Can Investor Sentiment and the Fed Propel the Stock Market?

The last two months serve as a classic example of how compounding works. The stock market was down 30% in one month and then it went up 30% in the next month, but it is still 10% below where it started. As interesting as this may be, the real interest is in what lies ahead. In this article, we focus on the two key factors that have driven the recent stock market rebound and question how long they can prevail against ominous outlooks for the economy and a very expensive stock market. Investor sentiment and the Fed are the contra forces propelling the market upward.

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Investor sentiment

The following table tells the recent history of market indicators. As we began the year, the economy was looking strong, but then by mid-February Covid-19 was threatening the economy, and most recently the economy has been decimated. Economic indicators have deteriorated.

Interestingly, market valuation indicators have remained static, consistently indicating a very expensive stock market, You’d think this indicator would move to less expensive after the 30% decline from 2/2 to 3/20, but the fact is that earnings plummeted in tandem with prices so Price/Earnings ratios actually increased – the stock market became more expensive on a P/E basis.

So we currently have a very weak economy and an awfully expensive stock market, factors that would ordinarily signal stock market losses ahead. But that has not happened yet because investor sentiment has moved from Bearish at the beginning of the year to Bullish currently. Observers say that investors are looking beyond COVID to total recovery and expecting a return to the delights of 2019. Some see this opinion as an overdose on Hopium, the euphoria drug that makes everything seem alright. The reality is that recovery will take years and things will probably never be the same.

Investors have learned two mantras that seem to be in play now: “Buy the dip” and “Stay the course.” These mantras have always worked in the past because markets have always recovered. But sometimes recovery takes a long time, and this time there’s a group of 78 million people who cannot wait for a long recovery. 78 million baby boomers are currently in the Risk Zone spanning the 5-10 years before and after retirement. Many are already spending their retirement savings to maintain lifestyles and soon most will be depleting savings for that purpose. So as a recovery restores losses, these people will participate less and less because their savings are being spent. Even worse, many baby boomers will panic and withdraw from the stock market, so they’ll get none of the recovery. See our recommendations for baby boomers at the end of this article.

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But investor sentiment alone might not be enough to sustain the current recovery. The Federal Reserve is resolved to do everything it can to support the economy and the stock market, and it appears that it can do a lot, creating the admonition to “never fight the Fed.” We discuss the Fed in the next section.

 

The Federal Reserve

The Fed has printed an unprecedented amount of money since the market crash of 2008, with three rounds of Quantitative Easing (QE) totaling $5 trillion, an amount that dwarfs all previous monetary expansions. Yet inflation, as measured by the Consumer Price Index (CPI) has remained subdued below 2%. That’s because all of the inflation has been in asset prices. Stock and bond markets have thrived because lots and lots of money has been dropped into them by the Fed. The following image tells the story.

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In the 11 years from February 2009 to February 2020, the total capitalization of the US stock market grew from $10 trillion to $39 trillion. About half of that growth — $15 trillion – came from corporate earnings, with $9 trillion from investors and $5 trillion from the Fed, representing about 35% of all new investments. QE has worked in supporting the US stock market, but at what price. We discuss below what is likely to happen when the Fed “unprints” all that money.  Until then, be aware that stock prices are inflated by Fed intervention.

Then in the next graph, you can see that investors yanked $11.5 trillion from the stock market from 2/20-3/20/2020 – more than the $9 trillion they invested in the entire previous decade. But then just as quickly they reversed course and put most of that money ($7.5 trillion) right back in, and for kickers, the Fed added another $2 trillion. And with investor sentiment in Bullish territory, it would appear that there is more to come, suggesting that the Valuation indicator could break beyond the deep red zone.

Many are now wondering how much money the Fed can print. Is there any limit? There’s no satisfactory answer to this question, and many point to Japan as trailblazing to test for a breaking point. One thing is clear though. Unprinting will hurt. We got our first taste of this fact in the fourth quarter of 2018 when the Fed eased into a very modest reversal of QE and the stock market quickly reacted with a 15% decline.  When the Fed put that money back, the market said thank you with a 32% return in 2019. We should all fear that there is no going back and that the ultimate consequence could be a total collapse of the US dollar.

 

Conclusion

Very few disagree that stock and bond markets are awfully expensive, but both the bulls and the bears remain. Also, most agree that the economy is currently in shambles, so there is no way but up. Young people have the luxury of time to see how it all plays out. Baby boomers do not. In my previous articles, I have been warning boomers to move to safety because (1) there are serious threats on the horizon beyond Covid-19 and (2) boomers cannot afford to take the standard 60/40 stock/bond level of risk at this time in their lives. Baby boomers should not “Buy the dip.” They should “Sell the rally.”