What’s an Investor to do when Fed Critics have no clue?

This article was also published on Seeking Alpha

By now, if you haven’t been investing under a rock, you have heard the constant back and forth of Federal Reserve Officials arguing why raising interest rates is the appropriate action to take in this financial environment.  While the critics insist that raising the Fed Funds rate will only blow up the market and push our economy into a deeper recession than that of the 2008 financial crisis.  The critics give many reasons for this doomsday scenario, but the two biggest reasons are inflation being under the Fed’s mandate and wage growth sluggish at best.  Janet Yellen however, has responded to each of these notions in various FOMC meetings throughout the past two years and has proceeded to raise rates.  Where is the US economy and market today…? rallying stronger than ever.  Both the Dow Jones Industrial Average and the S&500 have made new highs as recently as this September.  This doesn’t mean the critics were wrong.  In their defense, they could just be early, but I don’t see the proof.

The biggest argument critics make against raising the Fed Funds rate is inflation.  The Fed’s dual mandate calls for the Fed to pursue full employment and price stability.  The Fed has constructed price stability to mean an average of 2 percent inflation.  The Fed now follows the Personal Consumption Expenditure for their inflation target and PCE has not reached 2% since January of 2012.  The argument critics make is if inflation does not reach the Fed’s mandate before they raise interest rates then they could fall behind the curve and spur deflation, which the Fed has no tools to fight against.  This argument has been stretched to a tall order.  For one the Fed started raising interest rates .25% in December 2015.  The PCE Index as of December 2015 was 1.37%.  Since the Fed’s first rate in 2015 they raised three more times bringing the Effective Fed Funds rate to 1.16%.  Inflation as of July of this year has stayed relatively the same as it was in December of 2015, 1.40%.  Is 19 months enough time to quantitively decide if inflation is staying level?  Maybe not, but let’s not forget the most important aspect, which is also the most ironic aspect of this argument; the Fed made the interprets price stability to mean an average inflation threshold of 2%.  Meaning if inflation rises over 2% watch out because the economy might start to overheat and if it falls significantly under 2% our friend deflation will come.  The reason why this is the most ironic argument critics make is because they don’t believe in the Fed’s decision to raise rates, but they believe in the parameters they constructed to justify their actions.  And let’s not forget this isn’t the first time the Fed has raised rates when inflation was below 2%.  They did it in the 50’s; albeit they were using a different measure than PCE (Consumer Price Index) but nevertheless they proceeded.  And yes, the Fed did not establish the 2% inflation threshold till 2012, but this is still after the 2008 financial crisis that some argue the Fed helped put the economy in.

Wage growth, on the other hand, is sort of an anomaly until you think about it in the same terms as inflation in a globalized society.  One of the reasons inflation is staying low could be due to technology advancements.  As Edward Yardeni puts it, “I have been making the case for structural disinflation for almost 40 years that I’ve been in the forecasting business.  I’ve discussed how globalization, technological innovation, demographic changes, and Amazon have subdued inflation and continue to do so.”  On top of what Edward Yardeni is saying regarding inflation, wage growth might not be jumping off the chart due to ultra-low interest rates.  Remember the main focus of a company is to keep their shareholders happy.  The easiest way to keep shareholders happy is to increase earnings.  How do you do that in a low-interest rate environment?  Simple, you finance it.  Why would a company pay workers more when they could increase earnings while also delaying costs?

To further prove that raising the Fed Funds Rate does not directly correlate to a recession let’s look at the financial crisis 12/2007-6/2009.  I wanted to analyze two factors.  The first was if there was a relationship between the Fed lowering rates and corresponding price declines in the S&P 500, and two was the price of the S&P 500 negatively impacted by falling inflation, PCE.  In the below tables, you can see the SPX Z Scores, Fed Z Scores, and the PCE Z Scores.  The z scores were achieved by taking the geomean and standard deviation since inception to 7/2017.  Looking at the Regression Statistics table, a R squared of .68 does not show a lot of strength in the correlation between the S&P 500 and a decreasing Fed Funds Rate and inflation rate.  However, when you drill down and look at the p-values for both the Fed Z Scores and the PCE Z Scores you can see that there is significance.  Ideally, you are looking for a p-value under the significance level of .05.  In this sample, both the Fed Funds Rate and PCE are under .05, but the Fed Funds Rate is only under .05 slightly by .008.  Whereas, PCE is under by .05 signaling a stronger correlation with the S&P 500.  This proving that in 12/31/2007-6/30/2009 the lowering of the Fed Funds Rate did not directly impact the S&P 500.

What if you look at periods in the S&P 500 when the market is rising right before a crash and the Fed is raising rates.  The next period I looked at was 6/30/2004-10/31/2006 one year before the financial crash.

It is clear by the R square number of .99 and the Significance F number of 4.79 that there is a strong fitted line representing correlation.  However, looking at the p-value numbers we can see for this time frame there is no clear evidence that the Fed Z Scores or the PCE Z Scores predicted the price movements of the S&P 500.  This could all be explained by sample size.  For this time frame, there were only 29 samples and for the 12/31/2007-6/30/2009 period there were only 19 samples.  In these cases, our sample sizes might be too small.

I ran analysis through the following time frames 1/1999-8/2000, 3/1956-10/1957, and 7/1954-2-1956.  All showing the same inconclusive results.  However, the period that is the most intriguing is the 3/1956-10/1957 period where inflation -in this case CPI, because PCE didn’t exist back then- started off at a staggering low number of .40% in 3/30/1996 and ramped all the way up to 3.70% in 8/30/1957 only to fall back down to 2.90% in 10/31/1957 and then again in 9/30/1958 to 1.7%.  The Fed in this time frame was ramping up the Fed Funds Rate to try and combat the rising inflation.  As you can see in 7/31/1956 the Fed raised rates to 2.75% from 2.50% in 3/30/1956.  This stalled inflation but it quickly revved back up in 12/31/1956 to 3%.  The S&P 500 later pulled back in February of 1957 followed by a bottom in February of the following year.

The Fed Z Scores t Stat comes in at -3.29 and the P Value clocks in at 0.004 well under our significance level of 0.05.  However, the Significance F score of 0.012 and an R Square number of .38 shows that the overall probability is nonexistent.

This harks to the old saying what came first the chicken or the egg?  Did the impact of inflation cause the Fed to lower rates or did lowering rates further move inflation, which negatively impacted the S&P 500 in 12/2007-6/2009?  Inflation is a lagging indicator and the Fed Funds rate is a leading indicator, which means the Fed is reacting to inflation.  This therefore rejects our hypothesis that the Fed lowering interest rates impacts the S&P 500.  However, there could be a case for a domino effect argument whereby the Fed raising rates impacts inflation and therefore impacts the S&P 500.  It is true that the Fed does not do a great job in cultivating market tops, but since the 2008 financial crisis I don’t think anyone can argue that the Fed hasn’t boosted the stock market by institutionalizing Quantitative Easing.  The Fed’s decisions are reactive and therefore can boost an economy or a bear market significantly, but it tends to have problems when the market and/or the economy is matured as was the case in 2006 when then Chairman Allen Greenspan raised rates too quickly and spurred deflation.  In contrast, now Fed Chairwoman Janet Yellen has been very transparent that she wants to move rates slowly.  Now, even if Janet Yellen decided to raise rates another 1 percent in 2018 that would still only put the Effective Fed Funds Rate at 2.16% versus what Allen Greenspan did from 6/2004-10/2006 raising rates over 4%.

With all the noise constantly surrounding the Federal Reserve’s next move, it may be harmonizing to look at a different indicator all together, the Leading Economic Indicators Index LEI.

From this chart, we can see that the LEI Index has accounted for the past eight S&P 500 corrections circled in red.  Once the LEI Index goes negative it is a clear sign that a recession is coming.  The table below shows how early the LEI Index was in spotting all the past eight recessions.

As the table shows, there is no real consistency in timing ahead of a correction.  In fact, in 2011 there was no lead time at all, but in the 1990’s correction it was early by 17 months.  However, a note of caution, when I ran the same type of analysis on the S&P 500 and the LEI Index from 2/1960-6/2017 I came up with the same inconclusiveness.

This indicator is far from perfect, but in my opinion, I think there is still more value in following the LEI Index in relation to the S&P 500, as shown in the Leading Economic Indicators Index & S&P 500 Year over Year Chart, then from following this transparent slow-moving Fed raising rates in correlation to the S&P 500 especially for market tops, which we are currently in.

By | 2017-10-26T17:32:42+00:00 October 26th, 2017|Categories: Market Thoughts|0 Comments

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