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After last week’s better-than-expected employment report, many investors are predicting that the Federal Reserve will begin to aggressively taper its $85 billion per month bond-buying program. But based on my analysis of technical indicators and my study of economic history, I believe that’s unlikely to happen.
In order to understand why, we have to go back nearly 25 years. On Dec. 29, 1989, a massive inflationary bubble began to pop in Japan. Equity prices started dropping, but investors with cash sat on their wallets, waiting for prices to fall further. In contrast, the desire to get out became ever more pressing, driving stocks even lower. Thus began a process that central bankers have nightmares about — a deflationary spiral.
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| The Fed won’t repeat Japan’s mistakes. |
More than two decades later, Japan is still feeling the effects of this disaster. Even after this year’s big rally, Japanese stocks are nowhere near their 1989 high.
Bloomberg recently quantified the extent of the damage:
“It’s been 22 years since annual inflation in Japan exceeded 2 percent, according to data compiled by Bloomberg. In the last five years of the 1980s, when Japan’s gross domestic product climbed from $1.3 trillion to $3 trillion and the Nikkei 225 Stock Average peaked at almost 39,000, the monthly readings for consumer price gains averaged 1.2 percent, the data show.”
Japanese stocks are still 60 percent below the high
made 24 years ago!
Now imagine the uproar if this same scenario played out in the U.S equity market. How would institutional and individual investors react if their holdings began to lose value, and didn’t recover for 24 years? It’s not a pretty picture.
Why the Fed Won’t Repeat Japan’s Mistakes
There’s no doubt that Ben Bernanke, Janet Yellen and other Fed officials are very much aware of what has happened in Japan, and they’ll do everything they can to prevent the United States from going down the same deflationary path. PIMCO’s Mohamed El-Erian recently explained their thinking on CNBC:
“The Fed is committed to keeping its foot on the accelerator even though outcomes may well continue to fall short of expectations, and even though the ‘costs and risks’ are likely to rise. If it ends up making a mistake, something that it will try very hard to avoid, it would likely be one of excessive accommodation rather than premature tightening.”
You may argue that stronger economic data, such as what we saw from the labor market last month, makes it more likely that the Fed will begin tapering sooner rather than later. On that point, I’d agree with you. But U.S. policymakers’ knowledge of Japanese history, and their fears of a deflationary spiral, will dictate a conservative tapering schedule, rather than an aggressive one.
Should You Be Long or Short on This Market?
Many people think that once the Fed begins tapering its quantitative easing program, even if it’s on a relatively mild schedule, investors will immediately shift into a risk-off stance and we’ll enter a new bear market. I do think that the market will react to tapering, but it will be a short-term reaction.
Why? For one thing, the Fed will only taper if the economy is growing and the labor market is improving. And one of the tenets that all investors should live by is that you never short growth. In fact, growth is just what the bull market needs!
Second, if the market were going to have a violent reaction to tapering, we would have begun to see signs of it already, in the form of more investors moving into short positions. But that’s simply not happening.
The chart below shows the relative performance of the longs (S&P 500) versus shorts (the inverse S&P 500 ETF, symbol SH).
When investors are optimistic about the future performance of stocks, the price of this ratio is above its moving averages, and the slopes of the red and blue moving average lines are positive. As you can see, that’s exactly where we are now.
For those reasons, I remain long on U.S. equities. But I continue to watch this chart closely. If we see the pattern begin to look more like it did in the two red boxes, which indicate times of economic uncertainty, I will call for a reduction in the allocation to stocks.
Best wishes,
Douglas
