Published on November 09 2015

Why Higher Rates Could Kill the Bull Market in Stocks

Markets are nervous about the Fed’s plans…

The Bureau of Labor Statistics released its October jobs report on Friday. It was the strongest monthly jobs report this year…

The U.S. economy added 271,000 jobs in October. That’s far more than the 180,000 new jobs economists were expecting. It was also the largest one-month jump since last December.

On top of that, the unemployment rate fell to 5% last month. It hasn’t been this low since April 2008. Plus, wages grew by 2.5%. That’s their fastest growth rate since 2009.

•  Despite the good news, stocks fell slightly on Friday…

And on Monday, the S&P 500 lost 1%…its worst day in six weeks.

The market’s bad reaction to good economic news is a sign that investors are worried about the Fed…

Regular Casey readers know the Federal Reserve has held its benchmark interest rate at effectively zero since 2008. Rock bottom interest rates have made it extremely cheap to borrow money. Americans have followed the Fed’s lead by borrowing trillions to buy houses, cars, stocks, and commercial real estate.

In addition to holding interest rates at effectively zero, the Fed has flooded the U.S. financial system with easy money for the last seven years. Through its quantitative easing (QE) programs, the Fed has pumped $3.5 trillion into the U.S. financial system. QE is “central banker speak” for money printing.

The one-two punch of low rates and money printing has fueled a historic rally in U.S. stocks…

The current bull market in U.S. stocks started in March 2009. At 80 months and counting, it’s now 30 months longer than the average bull market since World War II.

The S&P 500 has gained 211% since this bull market started. But stocks haven’t risen much since the Fed stopped QE in October 2014. The S&P 500 has only gained 6% in the 13 months since then.

•  For now, the Fed’s key rate is still effectively zero…

But investors are worried that the Fed will see the strong jobs report as evidence that the economy is doing well. And if the Fed thinks the economy is doing well, it’s more likely to raise rates at its next meeting on December 15-16. It would be the first time in nine years that the Fed raised interest rates.

In a healthy economy, markets should go up on good news and down on bad news. But markets aren’t healthy today. They’re addicted to easy money. In this “Alice in Wonderland” economy, good news is bad news…

•  Jeff Gundlach thinks the U.S. economy can’t handle higher rates…

Gundlach is one of the world’s top bond experts. He runs Doubleline Capital, an investment management firm that manages $81 billion. This year, Gundlach’s bond fund has outperformed 94% of similar funds.

In an interview with Reuters last month, Gundlach said the U.S. economy looks a lot like it did 2007… which was just before the financial crisis started. He told Reuters that raising rates would be a mistake.

If the Fed raises rates against this backdrop, it just makes things worse.

Gundlach reiterated his stance last week at a conference, where he said “the Fed should not raise rates in December.”

Like us, Gundlach thinks the U.S. economy is very fragile. He’s worried about declining profits for U.S. firms. He also sees weakness in the stock market, as Yahoo! Finance reported on Thursday:

Interestingly, Gundlach said that perhaps the single most important indicator for the Fed may be the S&P 500, which plunged in August and September, prompting the Fed to refrain from moving on rates. Now that the index has recovered, it “appears vulnerable to another pushback down because earnings are not there,” he said. “The S&P 500's trailing 12-month P/E is 19; that's not cheap.”

•  Gundlach also said slowing industrial production is “flat-out indicating danger”…

Casey readers know trouble in the industrial sector is pointing to a slowing economy. The ISM Manufacturing Index, which measures the health of the U.S. manufacturing sector, fell to its lowest level in three years in October.

Big U.S. industrial companies are also warning about an economic slowdown. Equipment manufacturer Caterpillar (CAT), diesel engine maker Cummins (CMI), and industrial conglomerate 3M Co. (MMM) have all recently said they expect sales to decline next year.

Last month, Daniel Florness, the CEO of industrial parts distributor Fastenal (FAST), said the industrial sector is clearly slowing.

The industrial environment’s in a recession. I don’t care what anybody says, because nobody knows the market better than we do.

•  Plunging orders in the railroad industry also point to trouble for the U.S. economy…

Last quarter, new freight car orders plunged the most in almost three decades, as Bloomberg Business reported.

Third-quarter orders for new freight cars plunged 83 percent from a year earlier to 7,374, according to the Railway Supply Institute. That’s the biggest decline since at least 1988 and the lowest number for a quarter since 2010. A “healthy” three-month number is 10,000 to 15,000, Allison Poliniak-Cusic, a Wells Fargo & Co. analyst, said in a note Tuesday.

Many investors watch the railroad industry for clues about where the economy is headed. In a healthy economy, companies ship a lot of goods and materials across the country by rail. When the economy slows, they ship fewer goods and materials. This huge drop in freight car orders is another sign the U.S. economy is in trouble.

Chart of the Day

The current economic recovery in the U.S. is the slowest in over six decades…

Today’s chart shows the annualized real gross domestic product (GDP) growth rates during the last eleven U.S. economic expansions. “Real” growth rates account for inflation.

As you can see, the U.S. economy has grown at an annualized rate of 2.2% since 2009. That’s less than half the average growth rate of the past 10 recoveries.

Regards,

Justin Spittler
Delray Beach, Florida
November 9, 2015

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