the day of reckoning may still be a long time in the future.  The pessimists have given too much credence to the reality of the unsustainable debt globally and not enough importance to the power of infinite money creation by the central banks.”

Foreign inflows into U.S. equities have also been driven more recently by euro zone and China weakness.  This has been an overlooked aspect of equity market strength at home as other nations experience the effects of weak economies and are looking for a perceived “safe haven” from domestic woes.  The U.S. aptly fits the description as one of the strongest financial centers at the present time.

To further answer the question of whether central bank policy can overpower cycles, let’s look at some past analogues.  Perhaps the biggest instance of a yearly cycle “failure” was in 1954.  According to the cycle account of the Kress 60-year cycle, 1954 should have been a big down year for equities.  Yet the stock market boomed in ’54, achieving a 25-year high and finally overcoming the 1929 all-time high.  The 60-year cycle is admittedly a key long-term cycle; in fact it forms the basis of the Kress 120-year Mega Cycle.  1954 was also the year that the current 120-year cycle (the one that began in the mid 1890s) peaked.  Not only was there the counter-balancing peak of the 120-year cycle in 1954, but as Mr. Kress himself also pointed out the Depression years had done much to unwind the excessive debt which contributed to the Great Depression. 

More pertinently, money supply growth had greatly expanded in the 1940s and in leading up to 1954.  The Fed was young and inexperienced and barely had the policy tools to cope with the Great Crash of ’29.  It was heedless of the fact that by contracting money supply in the year leading up until 1929 it actually helped facilitate the crash and subsequent depression.  After the hard Depression years, however, the Fed learned some valuable lessons and realized that “easy money” was the way to go as far as inflating the country to prosperity. 

In defense of the Kress cycles I will point out that while the stock market may have ignored the 60-year cycle bottom of 1954, there has never been an instance of the 40-year cycle being ignored by the market.  The last 40-year bottom was in 1974 and it produced a major bear market and economic recession, as did the previous one in 1934.  The upcoming 120-year cycle bottom scheduled for late 2014 includes the latest 40-year cycle.

It’s still debatable whether the recovery bull market can continue much past 2013.  With some analysts believing that Fed Chairman Bernanke’s successor next year won’t continue his ultra-loose money policy, there is certainly a possibility that 2014 will vindicate the long-term cycles.  But the stock market game isn’t about next year; rather it’s about the hear-and-now.  And for now investors should be focused on the opportunities that Bernanke’s policy has presented them. 

Don Hays is fond of saying, “Bull markets don’t end until the Fed takes away the punch bowl.”  Another way of expressing this is in the Wall Street maxim, “Don’t fight the Fed.”  As long as the Fed is committed to “QE infinity” there’s no reason to expect a premature end to this bull market.  I’m sure Mr. Kress himself would agree – let’s take advantage of the opportunity while it lasts.

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