Inflection Point: (N) – Mathematics – A point on a curve at which the curvature changes from convex to concave or vice versa.
In describing our current thinking, I have to resort to an investment writing cliché where the financial markets are described as being “at an inflection point.” While the mathematical definition for an inflection point is presented above, in the business of investing inflection points occur where there is a change in the long-term trend or momentum of the financial markets, economy, or price of an individual security. Inflection points are critically important because if you recognize one and if you understand the significance of the change, then you can make a lot of money.
These days it appears that the era of easy money promulgated by our Federal Reserve is coming to an end. Recent statements by Fed Chairman Ben Bernanke indicate that if the economy continues to improve then the Fed may slow or even stop expanding its balance sheet through the purchase of bonds and mortgage-backed securities. These purchases, known as quantitative easing, have been a great source of debate among investors who have tried for the past four years to determine what impact such unprecedented purchases have on the real economy and the stock market. Today, in the current regime known as QE 3 (or QE Infinity), the Fed is purchasing $85 billion of these securities every month. To put that in perspective, the entire Sequester — a supposedly severe cut in government spending that captured the nation’s attention — was a total cut of $85 billion. The Fed is printing that much money every month to expand its balance sheet and stimulate the economy.
It’s easy to see the correlation between the Fed’s Permanent Open Market Operations (POMOs), when the Fed actually makes their purchases, and rising stock prices. Over the past four years the stock market has powered higher because either:
- Investors are leveraging Fed-provided liquidity to buy stocks when interest rates are at 0%.
- Corporate earnings have powered higher on the strength of stable consumer spending, recovering consumer confidence, rebounding real estate prices, and low interest rates.
Obviously if the correct answer is number 1, then investors should run for the door when the Fed stops buying bonds in the secondary market. On the other hand, since the Fed has clearly stated that it will only stop printing money and buying bonds when the economy is unequivocally stronger, then perhaps cutting back on QE is a sign that it’s time to sell your bonds and buy stocks.
So which is it? Is the end of QE the end of a liquidity-induced buying binge for stock investors who have gorged on this central-bank-created bull market for the past four years? If so, investors may be looking at a situation not seen since the late 1970s when both stocks and bonds underperformed at the same time. Interest rates that have been suppressed by massive Federal Reserve purchases of bonds will inevitably rise while stock prices suffer with new competition in the form of higher yielding alternatives in cash and fixed income. This is not a pleasant scenario.
Bullish investors see the end of QE, and the eventual end of zero interest rate policies as the beginning of a new “great rotation” out of bonds and into stocks. If interest rates are rising because the economy is stronger and the demand for money pushes rates higher, then earnings should follow. With the bond market finally rolling over after a secular bull market that began in the early 1980s, where else will money flow but to U.S. and international stocks? In this view the inflection point to buy stocks has arrived as bond prices recently turned sharply lower as interest rates turned sharply higher.
Pinnacle’s Investment Team has proponents of both views, and there have been some lively exchanges between analysts. Will the Fed indeed change course and end its QE policy? Will Ben Bernanke’s successor follow him in pursuing a “dovish” Fed policy? Will the U.S. economy be able to sustain its lackluster recovery if the Fed is no longer providing the juice? Will the current malaise in emerging markets around the world impact U.S. growth prospects and lead to a U.S. bear market? Will higher U.S. interest rates be caused by inflation or higher real rates of growth in the U.S. economy? Will interest rates actually move lower again as bond investors get rewarded for a slower U.S. economy and possibly even a recession brought on by a higher Fed funds policy? The debate continues.
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