Debunking the Myth of the QE II Rally
The single biggest market question is this one:
What happens at the end of QE II?
I have explained this on several occasions and promised more detail. After listening to countless talking heads talk about the QE II rally, we need some clarity.
There are two views of the world:
- Gains in various markets are all the result of Fed policy and things will reverse as soon as Fed policy changes.
- Stock market gains have resulted from improved fundamentals.
Viewpoint #1 gets most of the attention, especially when the market sells off a bit. The second viewpoint is almost a state secret. Too many people confuse actual market fundamentals with what they call "headwinds."
If you really want to understand market fundamentals, you need to consider valuation, risk, and future potential. I discuss these concepts every week in my Weighing the Week Ahead series. Today I want to consider a longer time frame.
My approach is very simple and based on hard data. It is easy to understand. It is contrarian since most traders and pundits want to use words and anecdotes rather than data. Here is the key table.
Let us consider each of the three key elements.
I use the one year forward earnings from the "bottoms up" estimate from Thomson/Reuters. Many critics take the inconsistent position that forward earnings are too optimistic, but explain the typical 70% beat rate by saying that estimates are guided down. I have written about this at length and challenged the skeptics. I maintain that there is a point where forward estimates by bottoms-up analysts are quite useful — the best we can do. That point is approximately one year ahead. I continue to invite any loyalist for another method — particularly those espoused by Hussman or Shiller — to show that they can predict earnings one year in advance with greater precision.
With this in mind, the "Jackson Hole" forward earnings yield was 8.31% and it has declined to 7.74% now. When compared to the ten-year yield (interest rates in the table) the risk premium was a huge 5.75% last Fall and is still 4.61%. On a long-term basis this is a juicy premium unless risk is huge.
When considering the yield premium, you need a way to evaluate risk. Most people do this by producing a laundry list of unquantified (and maybe unquantifiable) worries. I choose to focus on data. An excellent candidate is the St. Louis Fed Stress Index, which uses 18 different data series. The methodology employed isolates the specific contribution of each factor. These are not government measurements, but actual market data. It is a sophisticated way of letting the market speak to you. It was also a great method for spotting problems in 2007-08.
At the time of the Jackson Hole speech the SFLSI was at a worrisome .69 level. (1.0 is a one standard deviation change. I am doing reserach on the best warning level). Right now the SFLSI is in negative territory. Simply put, if you measure risk in objective terms, it is vastly different from last fall.
I view economic growth as the potential for future earnings. While the market is not a GDP futures contract, it does have a good long-term relationship with economic growth. Stocks famously have predicted ten out of the last three recessions. There is incessant skepticism, for political, mercernary, and publicity reasons. Let us compare then and now.
The ECRI growth index was at negative 10. Many widely-publicized pundits insisted that this never happened without a recession. Double dip was on everyone's lips. Nearly everyone ignored the ECRI's own interpretation.
The ECRI growth index is in positive territory and has stayed there for many months. A realistic estimate is a continuation of modest growth, but only extremists expect a recession in the next year. The perma-bears of last autumn have fallen silent.
Briefly put, the potential is much better.
For those of us looking at data, it is so easy to understand the stock market rally. The big question is why the market has not moved even higher. I see many specific stocks that are more attractive than ever on a P/E basis, even if the prices are higher. (JPM, AAPL, and CAT are among current choices).
This article has emphasized the real reasons for the rally, but I still expect to write about some of the alternative explanations.
In an era where many data series have moved higher, it is easy to find strong correlations. While most people pretend to know about the difference between correlation and causation, very few market studies demonstrate the ability to distinguish.
A Final Thought
I have tried to interest various economists in discussing the QE II effects. Most are completely uninterested because they only see a few basis points of effect. When I explain that traders and financial television (not to mention the conspiracy sites) are completely focused on this, they just express amazement.
One of my roles is to bridge this gap.