The Federal Reserve Spooks the Market

The Federal Reserve spooks the market... Fed officials are worried about stocks... Good news for the 'Trump Trade?'... Why corporate earnings could surprise to the upside...


Thank you to everyone who joined us for last night's big "Metropolitan Man" event...

We expected a big crowd, but the turnout was even better than we hoped... Unfortunately, this meant that despite our best efforts, some folks experienced poor audio and video or were unable to connect.

Rest assured, we're doing everything we can to ensure that doesn't happen again. In the meantime, as promised, we've prepared a full replay to ensure you don't miss a thing.

Everyone who signed up for the event received a link to this replay in an e-mail this afternoon. (Look for the subject line "Inside: Your Emergency Briefing Replay Link.") If you didn't receive it, please let us know at info@stansberrycustomerservice.com, and our dedicated customer service team will be happy to help.

We're also preparing a full transcript. We'll let you know as soon as it's available.

Yesterday, the Federal Reserve released the minutes from its March policy meeting...

Typically, these reports contain few surprises. But this one was an exception... and the market wasn't happy...

First, the minutes showed the Fed plans to begin shrinking its $4.5 trillion balance sheet later this year.

In simple terms, this means the Fed will stop reinvesting the cash from maturing U.S. Treasury bonds and mortgage debt back into these markets.

This isn't a surprise... As regular Digest readers know, the Fed has been discussing these plans for months. But this is the first time the central bank indicated this process would begin this year.

Why is this important?

First, as we mentioned back in February, the Fed's buying has been a big source of demand for Treasury bonds for the past several years. As the Fed stops buying bonds, it could put even more upward pressure on interest rates. (Remember, bond prices and interest rates move inversely... As bonds prices decline, interest rates rise, and vice versa.)

Second, as you can see in the following chart, stocks have largely followed the path of the Fed's balance sheet since the financial crisis...

This wasn't the only notable discussion from the Fed's minutes...

According to the report, some Federal Reserve officials are also worried the stock market is getting "bubbly" again. From the minutes (emphasis added)...

Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms...

Some participants viewed equity prices as quite high relative to standard valuation measures. It was observed that prices of other risk assets, such as emerging market stocks, high-yield corporate bonds, and commercial real estate, had also risen significantly in recent months.

The Fed has made some tremendous blunders over the years. (Former Fed Chairman Ben Bernanke's repeated denials of the housing bubble comes to mind.) But history suggests these warnings should be taken seriously...

According to analysis from financial-news network CNBC, the Federal Reserve's official minutes have mentioned an overvalued stock market six other times since 1996. Five of these six times, the S&P 500 was trading flat to down one year later, for an average return of -4%. Only the year following 1996 – which saw a huge 32% one-year gain – bucked the trend.

However, it's also worth noting that these signals have tended to precede corrections, rather than the end of a bull market. From the report...

The officials' discussion of an overvalued stock market often came before long pauses during bull markets when equity valuations were able to come back in line because of a period of consolidation.

So this doesn't mean the end of the bull is near, but it could be another reason to believe we're in for a long period of sideways trading until earnings can catch up.

But not all the news is bearish today...

Earlier this week, the Trump administration announced its proposed infrastructure program could be coming as early as May... and could be even bigger than originally promised. As political newspaper The Hill reported on Tuesday...

Trump had called on Congress to move legislation that would generate $1 trillion worth of investment for U.S. roads, bridges and airports, but he signaled Tuesday that the figure could actually climb higher.

"We're talking about a very major infrastructure bill for $1 trillion, perhaps even more," Trump said during a town hall-style event with American business CEOs...

Transportation Secretary Elaine Chao indicated Tuesday that the proposal could be unveiled as soon as next month. "We're working on a legislative package that will probably be in May, or late May," Chao said during the town hall event.

As we've discussed, infrastructure spending is one of Trump's "big three" policy proposals – along with tax reform and regulatory reform – that have driven expectations of stronger economic growth and inflation.

Of course, regular readers know we believe tax reform is likely the most important of the three...

In fact, much of last night's live "Metropolitan Man" briefing was devoted specifically to this topic.

In short, many pundits believe the Republican Congress' recent failure to repeal and replace the Affordable Care Act ("Obamacare") means their tax-reform plans are also doomed.

We can't share all the details here, but our contact disagrees... He believes tax reform remains likely regardless of Obamacare's fate. But even that matter may not be closed just yet...

Just this morning, Speaker of the House Paul Ryan unexpectedly announced that House Republicans are "really close" on finalizing a new bill to replace Obamacare. As he explained at a press conference...

We have made some real progress this week... We have come together on a new amendment that we all believe will lower premiums and provide added protections for those facing real challenges gaining access to affordable care.

Finally, we note corporate earnings could surprise to the upside this quarter...

First-quarter earnings season kicks off this month, and U.S. firms are already expected to report some of the strongest earnings in years.

According to research firm FactSet, analysts expect that earnings for S&P 500 companies grew by more than 10% in the first quarter. This would be the strongest quarterly growth since 2011.

But our colleagues at the Stansberry Newswire, our new real-time financial news service, believe earnings growth is likely to be even stronger this quarter... And this could be incredibly bullish for stocks. As they explained to readers yesterday...

Broker Cannacord Genuity is out with a call this morning saying by the end of 1Q we could wind up with earnings growth of 14%...

The interesting data point they highlight is that every quarter since the end of the recession has seen a median upward revision of 3.4% from the start of earnings season to the final numbers. Analysts don't want to get too aggressive on numbers like they typically did pre-recession.

Adding these numbers up, you see earnings growth more in the neighborhood of 14% than the 10% where you started. That would be a great scenario to play out. What looks like an expensive market suddenly gets cheaper... Sounds like a good reason to stay long.

New 52-week highs (as of 4/5/17): Guggenheim China Real Estate Fund (TAO) and short position in Hertz Global (HTZ).

We're still sorting through the hundreds of e-mails we received about last night's event. Again, everyone who signed up for the briefing should have received access to the replay this afternoon. If you didn't receive it, please don't hesitate to let us know. And be sure to let us know what you thought about the presentation at feedback@stansberryresearch.com.

Regards,

Justin Brill

Baltimore, Maryland

April 6, 2017