Summary of the GIC meeting – April 16, 2014

Sharing this summary from my dear friend David Kotok:

Summary of the GIC meeting – April 16, 2014
April 28, 2014

The GIC (Global Interdependence Center),, has an annual Monetary and Trade Conference in Philadelphia, Pennsylvania. My good friend Bill Dunkelberg, chief economist for the National Federation of Independent Business, and emeritus chair of the GIC conducted the conference. Below you will find his summary of the conference proceedings. Slides and information about the GIC and presentations are available on its website.

We note a few salient points in the summary and presentations. The transition in monetary policy and whether or not the Fed (Federal Reserve) did the right thing in QE1, QE2, and QE3 is an ongoing debate. As Bill says, those who say the alternative would have been worse are arguing the counterfactual. One can argue counterfactuals forever, and people do. The prospect is that they do not mean a lot because we do not know what the outcome would have been. Also note Bill’s reference to about half of the US economy, which is driven by independent and small business, the engine of growth in jobs and economic activity. As Bill says, the sentiment indicated by his survey data is not particularly robust. It seemed the conference confirmed this as well.

Last we note the references to the interference with economic growth that occurs because of the White House. The failure to approve a pipeline and other elements, including higher taxation, all come together to demonstrate that the economic recovery so far in the US is very slow and somewhat disappointing.

We hope readers enjoy the summary and have an opportunity to visit the GIC website. Bill’s summary follows.

Recently a group of experts assembled at Drexel University to discuss the future course of U.S. monetary policy and its implications for our global neighbors. GIC’s Annual Monetary Policy and Trade Conference focused on the phase-out of “quantitative easing” and its implications for financial markets and real economic growth (see the presentations at The first session provided an update on the current state of the economy and expected growth for 2014-15. Growth is expected to continue to be sub-par (as it has been since the recovery started in 2009), with real GDP growing between 2.5% and 3%. Inflation would remain below 2% and the unemployment rate would remain stubbornly high. Bright spots in the economy would continue to be energy (where all the growth has been in the private sector, not on government controlled land and the President continuing to withhold approval of the Keystone pipeline project and delay permits for more drilling, exploration and natural gas and oil exporting) and housing, where starts continue to lag expectations. Consumer spending on cars will be solid, but sluggish in other areas. Overall, not a strong outlook with the recovery now 59 months old, the average for a post-war recovery.

The causes of this anemic growth were discussed, top on the list being the uncertainty produced by the inability of Congress and the President to make any progress on top issues, the avalanche of regulations, the Affordable Care Act, tax hikes, and a loss of confidence in government (only 1 in 10 consumers think government policy is “good”, over 50% think it is “bad” [Reuters/University of Michigan]). Owners of small businesses (who produce half of private GDP) remain very pessimistic, with far more owners expecting the (or “their”) economy to deteriorate than improve in 2014 and record low numbers thinking it is a good time to expand, a third blaming the “political climate” directly. All of the “scandals” emanating from Washington are not inspiring confidence in government.

These and other more specific issues (including lingering effects from the financial crash for many consumers) are holding back the recovery, but the Federal Reserve has no tools to “fix” them beyond urging the fiscal authorities to act responsibly. But the Fed apparently decided to do what it could to “offset” the negative impacts of policies it could not fix. Thus several rounds of “quantitative easing” and “operation twist” followed the Feds initial foray into markets to guarantee the liquidity of the banking system. All together, these programs will take the Fed’s asset portfolio from $800 billion (mostly Treasury bonds) to around $4.5 trillion by the end of this year.

The Fed has now committed to ending the official QE3, “tapering” its monthly purchases from $85 billion each month to 0 in $10 billion increments. This does not mean that in the course of conducting normal monetary policy that the FOMC is precluded from purchasing more bonds which could, on balance, result in a further expansion of the Fed’s balance sheet if deemed necessary based on incoming data. Absent that, the Fed’s termination of QE3 will remove over a trillion dollars of demand for Treasury bonds and mortgage backed securities this year, a rather substantial reduction in demand. Taken alone, one might expect bond prices to fall and interest rates rise as a result. However, the supply of bonds is dramatically being reduced by a huge shrinkage in the federal deficit, by $600 billion or more (last year, the Fed purchased the equivalent of about 70% of new Treasury bond issuance). This would moderate the potential rise in interest rates, especially with the Fed’s “promise” to keep short rates low for a long period of time. Indeed, most forecasts for the rate on the 10 year Treasury anticipate only modest increases, moving toward 4% by year end.

The Fed’s policies do have major impacts on the rest of the world as well as here in the U.S. Low interest rates (which have reduced consumer interest income by half a trillion dollars) have encouraged investors to use this cheap money to find higher returns in other countries. Many of the targets of these fund flows are smaller countries with less well developed financial markets. The capital inflows to these countries induced by Fed policies have altered exchange rates and flows of exports and imports. China and Japan changed their holdings of Treasury securities very little, but transactions in Treasury securities were very volatile from the Caymans, a base for U.S. money investments. Other major central banks are conducting their own “QE” policies as well, all heavily impacting global liquidity. Their success or failure will have a significant impact on the U.S. and our policy choices will impact their economies.

Will or can monetary policy return to “normal”? With a $4 trillion dollar portfolio, it is hard to see how. Just “re-investing” the earnings means substantial bond buying. Letting the portfolio run off, as many suggest as the simplest way to reduce the portfolio (to what level? The pre-recession $800 billion or more because the economy is larger?) implies a reduction in bond buying as bond and mortgages mature and pay off. Discretionary policy must be framed around these possible scenarios of continued purchases or portfolio reductions. The Fed’s attempts to be “transparent” have produced many uncertainties and will probably continue to do so in the future. The Board of Governors has been appointed by one President, so diversity in views will certainly be muted. Many have criticized the Fed for continuing to purchase trillions of dollars of bonds with little evidence that it has made any difference for employment and unemployment, their “objective”. Supporters argue the counter-factual: it would have been worse had the Fed not undertaken QE2 and QE3. Something economists can argue about for years.

David R. Kotok, Chairman and Chief Investment Officer

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April 11, 2014

“An expansion reaching its 59th month, as this one did in April, is anything but young. The average length of expansions, or the time between recessions, since World War II, is precisely 59 months. Curiously, none have lasted 59 months. Some expansions have been shorter and others have been longer. The past three expansions lasted an average of seven and a half years, while the longest expansion in recorded U.S. history lasted precisely 10 years. Expansions do not die of old age. Recessions typically come about due to a rapid unwinding of imbalances that have built up in the economy that typically follow some sort of monetary or fiscal policy mistake, or some sort of massive exogenous shock. Given the sluggish recovery in the labor market and housing sector, as well as the absence of inflationary pressures, the recovery still more closely resembles an economy in its adolescence…”

– Wells Fargo Securities, Economics Group, “Monthly Outlook,” April 9, 2014

The Federal Reserve (Fed) minutes are out. They affirm gradualism, patience, and offer guidance that the slowly paced tapering direction will continue for the rest of the year. Of course, everything is “data-dependent.” All indicators are that there will be no change in the Fed’s policy.

What does that mean for “Sell in May and go away” (SIMAGA)?

Many, many years of seasonality studies indicate a dangerous period of time from May through October. Some studies offer April as a starting point for trouble. Others suggest that the risky interval is between Memorial Day and Halloween. Whatever the case may be, SIMAGA musters considerable historical evidence to support the notion of a rocky period of five months encompassing the end of spring, the summer, and the beginning of autumn.

Many of those studies show that if you practiced SIMAGA on May 1 and went fishing until November 1 you were better off. If you bought the market on the November 1 and sold it on May 1 of the following year, you made an enormous amount of money. You were long stocks for somewhere around six months out of every year, and you were all in cash for the remaining portion. Lots of history supports SIMAGA.

Other studies show the reverse outcome if stocks were bought around May 1 and sold around November 1. If you had done that for the last century and stayed in cash from November 1 through the following May 1, you would have made virtually nothing over the entire century. May through October was mostly the worst time of the year to be invested.

We examined those historical periods. Then we also tested them against Fed policy. Add in what the Fed did, not what they said but what they did, and the dynamics change.

Roughly, the results are something like this. When the Fed is in a stimulative policy mode and is easing during the dangerous SIMAGA period, the effect of the easing neutralizes the seasonal impact on stock markets. Therefore, during those years in which the Fed’s policy was stimulative, SIMAGA did not apply. Other factors apply, like geopolitical risk, market valuation metrics, political cycles, earnings momentum and economic growth rates or inflation rates. The one factor that was neutralized was the seasonal factor. A stimulative Fed neutralizes SIMAGA.

When the Fed was neutral, a different result occurred. Markets struggled, but they did not get knocked hard on the head. A mild version of SIMAGA applied.

When the Fed was tightening during the spring and summer periods, it was best to avoid the stock market. Negative seasonal factors were exacerbated when the central bank was tightening policy. Don’t fight a tightening Fed in the summer time; that is when to follow SIMAGA.

What do we have today?

The Fed is stimulative. The reality is as simple as that, but perceptions are more complicated. Suppose the Fed had been at neutral initially, and then announced a program that over the next six months the Fed would buy federal mortgage-backed securities and Treasury securities and add them to its balance sheet. Suppose they announced purchases beginning at the rate of $55 billion and gradually trending down to $0 over the rest of the year. In this hypothetical model, markets would react to that announcement as a stimulative policy.

The only difference between what was just described and what is going to happen for the rest of this year is that the Fed is reducing the stimulus from a starting level of $85 billion per month, not raising it from a position of neutrality. The Fed is adding to the size of its balance sheet by outright purchases of government securities. Meanwhile, the inflation rate remains below the Fed’s target and has persisted there for a substantial period of time.

In our view, the stock market is neutrally priced. It reflects the continued application of very low interest rates, low inflation, and the likelihood of a continued gradual economic recovery. This is what Well Fargo called an “adolescent” recovery. That will lead to ongoing growth at a slow pace in the US.

At the same time, the current account and federal deficits are both narrowing. The twin deficits that used to haunt us by their enormity and persistence are both headed toward a more neutral and balanced place.

Think of it in the following way. External event balancing shows the current account deficit improving. Internal governmental fiscal policy is also headed toward balance. The shrinking federal deficit piles on top of well-behaved state and local government debt, deficit, spending, and restrictive policy. The Fed is maintaining gradualism, committing itself for the rest of this year and is being stimulative even as it heads toward neutral sometime at the end of 2014 into 2015.

All this says SIMAGA may be a mild effect this year. We may see a correction in the stock market. Three to five to seven percent corrections in the stock market can occur at any time, for any reason, and without warning. Such corrections tend to be attributed to whatever current event happens to be unfolding. Whether it is Vladimir Putin flexing Russian military might in Ukraine or an energy policy shift, it makes no difference. Markets react with single-digit corrections for any reason at any time.

Bear markets do not happen when the central bank is stimulative. Nor do they happen when the inflation rate is low, when interest rates are low, or when external shocks are contained (as with Vladimir Putin and the Ukraine crisis). They do happen when the economy faces a rising recession risk. Right now, the former seem to apply in the spring and summer of 2014.

We are holders of stocks in April 2014. We are finally seeing a long overdue correction. We do not believe it signals a new bear market. We believe that policy still favors rising asset prices and not SIMAGA.

Our new book is in preparation. It will be a second, expanded edition of the former best seller From Bear To Bull With ETFs. Stay tuned.

David R. Kotok, Chairman and Chief Investment Officer

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