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Federal Reserve Extends Zero Interest Rate Policy (ZIRP) to 2014

By Jim Fink on February 3, 2012

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January 2012 was a very good month for world stock markets. The S&P 500 enjoyed its highest gains at the outset of a year since 1989. Other markets saw similar strong starts:

A big up-move to start a year does not guarantee that market will produce a positive gain for the full year–emerging market stocks actually fell 4.9 percent in 2001 after rising 14 percent in January of that year.

Federal Reserve Extends ZIRP By 18 Months

The bullish tone so far in 2012 was helped last week by the Federal Reserve, which surprised many observers by extending its commitment to a zero interest rate policy (ZIRP) for an additional 18 months–from mid 2013 to late 2014. Fed Chairman Ben Bernanke also opened the door to a possible third round of quantitative easing (QE3) by stating:

The Committee recognizes the hardships imposed by high and persistent unemployment in an underperforming economy and it is prepared to provide further monetary accommodation if employment is not making sufficient progress toward our assessment of its maximum level or if inflation shows signs of moving further below its mandated consistent rate.

PIMCO bond chief Bill Gross thinks QE3 will be just the beginning, stating that “a third, fourth and fifth round of easing lie ahead.” He considers ZIRP and more quantitative easing to be forms of “financial repression” that will keep real interest rates negative and make it impossible for fixed-income savers to earn a return that keeps up with inflation. Bernanke has publicly stated that he believes a sustainable economic recovery won’t take hold until the housing market improves, so Gross has bet big that the Fed’s next round of monetary easing will focus on buying mortgage-backed securities, which will result in lower home mortgage rates.

ZIRP Helps Financial Assets and Commodities, But Not Real Economy

QE3 and negative real interest rates are very bullish for gold and other commodities and stocks are likely to come along for the ride. But Gross makes a convincing argument that ZIRP actually makes the economy weaker because financial institutions no longer find it profitable to provide loans or offer money market funds, so banks take more and more of the nation’s money supply out of circulation and park it at the Federal Reserve. The end result is that ZIRP causes financial assets to rise, but the real economy remains moribund and what little economic activity occurs is limited to paying down debt. Eventually, the debt burden will be paid off and economic growth will resume. But the resumption of growth will be impeded by the huge money supply caused by all the rounds of quantitative easing. Additionally, hyperinflation becomes a real risk.

Not a pretty picture, but the likelihood of financial asset inflation in the face of QE3 and subsequent rounds of easing lead me to believe that a prolonged and severe stock market decline is probably unlikely. Even if corporate earnings growth slows down or even reverses, stock prices could remain flat if the earnings weakness is counterbalanced by higher valuation multiples caused by more quantitative easing. If earnings fall too much, stocks will fall even with quantitative easing.

Stock Market is Cheap Based on Current Earnings But Could Be Value Trap

So my market forecast depends upon how much of an earnings slowdown actually occurs. To a large extent, the stock market is already anticipating an earnings slowdown as its collective price-to-earnings (PE) ratio has been below its long-term average PE ratio for 446 days–the longest stretch since the 13 years beginning in 1973. With the S&P 500 index’s PE ratio currently at only 13.7, the index would need to rise above 1,700 to get back to the long-term average PE ratio of 16.4.

A return to an average PE ratio of 16.4 is unlikely because investors are scared about the future and have been cashing out of the stock market. Only 57.9 percent of all US companies that have reported fourth-quarter earnings in January have beaten analyst earnings estimates–the lowest percentage since early 2009. Furthermore, there are 3.3 percent more companies lowering earnings guidance for the upcoming first quarter than raising guidance, which is also the largest negative discrepancy since 2009.

The Economic Cycle Research Institute (ECRI) continues to forecast a US recession, as the year-over-year growth in the Weekly Leading Index (WLI) during the latest reporting period remains negative at -6.5 percent. To be fair, the WLI growth rate has improved recently with the latest -6.5 percent number being the least negative since early September. But during the 2008 Great Recession, WLI’s negative growth improved from -10.7 percent on March 28, 2008, to -5.5 percent on May 23, 2008, without changing the economic tumoil to come, so it’s way too early to conclude that ECRI is wrong.

Robert Dieli’s Mr. Model Says ECRI’s Recession Call is Wrong

However, economic optimists may be happy to learn that another highly regarded economic forecaster–Robert F. Dieli of Mr. Model fame–does not see a US recession occurring anytime in at least the next nine months. According to analyst Jeff Miller:

In the 50-year history of Mr. Model, when the indicator is at current levels, there has NEVER been a recession within nine months. In fact, we are not even close to the nine-month signal.

Europe remains a mess with Fitch Ratings downgrading five eurozone countries, including Italy and Spain. Greece’s impending agreement with private creditors to forgive 70 percent of the $270 billion of debt owed (up from a 50 percent cut) is a default by any other name. The European Central Bank’s (ECB) Long-Term Refinancing Operation (LTRO) gives European banks unlimited 3-year loans at 1 percent and has reduced pressure on Italian 10-year government bond yields–down to 5.60 percent from over 7 percent a few weeks ago. But Portugal is spiraling out of control with 10-year yields briefly hitting 16.6 percent earlier this week (now 15.2%), the highest they have been since the creation of the euro. Beyond that, Spain’s economy contracted in the fourth quarter with a long recession now a certainty.

News that 25 out of 27 eurozone countries have agreed to tighter fiscal spending limits is meaningless since these new fiscal limits aren’t very different from the fiscal limits that have been in place all along. The bottom line: the ECB’s LTRO program has delayed a Lehman-like financial event in Europe, but bank credit is still tightening for the worse. And French President Nicolas Sarkozy’s likely loss in the elections slated for late April could cause a new euro crisis if it means France backs away from its bailout commitments.  

S&P 500 “Golden Cross” Points to Higher Prices in the Intermediate Term

From a technical standpoint, the S&P 500 is on the verge of experiencing a “golden cross” where the 50-day simple moving average (SMA) crosses above the 200-day moving average. In early January a golden cross based on the exponential moving average (EMA) had occurred on the S&P 500, but a SMA golden-cross crossover is now confirming the earlier crossover. SMA crossovers are historically longer-lasting bull signals, so this is a good sign. According to Birinyi Associates, in the 26 instances since 1962 when the S&P 500 has experienced a golden cross, the market was higher six months later 81 percent of the time.

In the shorter term, investor sentiment has become overwhelmingly optimistic based on a collection of different measurements, including AAII, Investors Intelligence, and the negative put skew in S&P 100 options, as well as the fact that the S&P 500 is three standard deviations above its 20-day moving average. Based on history, when sentiment becomes too bullish, a significant correction typically occurs.

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  1. avatar
    rick daurora Reply February 4, 2012 at 7:49 PM EDT

    Agree