Markets Entering Area 51
Area 51 has been steeped in mystery and a favorite subject of conspiracy theorists for decades. But CIA documents released late last week officially acknowledge its existence and suggest that its actual function was far less extraordinary or essential than believed by some. The declassified documents include a map of Area 51’s location in southern Nevada, but more importantly that it was merely a testing site for U-2 surveillance aircraft as part of the Cold War spy programs.
Like Area 51, QE3 – the latest round of quantitative easing, as the Federal Reserve’s (Fed) bond-buying program is known – has been surrounded by mystery (What is it actually doing? Is it working? When will it end?). Also like Area 51, the truth of how QE3 operates is less exciting than many believe.
This truth often gets lost in the conspiracy theories about a U.S. government entity buying U.S. government debt, banks pumped up with taxpayer money, or how the Fed “manipulates” the markets.
With the next Fed meeting now less than a month away on September 17 – 18 and about a 50% likelihood that they announce a tapering, or reduction, in the amount of the monthly bond-buying program at that meeting, the economic data take on a lot of importance for market participants. For example, last week was the survey week for the employment report for August that will be released on September 6, putting greater-than-normal attention on this Thursday’s (August 22) initial jobless claims report that provides a glimpse into the health of the labor market last week. That means the markets may get spooked by mixed data points and volatility may remain high over the coming weeks.
The pending tapering has created concerns among market participants that fear the mysterious power of the Fed has been the only thing holding the stock market up. As we enter the unknown territory, or “Area 51” of tapering in the coming months, the reaction of the stock market should not be very mysterious: stronger economic data are good news for the stock market – maybe not every day, but on balance over weeks and months – no matter if that means QE3 is ending and interest rates may head higher.
The last time 10-year Treasury yields were this high (above 2.8%) was right around the end of QE2, over two years ago. When both QE1 and QE2 ended, the 10-year Treasury yield fell by 1.5 percentage points (and stocks fell more than 10%) because the economy was not ready to come off of Fed support. In contrast, the fact that yields are rising as QE3 is coming to an end suggests that market participants now see economic growth as self-sustaining, and the potential for a more favorable environment for the stock market.
Rising bond yields accompanying economic growth have been good for the stock market in the past. There have been four periods over the past 20 years when interest rates rose for more than 12 months and by more than 1 percentage point. The S&P 500 Index rose in all of those 12-month periods, including over the past year, while the bond market fell. This was not setting up for an eventual fall – stocks rose in the following 12 months, as well.
While in general, rising rates have been favorable for stocks, that has not been true for all sectors. The most interest rate sensitive sectors of the stock market, utilities and telecom, have suffered when rates rose in the past – including during the dip we have seen so far in August with these being the worst-performing sectors of the S&P 500. However, it is worth keeping in mind that they only make up about 6% of the S&P 500 Index
It is the swift, sharp moves higher in yields that have caused some short-term jitters for stocks this year, but not panic. We have only seen one 5% or more pullback this year and that ended with a total decline of 5.8% (which took place as the 10-year Treasury yield rose above 2% and quickly shot up to 2.6% in about a month), and the current pullback from the S&P 500’s all-time high two weeks ago on August 2 has been 3.2%. This is well below the typical amount of volatility in a given year. There have been three 5% or more pullbacks in every year, on average, since WWII. And the typical peak-to-trough drop each year is about 15%. We expect some volatility, but not a major downturn for stocks.
For true believers, faith in the existence of UFOs and a government cover up of extraordinary and essential activities at Area 51 is unshakable. Next week’s release of the minutes of the Fed’s July 31 meeting may help to reveal some of the behind-the-scenes deliberations and cast some light on when the Fed may begin to taper. The release may also help to shake the perception that the Fed’s QE3 program is something far more extraordinary than it really is.