Beware of the gaps in the market
About a month ago former Fed head, Richard Fisher, came out and confirmed the idea that the FOMC’s quantitative easing policies over the past seven years have pushed prices of risk assets, including stocks, beyond what would otherwise be supported by their fundamentals.
There are a few ways to visualize this. The first comes from Dr. Ed Yardeni who tracks a fundamental indicator shown below. Notice the yawning gap between the S&P 500 Index and the major economic fundamentals.
The Felder Report
We can also just look at the index versus its components’ earnings. Here’s another gap:
https://twitter.com/mims/statuses/695393596506116098
This chart is a gift to anyone with common sense. Have a nice day.
S&P EBITDA vs Price pic.twitter.com/THCADhUwso
And if you prefer to look at forward earnings estimates, you’ll find another massive gap:
https://twitter.com/mims/statuses/694230599788134400
Consensus Long-Term EPS Growth Rate Cut by 4th Largest Amount in 30+ Years I've Been Calculating It pic.twitter.com/zo0ZO22Boi
Specifically, Fisher said that the Fed had, “front-loaded a tremendous rally.” All this means is that the Fed pulled returns forward from the future to generate larger gains today.
Notice in the chart below that returns have recently been significantly better than valuations (using the Buffett indicator) 10 years ago justified. This is exactly what Fisher is referring to.
The Felder Report
The last time this happened was in the late 1990’s. From that peak, stocks fell more quickly than forecast in order to play, “catch up,” to the downside. Interestingly, the 3-year forecasts I generate usingmargin data show the very same gaps in the late 1990’s and today.
The Felder Report
And there are other indicators suggesting these gaps could close sooner rather than later.
Bond market risk appetites (very similar to spreads in corporate bonds, junk bonds and leveraged loans) have been falling farther and for a longer period of time than stocks. These are normally very highly correlated to stock prices yet here is another major gap.
The Felder Report
Another way to visualize this is to compare bond market risk appetites to stock market volatility. While fear in the bond market has soared recently, fear in stocks is relatively subdued. Notice the gap between them in the chart below.
The Felder Report
So when Richard Fisher says he, “can see significant downside,” in the stock market right now, he’s probably thinking about these sort of gaps between stocks prices and economic fundamentals. Between stocks and their earnings. Between stocks and the corporate credit markets. Because he helped create them. And, like Dr. Frankenstein and his monster, nobody knows better what they’re capable of.
NOW WATCH: Watch Tina Fey take on Sarah Palin's Trump endorsement speech on SNL