The Truth Behind The Rally

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There is no denying that the Fed’s current policy of Quantitative Easing has been effective in raising the prices of assets. The chart below shows the performance of the S&P 500 with QE, and without it. As you can see, the days in which there was no QE or no advance notification of QE, have been negative. This chart is proof in itself that the market has risen solely on the Federal Reserve injecting liquidity into the markets and has, thus far, ignored economic fundamentals. Economist David Rosenberg at Gluskin Sheff, estimates that government actions could be directly or indirectly responsible for as many as 500 points in the S&P 500, or 30% of its current valuation. We are in a fragmented market and one that relies solely on Fed Intervention. At some point, the market will either revert to economic fundamentals, or the Fed will begin to taper, and eventually discontinue their easing policies. When this ends, it will end ugly, and we have attempted to position our portfolios with this in mind.

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Keep in mind that prior to this recent appreciation, the market had declined 20% in the summer of 2011. While the markets have soared since then, the rise is coming off of a major decline. Also, keep in mind that the S&P 500 has averaged a less than 1% annualized return since 1999, with 2 declines of over 50%, and countless of 10% or more. While the recent surge seems to be immense, when put into context, it is minimal.

We are not the only managers who share this view. Almost everyday, someone of reputation says one of two things. Either, the markets are distorted and artificial because of QE, or QE is having little-to-no permanent effect on the economy. This is the dominant thought in the economy and markets today. Everything you see happening in the markets is thanks to QE, and therefore artificial and temporary. Someday the Federal Reserve will stop.  When this happens, it will all go away, and it will end badly.

In order for Quantitative to translate to the real economy and prove successful, investors and business owners need to believe that the current market gains are permanent and not temporary. This is a theory posed by Milton Friedman in the 1950’s called the Permanent Income Hypothesis. It states that a sense of permanence is necessary for a wealth effect to materialize. This is not the case currently. The increase in asset prices has been artificial as evidenced by many of the smartest and most successful money managers warning of the fallout that will ensue due the Fed’s extreme measures. The chart below, from Pew Research, makes it apparent that QE has not achieved the wealth effect it has set out, to as only the wealthiest 7% of households in the United States  have benefited from the Fed’s policy.

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