On December 5, 1996, Federal Reserve Chairman Alan Greenspan gave a speech entitled ‘The Challenge of Central Banking in a Democratic Society’. We imagine many in the audience found it difficult not to nod off, but one phrase from his speech became memorable. “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” The S&P 500 more than doubled after Greenspan’s speech, climbing from 744 to 1,553 in March 2000, according to Bloomberg.

1. - The Big Picture - http://www.ritholtz.com/blog -
Forward Markets: Macro Strategy Review
Posted By Jim Welsh On June 6, 2013 @ 8:00 am In Think Tank | 4 Comments
On December 5, 1996, Federal Reserve Chairman Alan Greenspan gave a speech entitled
‘The Challenge of Central Banking in a Democratic Society’. We imagine many in the audience
found it difficult not to nod off, but one phrase from his speech became memorable. “Clearly,
sustained low inflation implies less uncertainty about the future, and lower risk premiums
imply higher prices of stocks and other earning assets. We can see that in the inverse
relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how
do we know when irrational exuberance has unduly escalated asset values, which then
become subject to unexpected and prolonged contractions as they have in Japan over the
past decade?” The S&P 500 more than doubled after Greenspan’s speech, climbing from 744
to 1,553 in March 2000, according to Bloomberg. If he had reservations on a central bankers
ability to spot irrational exuberance before his speech, the doubling in the S&P500 in just
over 3 years only reinforced it. Greenspan ultimately concluded that rather than trying to
identify a burgeoning bubble, and taking action to let the air out before it became too large,
the Federal Reserve would simply deal with the fallout should one occur. After all, the Federal
Reserve had been able to handle the fallout from the stock market crash in 1987, which in
percentage terms was comparable to the 1929 crash. The 1998 collapse of Long Term
Capital Management came close to being a systemic crisis, relatively small compared to
Lehman Brothers in 2008, but the Fed dealt with it. The Fed’s playbook under Chairman
Greenspan was the same: flood the banking system with liquidity, stabilize the financial
system, and the crisis will pass. It worked in 1987, 1998, less well in 2001, but not so well
since the 2008 financial crisis. We think the Federal Reserve overestimated its capability to
handle asset deflation, especially after an asset’s valuation was allowed to exceed prior
valuation peaks by 40% to 50%.
The philosophical decision to be reactive rather than proactive in dealing with asset prices is
interesting since the Federal Reserve has always been proactive when dealing with the
economy. If strong growth raised inflation during the 1950’s, 1960’s and 1970’s, the Fed
would eventually increase interest rates, slowing growth enough to bring inflation down and
not infrequently (1954, 1958, 1961, 1969-1970, 1973-1974, 1980, and 1981-1982) tip the
economy into recession. Once a recession did develop, the Fed promptly lowered rates to
revive growth. The Federal Reserve’s choice of allowing asset prices to find their own level
was also based on the belief that markets are wiser than bureaucrats in establishing an
appropriate valuation for any asset. While we generally support this view, we also recognize
that the dot.com bubble proved that markets are hardly infallible. What’s interesting is that
the Federal Reserve, under Alan Greenspan’s leadership, had a ring side seat as the housing
bubble was forming so soon after the dot.com bubble and still remained reactive rather than
proactive.
As the Nasdaq Composite was doubling in 1999 and 2000, the philosophical decision to be
reactive rather than proactive was reflected in the Federal Reserve’s decision not to increase
margins for stock purchases, which would have curbed the level of speculation in technology
stocks in 1999 and 2000 without harming the overall economy. But how do we know when
irrational exuberance has unduly escalated asset values? [1]
It’s a fair question, but if
something walks and quacks like a duck, its only common sense to conclude there’s a high
probability it’s a duck. In 1999 and 2000 the valuation of the stock market was 50% higher
than any time in the last 100 years, as measured by the Price/Earnings ratio, Q-ratio, or
stock market capitalization as a percent of GDP. When the dot.com bubble popped, the Fed
executed the game plan and lowered rates to 1% to contain the fallout. Even as business
spending plunged and September 11, 2001 stunned America, low rates kept consumer
spending going so the recession was shallow and lasted only eight months.
As the housing bubble was forming after 2004, the Federal Reserve failed to respond from a
regulatory standpoint to oversee the availability of mortgages that allowed a home owner to
borrow 125% of their homes value, or supervise the lax lending standards that became
pervasive throughout the country. Starting in June 2004 the Federal Reserve increased the
Federal funds rate .25% at 17 consecutive FOMC meetings until it was 5.25%. Although rates

2. had been increased, home
buyers had many mortgage
options which made it easy for
them to circumvent the impact of
the higher Federal funds rate.
Demand increased even as the
Fed raised rates, increasingly
powered by lax lending
standards and liar loans. From
1965 until 2000, the median
home sold for about 333% of
median income. By 2006, home
prices rose to 475% of median
income. In just six years, median
home prices were more than
40% higher relative to median
income than they had been at
any time since at least the mid
1960’s. Many of the ‘hot’
markets were even more
stretched. Although a central
banker may not be able to know
for sure when a bubble is forming, these valuations were less than a subtle hint that home
prices had become unduly elevated.
[2]
We do not believe the Federal Reserve was primarily responsible for the housing bubble, as
some have suggested. The housing bubble developed because there were many
contributions from many contributors. Each political party pursued their respective political
agenda or philosophy; the rating agencies were compensated by the issuers of mortgage
securities which created a serious conflict of interest that potentially compromised their
ability to be ‘objective’; mortgage brokers who received higher commissions even when they
sold a more expensive mortgage to an unsuspecting homeowner or assisted in filling out the
application for a questionable home buyer; Wall Street investment banks which continued to
distribute mortgage backed securities even after they suspected some of the MBS wasn’t
worthy of their AAA rating; speculators who bought multiple homes with no money down
expecting a quick profit; and all those willing to game the system because there was simply
too much money to be made for everyone involved. The gravy train gained speed as it rolled
downhill, while the Federal Reserve remained a passive observer.
It is somewhat ironic that after not proactively responding to asset price fluctuations and
allowing two bubbles to form in less than a decade, the Bernanke Federal Reserve in recent

3. years has pursued an aggressive proactive approach that is intended to influence asset
prices. Rather than being indifferent to asset prices, the Fed is very much interested in
manipulating them as part of current monetary policy. By holding the Federal funds rate just
above 0% for the last five years, and launching quantitative easing programs that currently
include purchasing $85 billion of Treasury bonds and mortgage back securities every month,
the Federal Reserve has charted a course that has already resulted in a number of intended
consequences. [3]
Mortgage rates
are the lowest
since the Great
Depression, stock
prices have
vaulted to a new
all-time high, and
junk bond yields
have fallen to an
all-time low. The
risk is rising that
equity valuations
are becoming
disconnected from
the real economy
since economic
growth remains
sub-par and the
majority of
workers are
experiencing a
decline in their
disposable income. According to Sentier Research, median disposable income has fallen from
$54,275 to $51,320, a drop of 5.4% since the recovery began in June 2009. Corporate profit
margins are near record highs and earnings are growing but at the expense of the average
worker. Corporate stock buybacks have contributed meaningfully to the increase in earnings,
so the quality of earnings is not as good as it appears. While this may make the market
seem reasonably priced based on a P/E ratio of 15 or so, this is like getting fat by eating
one’s leg. Sooner or later, incomes must grow in real terms for aggregate demand to reach
a sustainable growth path. Absent that, the Federal Reserve has provided the financial
markets a placebo, even as the patient continues to get weaker. We hope the Federal
Reserve is successful in using asset prices to improve economic growth, but we remain
vigilant. In addition to the intended consequences, there are likely to be unintended
consequences. Some might be positive, but they won’t all be positive. Here are two
unintended consequences which are not positive.
After working hard for decades, saving money, and possessing a nest egg that would allow
them to retire comfortably, those prudent savers who retired before 2007 have been
crucified by the Federal Reserve’s low interest rate policy. In 2007, they could safely invest in
a 5-year Certificate of Deposit and earn at least 5.0% on their savings. When that CD
matured last year, they were confronted with a frightening new reality. Rather than receiving
$5,000 each year for every $100,000 invested, they would be lucky to earn $1,000 – a
decline of 80%. For those heavily dependent on interest income, this 80% plunge in income
is why the demand for Reverse Mortgages is growing, and why the demand for income
producing bonds and stocks has been growing. [4]
Those who previously were predominantly
dependent on CD’s or money market funds never really had to accept principal risk. Now
more of them do, and there’s a chance some of them don’t fully understand the additional
risk. When interest rates rise and bond prices fall, or the stock market experiences the next
bear market, some investors could become two-time losers. First, lower rates slashed their
income from safe savings accounts, forcing them to invest some money in higher yielding
bonds and/or stocks. Sometime in the next few months or years, bond prices fall from all-
time highs. Or the stock market falls from an all-time high. Worse, bonds and stocks decline
simultaneously as they did from 1942 until 1981, whenever interest rates rose materially.
Trees don’t grow to the sky, and there is nothing the Federal Reserve can do to change that.
Another unintended consequence of the Federal Reserve’s proactive monetary policy is its
impact on pension funds, both public and private. By law pensions are required to calculate
the present value of future liabilities using a discount rate based on current interest rates,

4. current assets,
future
contributions, and
for individual
workers, their
time of service,
income level, and
life expectancy.
This is not an
exact science
since employees
come and go, and
interest rates and
investment
returns can and
often change
dramatically in any
given year. Based
on all these
variables pension
actuaries estimate
how much money
a pension fund will
need over the
next 10, 20, and 30 years to pay retired workers their promised benefits. In the following
example we are excluding annual contributions to keep the math simple. For instance, an
actuary determines a pension with $50 million in assets today will need $400 million in 30
years to meet its obligations. What rate of return does the pension have to earn to ensure
there will be $400 million available in 30 years? The $50 million would double every 9 years if
the fund earned an average annual return of 8% based on the rule of 72 (72/8% = 9 years).
So after 27 years, the $50 million would have doubled three times and be worth $503 million
in 30 years. However, if a discount rate of 6% is used as the expected average annual rate
of return, the $50 million will have quadrupled in 24 years (72/6% = 12 years) and only have
$284 million to meet its obligations in year 30. The difference between 8% and 6% doesn’t
sound like a lot, but over time the effect of compounding becomes very significant and has a
large impact on the annual employer contribution.
The discount rate used by corporations to determine their pension contribution is based on
the yields of corporate bonds rated double A or higher with maturities equal to the schedule
of pension benefit payouts. As our example showed, the shortfall caused from a lower
investment return can be significant and must be narrowed by larger contributions by the
employer. As a result of the Federal Reserve’s monetary policy actions and quantitative
easing programs, corporate bond yields have fallen dramatically. A good thing for corporate
borrowing, not so good for corporate pensions.
Mercer is an employee benefit specialist that advises pensions on all aspects of pension
management. The Mercer Yield Curve Mature Plan Index is one of the rates used by large
corporations as their discount rate. Since December 2007, the Mercer Index’s yield has
plunged from 6.4% to 3.65%, which has created near record pension deficits. According to
Mercer, the 1,500 companies in the S&P 1500 stock index had a combined deficit of $607
billion as of November 30, 2012. Although pension portfolios benefited from the 16% gain in
the S&P 500 in 2012, the decline in interest rates more than offset it, lifting the deficit from
$484 billion at the end of 2011 by $123 billion. In 2013, Ford expects to contribute $5 billion
to its pension fund, which is almost as much as it spent building plants, buying equipment,
and developing new cars in 2012. In the fourth quarter, Verizon Communications contributed
$1.7 billion to its pension plan. In a recent securities filing, Boeing said a .25% drop in its
discount rate would add $3.1 billion to its pension obligations. At the end of 2012, Boeing
reported a pension deficit of $19.7 billion. According to J.P. Morgan Asset Management,
companies hold only $81 for each $100 promised to pensioners.
The pension underfunding gap for public pensions is worse. At the end of 2012, the shortfall
in 109 of the nation’s state pension plans rose to $834 billion, up from $690.3 billion in 2011,
according to Wilshire Consulting. In 2012, assets only amounted to 69% of liabilities, down
from 93% in 2007. According to Wilshire Consulting, these plans expect to average a median
rate of return over the next 30 years of 7.8%. Returns over the last decade fell well short of

5. 7.8%, and with 30-year Treasury bonds and high quality corporate bonds yielding less than
half of 7.8%, it is an understatement to suggest this expected return is not realistic. The
primary reason state and local governments have not lowered their expected return rate is a
lower rate would require larger contributions now and in coming years. With many state and
local government budgets under pressure, it is easier for politicians to ignore the problem.
Who knows, maybe trees can grow to the sky! Besides state and local governments have an
Ace in the Hole corporations don’t have. The California Public Retirement System (CalPers)
has $255 billion in assets to cover present and future obligations for its 1.6 million members.
In March, CalPers published a report that a number of state and school pension funds are
only 62% to 68% funded for obligations in the next 10 years, and only 79% to 86% funded
out to 30 years. To close the funding gap, CalPers approved a 50% increase in contributions
for those cities and school districts for the next six years. These cities and school districts will
likely pay for the increase in their pension contributions by tapping taxpayers with higher
taxes and fees, and rewarding those footing the bill with reductions in services. Chicago’s
pension fund is underfunded by almost $24 billion, and must contribute $404 million this year
to the teachers’ retirement system this year, which represents 8% of the 2014 education
budget. Over the next three years, Chicago’s annual pension costs will soar from $500
million to $1.1 billion, and that figure does not include the teacher’s pension contribution.
One anti-dote for the pension underfunding problem would come from higher interest rates,
as they would raise the discount rate corporations use, and lower the amount they would
have to contribute to their pensions. Higher rates would also help state and local
governments lower their annual contributions since higher rates narrows the gap between
current rates and the 7.8% median rate of return expected by state and local governments.
But we live in a time when the law of unintended consequences is the rule rather than the
exception. As policy makers address one problem, another problem pops up.
After the financial crisis erupted, the Federal Reserve went to the playbook it has relied upon
since the 1987 crash. The Fed injected a massive amount of liquidity into the banking
system, cut rates to stabilize the financial system, and then waited for the recovery to take
hold as it has in the past. It didn’t take long for the Fed to realize it would require an
extraordinary proactive monetary policy to offset the deflationary forces of banking and
consumer deleveraging. Lowering interest rates to help housing and auto sales has always
been part of traditional monetary policy, and we would suggest the initial round of
Quantitative Easing was more of an extension of traditional policy. The goal of QE3,
however,and the expansion of QE3, is to boost asset prices so consumption can remain
strong enough as fiscal tightening becomes a headwind. With stocks and bonds hitting new
all time highs and home prices recovering, this strategy is working. With time and higher
asset prices, the Federal Reserve and the other central banks can only hope real economic
growth accelerates. This is a strategy that is fraught with unforeseen risks, but the central
banks have no choice. This raises a good question. If central bankers aren’t able to identify
an asset bubble, even though the tech and housing bubbles were somewhat obvious, how
will they know when irrational monetary policy has unduly escalated asset values?
If and when the Federal Reserve begins to scale back QE3, stocks and bonds are likely to
fall, erasing some of the paper wealth created by the psychology of QE3. Some will point out
that the Fed will only reduce QE3 if the economy is doing well, so stocks should hold up.
When QE1 and QE2 ended investors will remember the stock market declined, so they will be
inclined to sell and ask questions later. Investors will also worry the economy may soften too
much without the assist from QE, especially if a couple of data points come in weaker after
the Fed has scaled back on QE3. Bond prices are likely to sag as well, since the supply the
Fed has been soaking up will have to be bought by other buyers. When the Fed decides to
increase rates, the higher rates will help savers and pensions, but hurt housing and autos
sales. Most importantly, higher interest rates will increase the interest expense on the
mountain of debt our economy is lumbering under. As noted last month, according to the
Federal Reserve, for each $1 in GDP there is $3.50 of debt. Federal debt now exceeds $16
trillion and the Treasury is paying an average interest rate of just 2.6%. For each 1%
increase in the Treasury’s funding cost, the Congressional Budget Office estimates interest
expense will go up by $100 billion, which won’t make lowering our budget deficit any easier
in coming years. The States Project, a joint venture of Harvard’s Institute of Politics and the
University of Pennsylvania’s Fels Institute of Government, estimated last December that
state and local governments now owe a total of $7.3 trillion in debt. According to studies by
the Pew Center on the States, states and large cities have made more than $700 billion in
promises for retiree health care insurance, but have set aside only 5% of the money to pay
for the insurance. Higher interest rates will not be beneficial for state budgets either.

6. We continue to believe the greatest risk to the Federal Reserve’s proactive monetary policy
is that it will be as successful as the Fed’s reactive policy. As we noted at the beginning of
our discussion, Federal Reserve Chairman Alan Greenspan asked, “How do we know when
irrational exuberance has unduly escalated asset values, which then become subject to
unexpected and prolonged contractions?” At this point we know the answer. What we do
not know is what the unintended consequences of the Federal Reserve’s and other central
banks proactive monetary policy will be. For investors the coming months and years could
prove treacherous, since the psychology of QE3 is likely to lift stock and bond prices further.
We just don’t know when the music will stop. Should central banks’ proactive policy fail to
result in a self sustaining economic expansion, the global economy will be at risk to suffering
a Japanese like lost decade, and investors will lose confidence. If the central bank proactive
policy succeeds, the financial markets could be vulnerable to a large increase in volatility that
results in declines in both stocks and bonds as monetary policy around the world is
normalized at some point in the future. This suggests that a tactical approach to the financial
markets is warranted, since no one knows whether this monetary experiment will succeed or
fail.
Stocks
As discussed in the April commentary, the S&P 500 was approaching an important trend line
which connected the highs in 2000 and 2007. The overall formation since 1999 is potentially
a broadening top which looks like a megaphone. On May 3, the S&P punched through this
resistance after a better than expected employment report. We thought a break out above
1,600 could lead to a blow off that could carry the S&P to 1,680 – 1,700, inspired by the
bullish psychology surrounding QE3. On May 22 the S&P traded up to 1,687 before reversing
lower. [5]
The run up above 1,600 has
stoked bullish sentiment, which under normal
circumstances would be worrisome.
However, as we have often stated, markets
don’t top because there are too many bulls.
Markets top when investors are given a
reason to sell, and investors currently
believe as long as QE3 is maintained the
stock market is immunized from a decline. If
the economy fails to pick up speed by year
end as we expect, investors may be
disappointed since the consensus is for
earnings and the economy to accelerate.
This is why we continue to believe the risk of
a meaningful market decline will increase in
the second half of 2013.
The Major Trend Indicator (MTI) is a proprietary indicator we use to measure the strength or
weakness of market rallies and declines. Whenever a rally carries the MTI above 3 (shaded
area), it is because investors have a number of fundamental reasons to be buyers and is a
sign of market strength. The recent rally pushed the MTI to 5.46, but that does not convey
how historic the recent rally has been. A Buying Stampede occurs when the market doesn’t
experience a three consecutive day of pullback as it progresses higher. The vast majority of
Buying Stampedes last between 17 and 25 trading days, with few lasting more than 30
days, according to Raymond James. Since the end of December the current Buying Stampede
has persisted for 100 trading days, almost double the prior record of 53 days. [6]
According
to an analysis by JP Morgan, the S&P has been up in 65% of the trading days this year.
Going back over the past 50 years, JP Morgan estimates that the probability of such a
frequency was only 2%. The market is extended and the odds favor a pull back after such an
uninterrupted run. The S&P is likely to retest the break out level of 1,600 at a minimum. We
would view a decline below the April low of 1,536 in coming months as a negative since it
would represent the first time the S&P would have violated a prior low since the bottom in
March 2009. It would also potentially negate the break out above 1,600 and suggest it was
just a bull trap.
Source:
Jim Welsh, David Martin, Jim O’Donnell
Macro Strategy Team, May 2013

7. Article printed from The Big Picture:
http://www.ritholtz.com/blog
URL to article:
http://www.ritholtz.com/blog/2013/06/forward-markets-macro-strategy-review-3/
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[2] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/ratio.png
[3] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/us-median.png
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