Senin, 24 Juni 2013

The Fed's Real QE Mistake:Timing

Mistake - Source: Fed Chairman Ben Bernanke screwed up royally at his press conference on 19 June 2013, as he announced that the Fed's Open Market Committee had moved up its timetable for when it would beginning drawing down its QE 4.0 program.

QE 4.0, which consists of the Fed's purchases of a net total of $45 billion worth of U.S. Treasuries each month, was originally announced back on 12 December 2012 and was intended to offset the negative effects of the fiscal drag of impending tax hikes upon the U.S. economy in 2013. (Combined with the Fed's QE 3.0 program for buying up Mortgage-Backed Securities, which started back in September 2012, the Fed has been pouring $85 billion per month into the U.S. economy to avoid having it fall into a full blown recession.)

As best as we can tell, it is working as intended.

So why shouldn't the Fed begin tapering its net acquisition of U.S. Treasuries sooner? And why would making an announcement that the Fed was planning to do so be such a huge mistake.

Timing - Source: In a single word: timing.

It's difficult to think of how the Fed Chairman could have handled the situation any worse, except perhaps to have put the responsibility for announcing the change in policy into President Obama's floundering hands.

But the key to understanding the huge mistake the Fed has made is not to look at the timing of when the announcement was made, as some influential people are likely to claim, but by considering how it changed the forward-looking focus of U.S. markets.

Investors in those markets are always looking ahead in time - the only real question is how far into the future are the market's most influential investors looking. And when we say "most influential investors", think of the primary owners and majority shareholders of businesses, as well as the people who make decisions at major investment banks and financial firms.

The reason why they do that is because what they expect to happen at certain points in time in the future directly drives their investment decisions. Those decisions, in turn, have tremendous influence over the prices of everything today.

That's because today's prices are really the approximate net present value of the sustainable portion of the profits that might be realized at discrete points of time in the foreseeable future (see here for a more refined definition). What that means is that if you can determine what the expectations are for given points of time in the future, you can work out exactly how far forward into the future the markets have focused in setting today's prices.

With that knowledge, you can then work out how today's prices will change based on changes in those future expectations. While that may sound challenging, in reality, it's complex, but not difficult to do.

For a stock market, the sustainable portion of profits that might be realized at discrete points of time are called "dividends". We can determine what the expectations are for a given point of time in the future by using dividend futures (via IndexArb or the CBOE) to calculate the change that is anticipated in their year-over-year growth rate. We make historic price, dividend and earnings data for the S&P 500 available for free so you can obtain that data as well.

S&P 500 Quarterly Cash Dividends per Share, 1988Q1 to 2013Q1, with Futures to 2014Q1

Since late-April/early-May 2013, the U.S. stock market, as represented by the S&P 500, has been focused on the future as given by the expectations associated with the first quarter of 2014. Until about 2:42 PM on Wednesday, 19 June 2013.

At that time, Federal Reserve Chairman Ben Bernanke metaphorically grabbed the noses of the market's most influential investors and forced them to shift their focus away from the first quarter of 2014 to instead focus on an earlier point of time in the future, to either the third or fourth quarter of 2013, which would now coincide with the timing of when the Fed will begin to taper off its QE 4.0 net acquisitions of U.S. Treasuries. Our chart below shows why the Fed's choice of timing in resetting the focus of the market's most influential investors to these particular periods of time is so poor, at least with respect to stock prices:

Change in Expected Growth Rates of Trailing Year Dividends per Share with Daily and 20-Day Moving Average of S&P 500 Stock Prices, 10 January 2013 to 18 June 2013

We estimate that in transitioning from a forward-looking focus upon the first quarter of 2014 to instead focus upon the fourth quarter of 2013, which would be the worst case scenario, stock prices for the S&P 500 would fall on the order of 45-50%, after which stock prices would stabilize at the level prescribed by the expectations for dividends in 2013-Q4. Until perhaps investors could shift their focus to a more promising quarter in the more distant future or an improvement in the outlook for that quarter.

By contrast, shifting their focus even earlier to the third quarter of 2013 would be more beneficial, as that would only involve around a 15-20% decline in stock prices from their 18 June 2013 closing level of 1651.

This analysis assumes that Bernanke's comments succeed in shifting the forward looking focus of investors to an earlier future, which would mark a shift in the expectations for the fundamentals driving the market. At this writing, it is too early to tell if such a fundamental shift has occurred, which is why we are presently classifying the market's reaction as a noise event. Depending upon how the Fed responds to the markets' reaction, it is still possible at this writing to arrest and reverse the decline in stock prices.

Now, we've gone into such basics in this article because we know that Federal Reserve Chairman Ben Bernanke and his successor are going to read it and might like to finally learn a little bit about how things like stock prices actually work. And then, maybe, do something that would shift the focus of investors back to the first quarter of 2014, in a way that ensures the Fed's credibility is not damaged.

Because we're pretty sure the Chairman and his colleagues at the Fed don't want to have to bear the full responsibility for having followed up one colossal error on their watch with another, marked by a second monster stock market rout during their tenure. We just don't think that too many people would want to be able to claim that they surpassed the accomplishments of Roy A. Young, Eugene Meyer and Marriner S. Eccles, the Fed chairmen who oversaw the formation of the Great Depression and the Great Recession of 1937-38.

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