From recession to a QE-boosted market
The last five years have truly been difficult for the U.S. economy, especially since it has been struggling to fully recover from the latest recession that cut financial assets’ value in half and pushed unemployment from a healthy rate below 5% to an alarming two-digit number. Even if it has been slower than we wish, the economy has been recovering. Not only the GDP has been growing, but jobs are also being created with the unemployment rate now halfway towards its pre-crisis level.
The Federal Reserve (FED) injected millions of dollars into the financial system in an attempt to pare losses and give the initial boost the real economy was in need of. Before the housing bubble burst, the FED was showing a balance sheet with $600 – $700 billion worth of Treasury Notes, but with a $600 billion asset purchase package started in November 2008, it was a matter of months until the FED’s balance sheet started expanding. By March 2009, the central bank held $1.75 trillion split over Bank Debt, Mortgage-Backed Securities, and Treasury Notes.
With the U.S. economy finally out of recession, but still struggling to grow and showing very weak signals, the FED unfolded a second quantitative easing package worth another $600 billion in Nov. 2010.
In Sep. 2012, a third asset purchase program was announced, this time with no end date and involving the purchase of $85 billion of assets per month. From the initial $600 – $700 billion, the FED’s balance sheet expanded to the current $3.2 trillion, which translates to the largest monetary base expansion ever.
The current state of the financial market
After such a period of extraordinary monetary accommodation, during which the FED not only expanded its balance sheet as never did, but also kept interest rates at a record low for an extended period, financial markets could only see one direction–and that is up. The successive quantitative easing programs injected liquidity in the financial system and pushed investors out of risk-free assets in the direction of more rewarding opportunities as the stock market. The S&P fully recovered from the financial crisis loss and even recorded all-time highs as of recently. One part of the problem was effectively solved by monetary policy. However, some questions remain: Is the economy also recovering? Are companies’ earnings growing as prices are? Or, is there a separation between financial and real assets?
Barclays’ research study
Barry Knaff from Barclays collected data covering a broad range of balance sheet and income statement metrics for the period running since 1973 until the present day. A conclusion was reached: S&P 500 isn’t cheap anymore, at least by historical terms. His metrics include several price ratios, which are all currently above their historical averages, as reproduced below.
The third column shows the ratio between the current and mean values for each metric and gives an idea about how many times current values are above their averages. With the exception of dividend yield, every ratio is above its historical mean, which depicts an overbought state. In the specific case of dividend yield, companies are paying lower dividends now, which isn’t exactly a way of saying the market is under or overvalued, but it at least tells us that companies are less valuable, as the dividend yield is a source of shareholders’ income adding to price appreciation.
Price-to-free-cash-flow is the less overvalued ratio while price-to-sales shows the biggest discrepancy to the mean. This is a direct consequence of monetary policy. Flooding the market with liquidity helped increase cash flows, but it hasn’t helped on the real economy, especially at boosting consumer spending. Thus, company sales aren’t rising in tandem with stock prices.
A suspecting quietness
The second part of Knapp’s study shows that risk isn’t rising, even though the FED’s tapering may occur in Sep.. As we have seen in the recent past, when FED chairman Ben Bernanke talked about reducing the current asset purchase program from $85 billion to $65 billion, stocks declined 4.3% in just three days, so it is somewhat strange that everybody’s staying calm right now.
With implied volatilities near lows, it may be a good opportunity for investors to buy some options as they may be cheaper than they usually are. With expected volatility coming in Sep., it may be a good opportunity to trade options. In this case, and because we don’t know the direction the market will take in Sep. after FED’s announcements, we may trade a straddle–which involves buying both a call and a put option at the same time, with the same strike price and maturity date. For more about the straddle, you can take a look at our article on How To Trade Earnings Announcements?
Comments Off on
Tradespoon Tools make finding winning trades in minute as easy as 1-2-3.
Our simple 3 step approach has resulted in an average return of almost 20% per trade!