Dec/Jan Outlook: FOMC, US Budget, Earnings, Asian Conflict

Hawkish Fed members and steady economics have suddenly convinced some analysts the Federal Reserve may taper its asset purchases at this week’s December FOMC meeting and policy announcement. These factors combined with fund managers protecting YTD profits have kept equity markets in check over the past  month. After breaking out above 1,775 in mid-November the S&P 500 has traded in a narrow range between 1,775 and 1,810 and is trading at 1,788 at the time of this writing.

Currently the street is giving the Fed only about a 25% chance of a December taper. But if the Fed actually puts on the QE brakes this week market weakness could take on an entirely new phase. Personally, I believe the Fed will wait until next year before tapering because they want to make sure the economy is improving and Washington actually passes a budget and gets us through the next debt ceiling deadline in February. Still, anything is possible.

The Washington budget deal passed last week at least removes one economic pothole for the Fed but it is not yet law. The Senate will take up the budget bill on Tuesday (December 17) and the vote is going to be close. There are Senators on both sides of the isle that don’t like the compromise and are vowing to fight. As such one has to assume that news from the Senate will be considered in the internal FOMC debate on QE which will be announced on Wednesday (December 18). If it appears the budget will pass the news could remove some FOMC member’s objections to a taper.

At the end of the day the Fed wants and needs to end QE. When they released their balance sheet last Thursday it was whopping $3.994 trillion as of November 30 and the December QE purchases will push it over $4 trillion. At some point they have to stop buying treasuries simply because of the stupidity of monetizing the US debt. The ratings agencies and global investors are eventually going to say enough is enough and they will force the US to change course. It is going to be painful if we don’t take control of the situation in advance instead of waiting for global investors to force action upon us.

To understand how QE affects the price of stocks please observe the chart below. When the taper occurs it will be negative for the market. Since the S&P 500 bottomed in 2009 the only other times the market really went down was when QE programs had ended. After the spike in 2013 on the latest version of QE I don’t see how anyone can conclude there will not be a market impact when it ends.

However, it is important to note QE is not going to end on day 1. Rather, it will take many months of progressively lower steps in Treasury purchases. This is the wild card but the fact of the matter is the QE has to eventually end and the market will be on its own. In other words, we don’t know how the market will react to $70 billion in purchases instead of $85 billion and then $50 billion instead of $75 billion, and so on. If the market prices in only $10 billion in cuts but the FOMC decides to cut $15 or $20 billion it should be a net negative for stock prices, and vice-versa.

BOTTOM LINE: We need to be prepared for market volatility around each FOMC announcement, and remain nimble over the next twelve months.

In 2013 the Fed purchased 70% of all new treasuries that were issued. Since the recession the Fed has printed over $3 trillion in new money, the equivalent of 20% of GDP, and spent it all on treasuries and mortgage backed securities. When the QE ends the binge will be over but we could have a few more hours to party.

Chart of the S&P 500 and Fed asset purchases since 2007: The red line is the S&P and the blue line is total purchases by the Fed.

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Earnings Will Eventually Matter

Thomson Reuters issued an interesting analysis last week about corporate earnings and it may point to trouble ahead. Reuters tracks earnings guidance and warnings and the guidance warnings for Q4 are the worst since they begin tracking the data. Historically they are about 2.2:1 or 2.2 negative guidance events for every company with positive guidance events. For Q4 they are currently at 11.4 to 1 and still growing. This is not an encouraging sign but it could influence the Fed to keep the stimulus flowing. In January 2013 consensus estimates for Q4 earnings growth were +18%. Currently they have been revised down to only +6.4% growth.

(click image to enlarge)


Link to the full article:

Finally, corporate stock buybacks announced in 2013 are over $635 billion. That is the largest amount since 2006. Stock buybacks increase earnings per share since they reduce the number of shares outstanding. Analysts claim buybacks have accounted for 2.4% of S&P 500 earnings growth in 2013, while total S&P earnings growth has averaged +4.6%. This suggests actual earnings from increasing sales has been minimal.

To summarize, in the short term the markets will likely be driven by the FOMC decision on whether or not to taper QE purchases at their December meeting. While a decision not to taper may prove to be bullish for prices in the short-term, the eventual withdrawal of stimulus could be negative for equities unless earnings really begin to accelerate. However, when analyzing the facts about earnings growth along with negative guidance warnings as illustrated above, investors and traders should be careful with getting married to the bullish case.

Asian Conflict

You may have heard about the new Air Defense Identification Zone (ADIZ) established by China over international waters and the various intrusions into that zone by US, Japanese and South Korean planes and vessels. On December 5th a US cruiser ship was challenged by Chinese vessels. The Chinese vessels attempted to halt the cruiser in international waters by ordering it to stop. When the cruiser did not comply Chinese vessels sailed directly in front of the US cruiser and tried to force it to stop. The cruiser was forced to abruptly change course and take on a more aggressive posture until the encounter eased and the Chinese forces moved away.

Many military officials believe the US and China could be at war by the end of the decade because the Chinese have decided a US presence in the South China Sea is no longer acceptable. Rick Fisher, a China military affairs expert, said China is deliberately staging these confrontations to test the US resolve. Fisher expects them to escalate until there is an actual confrontation where shots are fired. The Chinese leadership believes President Obama does not have the will to stand up to China and they will use his final three years as President to increase their aggression to remove the US and its allies influence from East Asia. Eventually somebody will cross a line and go too far in one of these confrontations. While this may not be something for investors to worry about today or next month, I would pay attention to future headlines. Don’t be caught in the dark.