A World Without Risk
via Andrew McElroy
- The Fed will never let the markets fall again.
- It’s a popular view, but it could be dangerous.
- At least prepare for the largest correction in over a decade.
I happened upon a note by Macquaire Research the other day which was titled, ‘A World Without Risk’. What a wonderful concept. It went on to look at the familiar scenario of central banks propping up the markets and the perception they will step in to save them the moment they even begin a healthy correction.
We maintain that the best explanation for investors’ perception that risks are low is that a combination of Central Banks’ liquidity (still running at ~US$1.5-2.0 trillion per annum), an assumption that Central Banks would swiftly reverse their policies at the slightest sign of volatility reemerging, and China’s real estate and infrastructure investment, act as ‘risk buffers’. Investors seem to believe that liquidity cannot be withdrawn, volatility must be arrested and cost of capital cannot go up, and hence, financial assets are in many ways underwritten.
And while they do their best to sound skeptical, Macquaire basically agree.
We remain constructive on financial assets, not because we believe in a sustainable recovery, but because we back the perpetual leveraging ‘doomsday’ machine.
Should we all just throw caution to the wind and back the ‘doomsday’ machine? Certainly it’s worked up until now. And with rates off the floor the Fed has worked some slack to reverse course again if so needed.
My concern is how effective rate cuts would be in propping up the markets if and when they fall. It would surely take a fairly heavy sell off to prompt the Fed to reverse course. Would they be closing the barn door after the horse has bolted?
Lessons From History
No moment in the market is the same. For every similarity I find, someone else could point out a hundred differences.
But the Fed has eased rates in response to market corrections before and there are some helpful observations we can make. Either the cuts come in mid cycle (think 1998) and equities recover to new highs, or they come in the late stages after the trend has ended (2000 and 2007).
Obviously we do not know for sure where we are currently in the trend, but at least we can look at each scenario and try to figure out how much risk really exists in a ‘world without risk’.
Scenario A: The Fed Cuts After The Market Has Topped
The worst case scenario is obviously a repeat of 2000 or 2007. By the time the Fed cuts it is too late and we know how the story ends.
A less extreme example comes from November 1966 after the Dow Jones (DIA) had topped and fallen over 20%. Rate cuts helped a recovery back to the highs, but couldn’t prevent another 36% decline into the 1970 bottom.
Obviously the market’s reaction depends on the drivers at the time, but the lesson is simply the Fed cannot always save the market and send the markets back into the previous trend.
Scenario B: The Fed Cuts As The Market is Trending
1987 perhaps falls into the first category, but I have put it here. Some people will say the market had topped and 1987 was a bear market, but I tend to think of it as an early cycle correction in one continuous bull market up to the 2000 peak (partly demonstrated by the channel in the chart below). There was no recession and the trend recovered quickly. Still, by the time the Fed acted, the Dow had fallen 40%.
The cuts in 1995 were not a reaction to a stock market move, but to concerns in the economy so I won’t include them here. Neither have I included every twist and turn in policy through the 1970s and early 1980s as these were in response to inflation and unemployment. If you want to check every single Fed Funds Rate change, they can all be seen here.
Mid to late cycle cuts are illustrated by the 1998 correction. In fact, this is the best case scenario in terms of draw down as the market only dropped 20% before rallying strongly again (but not for long).
Both the 1987 and 1998 easing measures were brief and it took less than a 1% cut to support the market. Actually you could argue the market had enough support and would have rallied anyway, but that is another discussion.
The main takeaway is on both these occasions the market recovered, but suffered a 20-40% decline first.
A closer comparison
So are we closer to 1966, 1987, 1998, 2000 or 2007 (or even some other period)? Again, fundamentally it is hard to come up with a match based on GDP, employment, inflation and market structure. However, I base most of my analysis on market structure first as there are much less variables.
Based on this alone, the 2009-2017 rally is closest to 1982-1987. Prices have broken from a long sideways bear market and rallied just over 250%.
Also the Fed raised rates from April to September 1987. This was in response to inflation running hot again, but also the market was in a blow off stage and rallied over 50% in the 12 months before the 1987 top. Although the blow off stage this time around is slower, the numbers are similar (the Dow is +48% from the 2016 low).
Anyway, this is just an add on observation, not another crash call. The main points are summed up below.
The market perceives a ‘world without risk’. I read quite a lot of comments (and even articles) saying the Fed will never let the market correct again.
But history tells us the Fed is either powerless to stop the market falling, or acts after the market has corrected >20%. And clearly any recovery is not only a function of what the Fed does, but also of the myriad of other drivers.
The fact is the market could fall 20, 40 or even over 50%. Even the smallest of those figures would constitute the largest correction the market has undergone since 2009. A world without risk? I’d like to believe it, but think it better to take that perspective after the market drops and we are buying 20-30% lower.