Then we agree. We both believe we shouldn't fight the Fed. Then what do you think the Fed will do next, over the long term? Well, the good news is that we don't really need to speculate. Yellen has told us. Check out this article that dissects Yellen's most recent and what may come to be known as a seminal speech. A policy change is underway and I think most folks who have lived through 3 decades of Greenspan and Bernanke puts are going to be caught flat footed.
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A Once In A Generation Change For Stocks
seekingalpha.com
Oct. 30, 2014 5:30 AM ET
Summary
The Federal Reserve is currently undergoing a monumental change in its monetary policy priorities.This shift marks a major departure from the focus that has defined the Fed’s work for more than a generation.This transition will have dramatic implications for years if not decades to come on financial markets that have become so heavily dependent on the persistently generous support of monetary policy.Stock investors will almost certainly be required to work much harder to generate consistently positive returns than has been required over the past few decades.
The Federal Reserve is currently undergoing a monumental change in its monetary policy priorities. This shift marks a major departure from the focus that has defined the Fed's work for more than a generation. And if the Fed actually follows through with this transition, it will have dramatic implications for years if not decades to come on financial markets that have become so heavily dependent on the persistently generous support of monetary policy for over a quarter century. Yet financial markets seem to hardly notice these recently explicit signs that we may be right now at the dawn of a new era for Fed policy. As for what lies ahead in the next phase, stock investors will almost certainly be required to work much harder to generate consistently positive returns than has been required over the past few decades.
The behavior of market participants is sometimes curious. Investors will wait with bated breath for the release of the Fed statement that follows their Open Market Committee meetings that occur eight times a year. They even go so far as to redline the previous statement versus the current statement to identify every single wording change and extract every single possible nugget of information about what the Fed might do next. Along the way, investors will wring their hands over the potential inclusion or exclusion of phrases like 'considerable time'. And markets will react both accordingly and violently either in the positive or negative direction following the release of such Fed statements. Yet Janet Yellen, the Chair of the Federal Reserve and arguably the most powerful person in the world given her control and policy making autonomy over the world's reserve currency, recently gives a speech that has landmark implications about her priorities with the future direction of the Fed's monetary policy, yet hardly anyone in financial markets seemed to notice. Perhaps it is the prior conditioning of market participants to focus exclusively what they have known to matter from the Fed in the past, but such habits may lead investors to miss the broader secular shift until it is well underway.
A Revolutionary SpeechOn October 17, Fed Chair Janet Yellen gave what may ultimately prove to be a landmark speech at a conference on inequality at the Federal Reserve Bank of Boston. This would not be the first time that Ms. Yellen has spoken on the topic of inequality, but her various remarks over the course of her 30-minute speech were notable not only for their candor as well as the fact that we had the Fed Chair speaking about issues that normally fall squarely under the confines of fiscal policy. Her speech seemingly left most market participants confused if nothing else. Perhaps this is why it was largely ignored.
But one need not look very far between the lines of her speech to find the profound underlying meaning and intent of her words. In short, the dawn of a new era in Fed policy has arrived, and it is no longer the priority to support the stock market the same way it has for more than a quarter century. This is Janet Yellen's Federal Reserve now, and she means to differentiate herself from her predecessors and put her own distinctive mark on the institution for years to come.
A closer examination of the transcript of Ms. Yellen's speech reveals a variety of key points that are almost impossible to overlook in regards to her likely intent for future Fed policy. The second paragraph in her speech is particularly informative, so much so that I have included it below along with related commentary.
"The extent of and continuing increase in inequality in the United States greatly concern me."
The opening reveals the fact that inequality is such a key priority for our still relatively new Fed Chair that she feels bold enough to freely venture outside of the realm of monetary policy to candidly speak on this issue including outlining a four building block approach on how to deal with it. Such an assertive step strongly suggests that the issue of inequality is likely to play an increasing role in Fed policy decision-making going forward. And given that her current appointment to the position lasts until early 2018, she will have quite a bit of time to follow through on these priorities.
"The past several decades have seen the most sustained rise in inequality since the 19th century after more than 40 years of narrowing inequality following the Great Depression."
At first glance, this statement appears relatively benign. But a closer dissection of this sentence reveals its great significance. The key is in the time frames. The first is a mention of more than 40 years of narrowing inequality following the Great Depression. In this statement, she is essentially describing the period from the early 1940s when the Great Depression ended up until the late 1980s. This period is being cited as the time when inequality was narrowing, thus implying that more suitable government policies were in place to support this outcome. But in the past several decades since from the late 1980s through today, we have seen the most sustained rise in inequality since the 1800s. Implicit in this statement is the idea that government policies shifted starting in the late 1980s to lead to this less than desirable outcome.
This leads to the following key point. What exactly took place from a government policy perspective in the late 1980s? It was the advent of the "Greenspan Put" first seen in the aftermath of the 1987 stock market crash that brought to the forefront the Fed's priority to support capital markets including stocks at all costs by lowering interest rates and encouraging liquidity flows into the markets in order to foster a "wealth effect" that would eventually pass through in supporting broad economic growth. In the years since, this has been such a defining policy priority from the Fed that the "Greenspan Put" eventually evolved into the "Bernanke Put" starting in 2006 and going into overdrive in the wake of the financial crisis that followed only a few years later. In short, Ms. Yellen in her speech is effectively indicting the key policy approach undertaken by her two immediate predecessors in the 28 years prior to her assuming the post. The fact that she chooses later in her speech to compare the inequality gap that has occurred specifically between 1989 near the beginning of the Greenspan era and 2013 at the end of the Bernanke era further supports this point.
"By some estimates, income and wealth inequality are near their highest levels in the past hundred years, much higher than the average during that time span and probably higher than for much of American history before then. It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority."
Here Ms. Yellen highlights the winners and the losers from the increase in inequality that has resulted from the "Greenspan/Bernanke Put" that has been in place since 1987. Put simply, the very top has benefited over this more than a quarter century time period, while all others have stagnated. And, in her opinion, inequality conditions are about as bad as they have been in American history. In other words, she sees this as a problem of epic proportions that needs to be addressed.
" I think it is appropriate to ask whether this trend is compatible with values rooted in our nation's history, among them the high value Americans have traditionally placed on equality of opportunity."
The closing sentence of the second paragraph is a haymaker. This sentence could easily be reworded as follows - I am the Fed Chair and I intend to do something directly about this problem. For if she believes it is appropriate as Fed Chair to ask others to consider whether this trend in inequality is compatible with values rooted in our nation's history, obviously she is introspective enough to ask this same question of herself. And unlike most everyone else, she has a position where she can actually do something about it.
A number of other critical statements were included in Ms. Yellen's speech that clarifies even further her views on the topic of inequality.
"There have been some times of relative prosperity when income has grown for most households but inequality widened because the gains were proportionally larger for those at the top; widening inequality might not be as great a concern if living standards improve for most families. That was the case for much of the 1990s, when real incomes were rising for most households. At other times, however, inequality has widened because income and wealth grew for those at the top and stagnated or fell for others. And at still other times, inequality has widened when incomes were falling for most households, but the declines toward the bottom were proportionally larger. Unfortunately, the past several decades of widening inequality has often involved stagnant or falling living standards for many families."
The key takeaway here is the following. Ms. Yellen concedes the fact that the Greenspan/Bernanke policies were proving effective at first in the early years in the 1990s since real incomes were rising for most households, but it has been broken since the turn of the millennium and on net overall as living standards have improved substantially for the very top but have stagnated or fallen for the rest.
In examining the specific differences between 1989 and 2013, Ms. Yellen presents a number of damning statistics including the following:
"After adjusting for inflation, the average income of the top 5 percent of households grew by 38 percent from 1989 to 2013, as we can see in figure 2. By comparison, the average real income of the other 95 percent of households grew less than 10 percent."
"The distribution of wealth is even more unequal than that of income, and the SCF shows that wealth inequality has increased more than income inequality since 1989. As shown in figure 3, the wealthiest 5 percent of American households held 54 percent of all wealth reported in the 1989 survey. Their share rose to 61 percent in 2010 and reached 63 percent in 2013. By contrast, the rest of those in the top half of the wealth distribution--families that in 2013 had a net worth between $81,000 and $1.9 million--held 43 percent of wealth in 1989 and only 36 percent in 2013."
Put simply, the wealthiest of American households are squarely in the crosshairs, as by these statements from the Fed Chair the top 5% have benefited at the expense of the bottom 95% during the Greenspan/Bernanke era.
"The lower half of households by wealth held just 3 percent of wealth in 1989 and only 1 percent in 2013. To put that in perspective, figure 4 shows that the average net worth of the lower half of the distribution, representing 62 million households, was $11,000 in 2013. About one-fourth of these families reported zero wealth or negative net worth, and a significant fraction of those said they were "underwater" on their home mortgages, owing more than the value of the home. This $11,000 average is 50 percent lower than the average wealth of the lower half of families in 1989, adjusted for inflation. Average real wealth rose gradually for these families for most of those years, then dropped sharply after 2007. Figure 5 shows that average wealth also grew steadily for the "next 45" percent of households before the crisis but didn't fall nearly as much afterward. Those next 45 households saw their wealth, measured in 2013 dollars, grow from an average of $323,000 in 1989 to $516,000 in 2007 and then fall to $424,000 in 2013, a net gain of about one-third over 24 years. Meanwhile, the average real wealth of families in the top 5 percent has nearly doubled, on net--from $3.6 million in 1989 to $6.8 million in 2013."
More specifically, the inequality has amplified greatly since the outbreak of the financial crisis in 2007, the aftermath of which was marked by the most aggressive monetary easing campaign by the Fed in history that included three rounds of quantitative easing asset purchases totaling more than $4 trillion. The implied takeaway from Ms. Yellen's comments - Fed policy in the post crisis period has benefited the wealthiest 5% of Americans at the expense of everyone else. More directly, Fed policy in the post crisis period has not worked at all.
"Housing wealth--the net equity held by households, consisting of the value of their homes minus their mortgage debt--is the most important source of wealth for all but those at the very top. It accounted for three-fifths of wealth in 2013 for the lower half of families and two-fifths of wealth for the next 45. But housing wealth was only one-fifth of total wealth for the top 5 percent of families. The share of housing in total net worth for all three groups has not changed much since 1989."
Ms. Yellen continues on to explore the direct source of this widening inequality. On the downside for the masses, it has been the collapse of the housing market, as the bottom 95% of U.S. households derives 40% to 60% of their total wealth from homeownership. While the improvement in the housing market in the years since has provided a boost to the bottom 95%, it has been insufficient to prevent the inequality gap from widening dramatically over this post crisis time period.
"Another major source of wealth for many families is financial assets, including stocks, bonds, mutual funds, and private pensions. Figure 7 shows that the wealthiest 5 percent of households held nearly two-thirds of all such assets in 2013, the next 45 percent of families held about one-third, and the bottom half of households, just 2 percent. This figure may look familiar, since the distribution of financial wealth has concentrated at the top since 1989 at rates similar to those for overall wealth
Those are the basics on wealth and income inequality from the SCF. Other research tells us that inequality tends to persist from one generation to the next."
This is the knockout punch. Ms. Yellen immediately goes on to capital markets including stocks. The top 5% of households hold nearly 67% of all financial assets. She suggests that this is precisely how the wide inequality gap has been formed and goes on to indicate that it is likely to become a multi generational problem if left unaddressed.
We bring all of this information back to the opening paragraph of Ms. Yellen's speech, which naturally ties it all together (emphasis below is mine).
"The distribution of income and wealth in the United States has been widening more or less steadily for several decades, to a greater extent than in most advanced countries. This trend paused during the Great Recession because of larger wealth losses for those at the top of the distribution and because increased safety-net spending helped offset some income losses for those below the top. But widening inequality resumed in the recovery, as the stock market rebounded, wage growth and the healing of the labor market have been slow, and the increase in home prices has not fully restored the housing wealth lost by the large majority of households for which it is their primary asset."
When reading between the lines of Ms. Yellen's speech on October 17, it quickly becomes clear. As Fed Chair, she no longer intends to focus on supporting the stock market to the benefit of the top 5% the way that her predecessors in Mr. Greenspan and Mr. Bernanke had over the past several decades. Instead, her policy priorities are to try to more effectively and directly address the inequality gap including the employment, income and housing challenges most affecting the bottom 95%.
What About What Yellen Did Not SayThose that were puzzled by Ms. Yellen's October 17 speech criticized her for what she did not say. In short, she neglected to explicitly state that it has been the Fed's policies over the past several decades and in particular since the financial crisis that has driven the widening inequality gap. But as highlighted in the commentary above, while the critical role of the Fed in this problem was never outright stated, it was implied throughout her entire speech. Just like with a good work of literature, cinema or art, it is often up to the reader/viewer to analyze and discover the key themes embedded in a work instead of needing to have it explicitly stated by the writer/artist. And in the case of Ms. Yellen's October 17 speech, so much in this regard could be found right between the lines. She gains no benefit from explicitly criticizing her predecessors and their policies, particularly since she supported them for most of her tenure at the Fed prior to assuming the Chair role. Instead, this speech provided the setting for her to reveal her conclusions that these past policies have not worked and a new policy approach is now required going forward.
The Implications For Financial MarketsMr. Greenspan has already spoken and apparently his inclination is to be long gold (NYSEARCA: GLD). This opinion is highly ironic coming from a former Fed Chair. But what was even more notable was that Mr. Greenspan in his recent speech essentially affirmed in a more explicit way what Ms. Yellen implied during her October 17 speech. The conclusion, Fed policy, particularly during the post crisis period, has not worked. And when something has not worked, it is time to change.
So what does this dawning generational change in Fed policy mean for financial markets in general and stocks in particular. The Fed may no longer wish to further inflate stock prices to new heights. But they also have absolutely no interest in allowing the stock market to completely collapse either. For the moment, the stock market as measured by the S&P 500 Index (NYSEARCA: SPY) starts going down in a sustainable way, the focus in the media quickly turns to all of the things that are actually wrong with the U.S. and global economy (and there is an abundance of such things to focus upon), which can have a compounding effect to the downside for not just the markets but the economy as a whole. But given the fact that stocks are currently trading at lofty valuations, the likely move without the support of further policy stimulus is to the downside as stocks seek to find their true equilibrium price. In recognition of this fact, the most desirable outcome for the Fed, particularly if they wish to close the inequality gap moving forward, is to let the air out of the stock market very slowly in fits and starts over the next few years. Such is the makings for the long, slow, grinding bear market that would mark the third and final leg lower in the traditional secular bear market cycle, as the cleansing process is finally allowed to play out along the way. In an upcoming article, I will explore in more detail the implications for stock valuations if the Fed is indeed embarking on a different path for monetary policy going forward.
As for the fate of Treasuries (NYSEARCA: TLT), this will continue to rest in the hands of the economic outlook. In a reality that appears to finally be dawning on investors six years after the fact now, Treasuries perform well when the Fed is NOT buying and struggle when the Fed IS buying. The rally in Treasuries began just days after the Fed's tapering of QE3 began, and as long as the economic outlook remains challenged, Treasuries should catch a nice bid.
The same cannot be said for spread product such as investment grade corporate bonds (NYSEARCA: LQD) and high yield bonds (NYSEARCA: HYG). Just like stocks, these categories have benefited from the lower risk environment provided by Fed asset purchases. But with interest rate spreads relative to U.S. Treasuries at historically low levels, the risk is to the downside for these categories as these bonds are forced to once again deal with the realities of the economic cycle. These downside risks are particularly pronounced for high yield bonds, where the credit risks being assumed in this area of the market have been of increasingly speculative proportions to be kind.
Bottom LineThe three decade long era of Fed support for stock prices appears to be coming to an end. In its place is the dawn of a new era of Fed policy that is likely to be more targeted with its policy initiative with a focus on the bottom 95% that has been left behind from an employment, income and housing perspective. Whether the Fed will be successful with these priorities remains to be seen. But given their priority to address what their Chair perceives to be among the worst inequality conditions in American history, any future support that passes through to the stock market is likely to be nil barring some sudden and catastrophic decline in prices along the way. If this is indeed the new reality for stocks, it is important for investors to begin prepare for this reality today, as stock investors may finally be forced to truly work at generating positive returns without the free pass they have been receiving for nearly three decades. |
