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No Fed, No Rally

The data that doesn't mesh with the current status quo is sometimes the most important


It’s kind of interesting that when you see a data point like Monday’s announcement from the Chicago Fed district you kind of dismiss it because it does not fit with the market moving to new highs. For those who missed it, the index’s 3-month moving average suggested that national economic growth was very near its historical trend and that inflationary pressure from economic activity over the coming year should remain subdued. You figure, oh well, just a blip out of the Midwest, no big deal.

But they may have something, and I’ll tell you why from two perspectives.

Bankers are Bearish

First of all, I was playing tennis with a Seattle-area banker over the weekend who told me that he has never felt more discouraged in his career. He is charged with making commercial and industrial loans to Northwest companies in the $50 million to $150 million-plus range, and has found demand is practically non-existent. Additionally, due to new federal rules, his bank won’t make loans based on cash flow projections; there has to be an immediate prospect of payback before any loan is approvable.

So on the one hand, banks are essentially saying that you can only have a loan if you don’t need one. And on the other hand, companies are saying they are not confident enough in the future to add capacity. Bankers are stuck in the middle, and do not see any hint of improvement on the horizon.

Traders Hooked on ZIRP

That’s the first perspective that I wanted to share today. The second one comes from the research director at a large money management firm — another old friend. He said his analyst team has been trying to figure out exactly why share prices have risen so much this year. They do this via a method called “factor analysis” that helps them isolate the reasons that prices of individual stocks or sectors are rising or falling.

He said the team had concluded that improved earnings are not the cause, and of course revenues are not the cause because they are flat to down. He said valuations are definitely not the cause the way they figure it. He noted that most assessments of the Russell 2000 aggregate trailing price/earnings multiple now is 18 because the standard approach to the question ignores companies that are losing money. If you include all the companies that are profitless, the Russell 2000 P/E multiple shoots to 55, which is obviously very high.

The analyst team concluded that the factor most responsible for higher prices is the Federal Reserve’s quantitative easing, or QE, and its zero interest rate policy, or ZIRP.

No Fed Intervention, No Rally

This may not sound like an earth-shaking conclusion, but it does suggest that if and when interest rates start to move higher, which could happen if the great collective unconscious that is the market decides that the Fed plans to taper down its debt purchasing program, then stocks will fall as well.

Put more simply, according to this analysis, QE and ZIRP have to stay in place for the rally to remain on track. So any news item, shift in body language or hint that the Fed plans to diminish its programs would likely have a sharp negative effect on shares.

This is probably one reason the market stumbled Monday: The market appears to be looking forward to the release of the minutes from the last Fed meeting later this week, as well as Fed Chairman Ben Bernanke’s testimony on Wednesday to see if any new information or nuance on potential tapering will emerge.

If there is a change, we could see at least a 10% correction in U.S. markets, and perhaps more in Europe and Japan.

Want to learn how to rein in your subjective side to capture more profits? John Markman is hosting a free 30-minute webinar this Wednesday at 4:30 PM Eastern : Trade Against Your Gut: When Instinct is Your Worst Enemy.

Article printed from InvestorPlace Media,

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