The Fed-Led Rally Creates Uncertainty & Volatility

Investing
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By Jonathan DeYoe

Learn more about Jonathan on NerdWallet’s Ask an Advisor

When I look at the stock market today, I feel as if many of the investors around me are willfully deluding themselves. The market’s advance is due to some extent to Federal Reserve support, not basic economic improvement. Stock investors should be wary.

It feels fantastic to reach new highs. I am glad that is happening and even expect the rally to continue a bit further, but this makes it no less an illusion. A reckoning over the country’s high levels of borrowing is coming. Ignorance is bliss, but only until reality catches up with you.

In the past weeks, stock market indexes such as the Dow Jones Industrial Average recorded new highs, breaking previous records from before the plunge that started in 2007. To be fair, after adjusting for inflation, the Standard & Poor’s 500 index is still 25% below the last peak. Stock gains are supposed to reflect an improving recovery. Yet today’s buoyancy may be just a feel-good illusion.

While we feel good about our portfolios, the real economic recovery is just starting to take hold. And we can’t be fooled into thinking that this recovery is natural. The U.S. economy is still heavily reliant on government life support.

The market gains have come from earnings growth, but a lot of that growth is focused in the U.S. banking sector, which has been heavily reliant on bailout funds. Financial companies are making a killing thanks to the Federal Reserve’s monetary stimulus. Remember, the Fed is on a massive $85 billion monthly bond buying spree to keep rates low and markets flooded with cheap money.

This quantitative easing (QE-infinity) program aims to lower short and long-term interest rates, spur businesses into hiring, and consumers into spending. Lenders also benefit directly from accommodative interest rates. Banks can borrow from the Fed for virtually nil, and lend it out to businesses or the Treasury for an easy, risk-free yield. How can banks not make a profit like that?

Quantitative easing is ongoing and has no set ending date. But it still is only barely trickling down to citizens of the real world. Low interest rates, while great for banks, are terrible for depositors. This is why you get pennies in interest on your checking, savings and certificates of deposit. Low rates are supposed to spur investment, but in reality, it’s just pushing money into stocks, inflating a potential bubble.

The Fed is playing Robin Hood in reverse, transferring wealth from bank depositors to bank balance sheets. For now at least, it is the Fed’s market but this must end at some point. The Fed can’t keep pumping money into the system forever, and at some point, perhaps due to politics or inflation, they will have to pull back. When this day comes, possibly even later this year, we have to be ready to either ride it out or do some portfolio damage control.

The worst time to buy stocks or any other asset is when the price is highest. This is when the risk of a crash is greatest. Right now, I am very cautious about stocks because I fear they are moving from “fairly” valued and becoming overvalued. Now, they can stay over-valued for a long time.  They can even get MORE overvalued.  Still, I am afraid that when the sluggish economy catches up to us or the Fed puts on the brakes, another major crash might happen.

The big returns have been exciting since November 2012, but don’t become irrationally exuberant.  We know exactly how that ends.

Jonathan K. DeYoe, AIF and CPWA, is the Founder and CEO of DeYoe Wealth Management in Berkeley, Calif.  Want more information? Follow DeYoe Wealth Management on Facebook at www.facebook.com/DeYoeWealth or Twitter at @DeYoeWealth.
Jonathan DeYoe, California Insurance License #0C21749, is a registered principal with and securities and advisory services offered through LPL Financial, a Registered Investment Advisor – Member FINRA/SIPC.
The opinions voiced in this material do not necessarily reflect the views of LPL Financial and are for general information only and are not intended to provide specific advice or recommendations to any individual. For your individual investing needs, please see your investment professional regarding retirement planning.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 companies representing all major industries.  All indices are unmanaged and may not be invested into directly.

 

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