Once again markets were highly volatile yesterday with the Dow swinging well over 500 points before finishing with a slight gain.

 A 7% decline in oil prices weighed on that sector and the entire market. As we have been warning, volatile has risen in front of the FOMC rate decision. That decision will be announced at 2pm today and I can almost guarantee, heightened volatility after the fact no matter what the Fed decides to do.

While most of the focus this week has been on interest rates and today’s pending rate decision, the Fed has another important tool it uses to control interest rates and contain inflation. Through the purchase, sale and liquidation of government debt, the Fed can activity control the amount of liquidity in the U.S. financial system. Before and during the Great Recession, the Federal Reserve banks held less than $1 trillion of assets, mostly Treasury securities and some agency debt. When the apex of that recession hit in September 2008, the Fed stepped in and quickly expanded its balance sheet to $2.5 trillion at a time when commercial paper markets literally dried up, Fannie Mae and Freddie Mac were taken over by the Federal government, Lehman Brothers failed, Merrill Lynch collapsed along with associated mortgage backed derivatives. Clearly, that injection of liquidity prevented a complete collapse of our financial system. Even as a recovery began, it was the Fed’s decision that the recovery was so fragile that had to inject more liquidity into markets as Europe faced the prospect of sovereign defaults in Greece and elsewhere. By the time quantitative easing (QE) ended in 2014, the Federal Reserve’s balance sheet had swollen to about $4.5 trillion. Finally, at the start of 2018, the Fed thought our economy and financial markets were stable enough to begin the process of reducing its balance sheet back to a more desired level. This year it will liquidate about $400 billion and next year the current plan is to reduce the balance sheet by an additional $50 billion each month or a total of $600 billion. Thus, over a two-year period, the Fed will have reduced its balance sheet by about $1 trillion meaning that it will have withdrawn that same amount of liquidity from our financial system.

When QE began, the idea of adding liquidity was to stimulate the flow of money once again. In theory, the banks through which the liquidity was channeled would help to circulate funds through the general economy and stimulate lending activity and economic growth. One measure of the success of this plan is to look at the turnover rate of money or velocity. Although it rose from 1.71 to 1.74 from the second quarter of 2009 at the bottom of the recession to the third quarter of 2010, soon thereafter it began to fall. Since the government began measuring velocity in the late 1950s, the lowest it had ever gotten was 1.65 in 1964. It matched that level of the end of 2011 ultimately reaching a record low of 1.43 in late 2017.

What does this all mean? It means the money the Fed injected to stimulate activity and growth wasn’t doing what was intended. Instead the excess liquidity just sat there. Well, it didn’t just sit there; it was invested. In simple terms, the liquidity went into the financial markets, not the commercial markets. It created more demand for investment and raised the value of all assets. Long term bond yields fell below 1.5%. Stocks rose to 19x forward earnings. Home prices rose faster than inflation. Oil recovered from near $30 per barrel to more than double that.

That has all changed this year as the Fed began to reduce its balance sheet and remove liquidity from the market. But since very little of the liquidity the Fed provided went into the general economy, there has been relatively little impact on general economic activity from the withdrawal of liquidity other than in those industries highly dependent on debt financing. Instead, the impact has been felt in financial markets. As inflated prices return toward normal, we have seen interest rates rise, equity P/E ratios fall and real estate values drop.

The Federal Reserve has stated a game plan of normalizing rates as well as the size of its balance sheet. The two, raising rates and reducing the size of its balance sheet, work in tandem. Both serve to slow the pace of economic growth and keep inflation under control. The trick is to slow, not stop growth. As the excess liquidity is withdrawn and, as noted above, most of it is coming from financial markets, volatility has risen. Volatility had been in steady decline from the 2009 bear market end until the very beginning of this year. But it has started to rise again and should continue to rise as the Fed continues to pull money out of markets. The 50-week average for the VIX volatility index bottomed around 11 in late January and now stands at over 16. The extremes of the past few weeks may not be sustained for much longer but the calm markets of 2017 are probably not going to return either.

The fact that securities transaction costs and bid-asked spreads have narrowed to less than a penny has taken away all inducement for market makers to carry any inventory. Volatility raises the animal spirits for algorithmic traders, particularly is relatively small markets like oil where prices have declined more than 6% per day four times over the past month.

At the moment, the volatility has been to the downside and we all feel the pain. But even in bear markets, there can be and almost certainly will be violent bursts to the upside.

What conclusions does all this lead to?

  1. Given all inflation indicators right now show a deceleration in the rate of price increases or an acceleration in price declines, there is risk that the Fed might be close to overplaying its hand. It seems logical to me that the risks of not raising rates today and letting inflation get out of hand are much less than the possibility of creating more downside fear over the short run. With that said, one quarter point change in interest rates isn’t likely to be the event that separates slow growth from an outright recession.
  2. Heightened volatility doesn’t mean prices have to drop. Volatility works in both directions. We have made the case that fair value for the S&P 500, assuming earnings rise less than 2% next year, is around 2700 based both on historic norms and the relation of stocks to high grade junk bond valuations.
  3. With that said, in the short run, emotions dominate rational behavior. If markets were overvalued by 5-10% earlier in 2018, they can become undervalued by the same amount. That suggests risk to the downside of 2400-2450. That isn’t a prediction. It is a statement highlighting what we believe the risk might be today. If stocks are going to trade between 2400 and 2900 for the S&P 500, then when the average is closer to the lower end of the range, the risk/reward ratio rises.
  4. If we are getting back toward normal and given recent volatility, it would make sense for the Fed to slow or even stop the pace of future rate increases as well as the pace of balance sheet liquidation. If I were a voting member of the Fed, after today I would say let’s stop and assess for the next six months unless we see data suggesting a broad acceleration in inflation. Moreover, I would slow the pace of balance sheet sales hoping for a more normalized rate of volatility.
  5. Just because an asset is cheap doesn’t mean it won’t get cheaper. The way to deal with this is to identify what you want to buy, what is an attractive entry point, noting that when everyone is in a mood to sell you can get your best bargains, and nibble slowly. If your stock keeps going down, add a little more. If your target price proves to be too low, you will miss an opportunity but, in all likelihood, you will pick up some bargains and miss some others. Don’t buy anything based on price alone. In this kind of market, only buy companies you really want to own.
  6. Finally, don’t let your emotions get the better of you. If you buy stocks of great companies at bargain prices (i.e. below fair value) you will be a winner every time in the end. Market bottoms end when weak hands capitulate.

I have no idea what markets will do later today or tomorrow after the Fed rate decision but I expect a lot of volatility for the rest of this week related both to the Fed decision and options expirations on Friday. They then should start to calm down. Given most markets are oversold on a short term basis, we just might see a healthy rally between now and the end of the year. Don’t get suckered in. We are in a decelerating economy where stocks sell at a very modest discount to fair value. That discount can be wiped out quickly with any steep rally. Rather than trying to guess the market, probably an impossibility, identify stocks of great companies you want to own at really attractive prices. Also look at your asset allocation. A sharp drop in equities relative to fixed income may mean stocks are the better bargain at the present time.

Today, Jake, Gyllenhaal is 38. Alyssa Milano is 46. Cicely Tyson turns 94. We’ll miss you, Penny Marshall.

James M. Meyer, CFA 610-260-2220

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