Thank Obama’s Fed for a Weaker U.S. Economy

Stock market investors celebrated the continuing economic downturn by driving stock prices higher again last week. The Dow Jones Industrial Average rose 132 points, while the S&P 500 added 18 points. The worse things get, the more investors believe that the Fed will delay any interest rate increase into 2016.

They are probably being too optimistic. At the rate things are going, we may not see an interest rate increase until President Barack Obama leaves office. And if we do, it won’t be more than a token 25 basis points that won’t amount to a hill of beans.

The U.S. Fed Reserve (image source: Getty Images)
The U.S. Fed Reserve (image source: Getty Images)

And that probably isn’t a coincidence. President Obama has appointed every member of the U.S. Federal Reserve’s Board of Governors. This is highly unusual. The Federal Reserve Act provides for terms of 14 years, but in the past two decades, the average tenure of governors has dropped to five years. This has arguably reduced the independence of the board.

Based on their actions, this has to be the easiest money Fed in history – as well as the most feckless. President Obama still likes to blame his predecessor for his own mistakes seven years into his own presidency, but he has to take ownership of this Fed and its policies.

And those policies are responsible for a weak recovery that is growing weaker. About the only decent economic number reported in recent weeks was last week’s jobless claims, which were the lowest in years. But by now everyone should have figured out that with almost 100 million people out of the labor market, jobless claims are meaningless as a barometer of the economy’s health.

Look at Structural Problems, Not the Business Cycle

The jobs market is suffering from a structural jobs deficit due to the mismatch between the skills of the workforce and the jobs that are available in today’s economy. Unfortunately, the Fed hasn’t figured it out – it still thinks that the jobs market is undergoing a cyclical downturn.

Cluelessness reigns among the academics in the Eccles Building. But the rest of us shouldn’t let the low official unemployment rate fool us into thinking the Fed’s policies are working. All we need to do is look around us to realize they aren’t.

Manufacturing activity in the United States is getting worse due to the strong dollar and weak overseas economies. Industrial output in September fell 0.2 percent after falling 0.1 percent in August. Retailers are doing terribly. The economy is moving backward while stock market investors remain in denial. Barron’s latest Big Money poll calls for stocks to rise by 7 percent through mid-2016.

George Ettinger, right, works with fellow traders on the floor of the New York Stock Exchange, Monday, March 3, 2014. Global stock markets are down sharply on tensions over Russia's military advance into Ukraine and the threat of sanctions by Western governments. (AP Photo/Richard Drew)
George Ettinger, right, works with fellow traders on the floor of the New York Stock Exchange, Monday, March 3, 2014. (AP Photo/Richard Drew)

This comes just a couple of weeks after a survey of so-called top Wall Street strategists predicted a big rally into the year-end. Mindless bulls like Tom Lee continue to be featured on CNBC claiming that the market will rise by double digits in the next couple of months. The beginning of the third quarter is meeting these expectations despite the fact that none of the headwinds that caused the summer sell-off have dissipated – China’s economic meltdown, the commodities collapse, weak economic growth around the world, and now expectations of poor third-quarter earnings that are coming true.

Rather than paying attention to consensus-seeking polls, investors should pay attention to the slew of large hedge funds that are being forced to close after suffering large losses and huge investor redemptions. This has been one of the toughest environments in years for the so-called smart money to navigate because most people don’t want to admit that the economy is as weak as it really is.

Early third-quarter earnings reports have been uniformly lousy. JPMorgan Chase & Co. (NYSE: JPM), Goldman Sachs Group Inc. (NYSE: GS), Intel Corp. (Nasdaq: INTC), Netflix Inc. (Nasdaq: NFLX), Alcoa Inc. (NYSE: AA), and Blackstone Group LP (NYSE: BX) are just some of the companies that missed expectations in the first week of earnings season. The energy sector as well as the rest of the commodities sector is seeing no sign of recovery and will add to the disappointment. Things are only going to get worse on the earnings front.

The Credit Markets Signal Pain Ahead

Pain is also spreading in the junk bond sector, where bond prices are dropping as investors grow increasingly concerned about the ability of highly leveraged companies to deal with all of the cheap debt they were able to borrow since the financial crisis. The credit markets tend to serve as better barometers of the economy than equity markets, especially when the latter have been overtaken by quantitative traders driven more by technical than fundamental factors.

Right now credit markets are flashing red, which is consistent with the poor economic data being reported. With little sign that the Fed has figured out that its policies are responsible for this poor data, it is likely to continue and lead markets further downward.

Having started the year expecting the stock market correction that we saw this summer, I am increasingly coming to the view that we are at the beginning of a bear market. This means that rather than a mere 10 percent correction from its high, markets are likely to drop further and see at least a 20 percent drop from those levels. That means that the rally that opened the month of October is likely to fade.

This rally is wholly based on a belief that the Fed won’t raise rates in December, but this “bad news is good news” thesis is getting old. Earnings are getting worse, the economy is getting worse, and the geopolitical situation is getting worse.

If that is a recipe for a rally, I will leave it for others to risk their money. I would remain cautious. The market is more likely to test its August lows than hit new highs before the end of the year.

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