Change in the Air?

Last week, Janet Yellen, Chairman of the Federal Reserve Bank, said to Christine Lagarde, the head of the International Monetary Fund, that “equity market valuations at this point are quite high.” Perhaps she knows something!

Despite various strong or weak economic reports this year, there has been a steady stream of Fed officials starting to “talk up” the potential for rising rates.

Earlier today, Federal Reserve Bank of San Francisco President John Williams said that the U.S. central bank is unlikely to provide much warning ahead of an increase in short-term interest rates.

Very few investors are really prepared for what could happen if interest rates were to rise faster than expected. There have been so many false starts in the past that most market participants remain complacent and will only be motivated to react after the fact.

Business Insider (www.businessinsider.com) reports: “the big disconnect in the US stock market just keeps getting bigger.”

“A new Bank of America Merrill Lynch survey published Thursday finds that US investors have pulled $99 billion out of equities year-to-date — including net outflows in 11 of the past 12 weeks — despite stock prices continuing to break record highs.”

This week also saw the biggest outflows from equity ($17.2 billion) and high-yield bond funds ($2.6 billion) this year. This data follows a similar report from BAML last month showing that investors pulled $79 billion from the stock market so far this year and pulled money out in nine of the ten weeks to that point.

According to Bank of America Merrill Lynch, as this imbalance grows so does the risk of something we haven’t seen in the market in years: a correction.

chart1

The color-coded graph below, from the bottom of the financial crisis in 2009 to the present, shows the return on the S&P 500 after specific Fed actions, which have dramatically propelled markets to higher levels.

s&p

Can the trend in the graph change significantly if the Fed finally ends it artificial manipulation of the stock and bond markets? Can the asset bubbles created over the last six years be deflated in an orderly manner without the support of the Fed’s zero interest rate policy? I think you know the answer.

Six years from the March 2009 equity market trough, the Fed’s continued “emergency” largess is putting capital markets, as well as the underlying real economy, at increasing risk. Asset prices are elevated. Global debt to gross domestic product is higher today than it was prior to the 2008 financial crisis, creating significant deflationary pressure.

As stated in the past, we believe that the stock market could become exceptionally volatile if and when rates begin to rise. We welcome any rise in interest rates after years of financial repression from the Federal Reserve.

J. Brock Hamilton
May 11, 2015

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