The Fed’s “Contracted Experiment in Price Control (i)”

The Fed’s “Contracted Experiment in Price Control (i)”
April 7, 2015 phillip_toews_1p9l0e9h

Just as investors were unable to perceive how a housing market crash would affect their investment portfolios, we believe similar, unanticipated risk exists in the stock market due to
Federal Reserve asset price manipulation.

Six years ago, on March 9, 2009, the S&P 500 closed at 676, the lowest level during the agonizing decline of the financial crisis. Since then the S&P 500 is up more than 200%, making this the fourth longest bull market in history. Those gains continued moderately in the first quarter, with the S&P advancing 1.0% to close at 2,068.

Does the fact that we’ve rallied for six years indicate that stocks are in a bubble? According to Investopedia, a bubble occurs “when stock prices rise above their true value and will continue to do so until prices go into freefall and the bubble bursts”. We won’t know for sure if we’re in a bubble until we know the second half; if there’s a precipitous fall. The more valuable questions are: 1) are stocks over-priced? and 2) are there other factors in the economy that create significant risks? Current valuations suggest that yes, stocks are over-priced. S&P 500 stock prices are currently 19.5 times their earnings over the past year, versus an average multiple of 15.5, placing stock prices 25% above average valuations. Are there other significant risks in the economy? We believe there are.

History of the Federal Funds Rate (1954-Current)

As most investors are aware, the Federal Reserve has taken extreme measures to boost the economy over the past 7 years. Beginning in 2008, the Fed decreased interest rates to levels not seen since the 1960’s. It also engaged in unprecedented new types of Quantitative Easing such as buying mortgages and other securities to keep interest levels low. In addition to lowering interest rates, they have a second objective of increasing economic growth by keeping asset prices (stocks, home prices) high. This aberration in Fed policy can be clearly seen in the graph above that shows the history of the Federal Funds Rate since 1954. Never before has the Fed had a Zero Interest Rate Policy (ZIRP) which has now lasted for over five years.

For the moment, Fed policy has achieved its objectives. Unemployment is returning to normal levels. The economy is in its sixth year of expansion, credit markets have normalized, and asset prices are high. It is the last of these fed successes, that assets prices have been kept [artificially] high, that is cause for concern.

For years now, each time the economy has turned lower and asset prices have followed, the Fed initiated measures to show its resolve to reverse the decline. And there is no reason to believe that if the economy deteriorates they won’t act again. The Fed has become the de facto guarantor of increasing stock prices.

As Jim Grant of Grant’s Interest Rate Observer States, “insofar as price controls have never been successful, this experiment…will end in failure.” We tend to agree.

What does “failure” imply?

Many view the housing market crash that brought on the financial crisis as an isolated event. Our view, however, is that this crisis was only a symptom of a growing global debt that has actually accelerated. Mckinsey, a global consulting firm, estimates that since 2007, total global debt has increased by 57 trillion dollars, rising from 269% to 286% of global economic output (ii). Viewed from that perspective, the question becomes when, not if, we will see the effects of the growing global debt bubble. Before the financial crisis, it was housing prices that were pushed artificially higher to unsustainable levels. What will it be the next time?

No one doubts that the Federal Reserve is a powerful player in the financial markets. But their power rests primarily with their ability to lower interest rates. Asset purchases have had little effect on economic growth (iii). With interest rates already at zero, we believe that the Fed has little capability to actually have an impact on economic growth, which brings us to our most important point:

There is currently a disconnect between the perception of the Fed’s capacity to reverse economic adversity and its ability to actually do so.

Over the past 60 years when the country entered recession, the Fed acted by lowering rates. In the immediate future, it has no ability to do so. The game is over when the investors finally realize that, despite dovish comments, the economy and asset prices can’t forever be held higher.

Toews Set to Exit Assets if Declines Ensue

Toews began the quarter fully invested in U.S. and International Stocks. Our Dynamic Fixed Income models that invest in High Yield and Aggregate Bonds moved briefly to a protective stance, but ended the quarter fully invested. Although we are currently fully invested, our target sell levels are close across all asset classes.

The path to navigate these markets and address possible significant declines is straightforward but requires constant vigilance: 1) stay committed to equity markets, historically the best performing asset class to help protect against inflation and 2) hedge your portfolios against losses. Both are pillars on which the Toews system is built.


Prior performance is no guarantee of future results. There can be no assurance, and individuals should not assume, that future performance of any of the portfolios referenced will be comparable to past performance. There can be no assurance that Toews will achieve its performance objectives. This commentary may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

This commentary is intended to provide general information only and should not be construed as an offer of specifically-tailored individualized advice. Please contact your investment adviser, accountant, and/or attorney for advice appropriate to your specific situation. This document refers to the performance of the majority of Toews portfolios to illustrate the effect of Toews management on US and intl. stocks and high yield bonds. Performance of individual accounts varied based on the client’s investment risk profile and their specific investment funds. For your individual account performance, please refer to the enclosed quarterly statement or the quarterly statement recently sent to you. In addition, not all model portfolios were referenced in this letter. It is not, nor is it intended to be, a comprehensive accounting of Toews asset management. There are other portfolios that Toews manages that performed differently than what is referenced in this letter. For a complete list of GIPS firm composites, their performance results and their descriptions, as well as additional information regarding policies for calculating and reporting returns, please go to Toews Corporation acts as the investment advisor that implements the asset allocation and models for each of the portfolios. Investors cannot invest directly in an index.

(i) Statement by Jim Grant of Grant’s Interest Rate Observer in a CNBC interview on March 18, 2015
(ii) Source: “Debt and not much Leveraging,”
(iii) The Federal Reserve Bank of San Francisco estimates that QE2, the Fed’s decision to purchase 600 billion in securities, added only .13% to GDP growth in late 2010, and would have added only .04% GDP growth without forward guidance on interest rates.