This week’s global selling panic that was triggered but the Fed’s worrisome comments, major bank credit downgrades, continued fears of an imminent Greek default and just generally everybody and their dog running for the exit at the same time. Many Fed watchers are shocked at the adverse reaction to the Fed’s $400 billion “Operation Twist,” where it purposely flattens the yield curve via bond swaps, which normally would cause money to flee low yielding investments into stocks.
However, the fact the Fed said after its Federal Open Market Committee meeting that there are “significant downside risks to the economic outlook, including strains in global financial markets” effectively caused Asian and European investors to sell everything, including gold and other commodities. As a result, in the aftermath of the selling capitulation, there could be an incredible buying opportunity at hand.
Long-term Treasury yields are at record lows and the 30-year Treasury bond just had its biggest rally since 2008, resulting in plunging yields and the commensurate price increases of Treasury securities. Operation Twist essentially is expanding the Fed’s “0% interest rate policy” farther out the yield curve. The three-month Treasury bill now yields 0%, the six-month Treasury bill 0.03%, the one-year Treasury note 0.1%, the two-year Treasury note 0.2%, the three-year Treasury note 0.34% and the five-year Treasury bond 0.79%. Eventually, I predict that the Fed will push the five-year Treasury bond yield to 0.5% or less after Operation Twist is over.
Interestingly, the Fed also announced a new plan to purchase mortgage-backed securities to help the banking industry, which still needs help — see Bank of America (NYSE:BAC). In a way, the Fed essentially is forcing investors to buy stocks, since the S&P 500’s dividend yield is significantly higher than most bond yields.
One of my favorite economists, Ed Yardeni, said Thursday that “Pretzels should be twisted, not monetary policy.” Clearly, the Fed’s actions appear increasingly desperate. The 7-to-3 split FOMC vote does not help to instill confidence either. On Tuesday, Yardeni pointed out that, relative to bond yields, the S&P 500 should be trading at a price-to-earnings ratio of 51.2 versus 11.3. So that essentially means the S&P 500 has to climb 400% to be fairly valued relative to bonds. Only a “crisis of confidence” — very similar to when Jimmy Carter was president — can explain why stock valuations are so out of whack relative to bonds.
The only thing that is certain is that the S&P 500 has a higher average dividend yield than long-term Treasury bonds, so I expect there will be more bargain hunting by institutional investors. Companies continue to issue new bonds at ultra-low interest rates to buy back their stock, which in turn boosts their earnings per share. So in a way, the stock market has an increasingly firm foundation despite all the gloom and doom. I wouldn’t be surprised to see a big rally next week as companies scramble to buy back their stock by the end of the quarter to help boost their earnings per share before the upcoming third-quarter earnings announcement season — just like the stock market staged a similar rally in late June as the second quarter drew to a close.
It appears what we’re seeing in the market this week is a classic overreaction. The Fed’s statements, coupled with renewed fears about a Greek debt default, have made plenty of skittish investors even more nervous, but the bottom line is this could be an incredible buying opportunity for long-term investors.