1st Quarter of 2019

In October 2018, Chairman Powell of the Federal Reserve said the Fed was on cruise control to a 3.0% Fed Funds rate. This statement shocked the markets and the stocks began to fall by 19% (peak to trough), and interest rates rose in the fourth quarter. In December 2018, the Fed raised Fed Funds rates to 2.25%-2.50%. In January 2019, Chairman Powell announced that the Fed would be “on hold indefinitely and would not raise the Fed Fund rate for the foreseeable future”. At that point the S&P rallied by 16% YTD through April 21, 2019. The rally has not happened on the back of sharply rebounding earnings, but rather on the P/E Ratio’s multiple expansion.

In the 4th Quarter 2018 Review & Outlook we pointed out that on January 18, 2019 the trailing Price/Earnings Ratio (P/E Ratio) of the S&P 500 was 20.03x. The market was overpriced compared to the historical norm of 14.5x. Then Powell said what he said. In the Wall Street Journal, as of April 19, 2019 the trailing P/E Ratio was 21.78x and the forward estimate 17.62x. Still overpriced. By ceasing to raise the Fed Funds rate and the market thinking that the Fed may lower rates late in the year, the Fed is reinflating the stock market bubble that we have discussed in the past.

FactSet publishes its predictions based on what Wall Street analysts are estimating for earnings and revenue growth in 2019 for the S&P 500. Please see the table below:

Quarter Current Earnings Estimate Current Revenue Estimate
1st Qtr
2nd Qtr
3rd Qtr
4th Qtr
FY 2019


The slowdown in U.S. economic activity that started in 2018 has continued into 2019, as confirmed by deteriorating indicators in cyclical bellwether sectors like autos, housing and capital spending, as well as other broad economic aggregates. This has now been acknowledged by the FOMC and recognized in the market, as revealed by declining yields in high grade money and bond markets. These developments reflect the unfolding of the following two major economic theorems:

    (1) Federal debt accelerations ultimately lead to lower, not higher, interest rates. Debt-funded traditional fiscal stimulus is extremely fleeting when debt levels are already inordinately high. Thus, additional and large deficits provide only transitory gains in economic activity, which are quickly followed by weaker business conditions. With slower economic growth and inflation, long-term rates inevitably fall.

    (2) Monetary decelerations eventually lead to lower, not higher, interest rates as originally theorized by economist Milton Friedman.

Theorem 1: Government Debt and Interest Rates 

In the past twenty years, gross government debt as a percent of GDP advanced dramatically in all major economic areas of the world – the U.S., the euro area, the U.K. and Japan. Yet, long-term government bond yields dropped sharply in all four areas.

Undoubtedly, government debt will rise sharply relative to GDP over the next several years. This increased debt level will weaken economic activity, thus inflation, pushing long-term yields lower, thereby continuing the now almost three-decade long trend to lower long-term Treasury yields. The empirical evidence is clear. In the past two decades, the government debt-to-GDP ratio rose by 45%, 119%, 15% and 63% in the U.S., Japan, the euro area and the U.K., respectively, unprecedented amounts for any peace time period. At the same time, government bond yields dropped 285, 235, 380 and 400 basis points, respectively.

Theorem 2: Monetary Deceleration 

The great U.S. economist Irving Fisher provided us with the equation of exchange (M2*V=GDP) which states that money times its turnover (velocity) is equal to nominal GDP. The Federal Reserve has virtually no control over the velocity of money, but it can influence the monetary and credit aggregates. It is somewhat ironic that the Fed pays little attention to these important variables in its policy discussions. The Fed’s main focus has been on the highly disputed Philips curve which has been empirically and theoretically shown to be an unreliable guide to policy. Further, in recent years they have paid increasing attention to the esoteric so-called neutral interest rate which cannot be directly observed or contemporaneously measured. With this misdirection in emphasis, the Fed has once again steered the U.S. economy toward recession. The Fed’s influence on the economy is through changing interest rate levels (the “price effect”) and influencing the growth of the monetary aggregates (the “quantity effect”).

Market Implications  

The parallels to the past are remarkable, but there appears to be one fatal similarity – the Fed appears to have a high sensitivity to coincident or contemporaneous indicators of economic activity, however the economic variables (i.e. money and interest rates) over which they have influence are slow-moving and have enormous lags. In the most recent episode, in the last half of 2018, the Federal Reserve raised rates two times, by a total of 50 basis points, in reaction to the strong mid-year GDP numbers. These actions were done despite the fact that the results of their previous rate hikes and monetary deceleration were beginning to show their impact of actually slowing economic growth. The M2 (money) growth rate was half of what it was two years earlier, signs of diminished liquidity were appearing and there had been a multi-quarter deterioration in the interest rate sensitive sectors of autos, housing and capital spending. Presently, the Treasury market, by establishing its rate inversion, is suggesting that the Fed’s present interest rate policy is nearly 50 basis points too high and getting wider by the day. A quick reversal could reverse the slide in economic growth, but the lags are long. It appears that history is being repeated – too tight for too long, slower growth, lower rates.

Garcia Hamilton & Associates, a fixed income manager in Houston, thinks that the Fed will raise short term rates sometime this year because the U.S. economy will stay strong, unemployment will continue to fall, wage inflation will grow, and the trade war with China will end. It believes that we will be back to the 10-year treasury yield of October 2018 (3.25%) in the next 12-18 months.


In the fourth quarter of 2018, Monroe Vos recommended that our clients reduce their equity exposure to 40% of their portfolios. Making this move was not market timing, but reducing our clients’ risk (volatility) by going to what we consider a neutral allocation based on the Fed policy at the time of raising the Fed Funds rate to 3.0%, the overpriced stock market, the slowing global economy and its effect on corporate earnings, the ending of the effect of the corporate tax cut and negative investor sentiment. This move reduced the losses in the 19% dip in the S&P 500 in the fourth quarter. As of this writing the Fed is on pause, the global economy is still slow and the consensus earnings projections are negative for the first two quarters of 2019. Sentiment has improved some, but investors have been taking money out of the stock market during the first quarter rally. The S&P 500 is back at its high from September 2018. Projections are that interest rates will stay low for the foreseeable future, leading to the asset bubble expanding.

If Garcia Hamilton is right and the Fed raises short term rates, it will have a negative effect on the stock market. If Hoisington is right and the economy slows while interest rates drop, it can have a negative effect on the stock market. We will see what happens.

Jamison Monroe
Chairman & CEO
Director of Consulting

Released: May 02nd, 2019 01:09 PM

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