Parish: Post-QE Fundamentals In Focus

April 28, 2014

After five years of Fed-sponsored monetary steroids, real fundamentals are coming back into focus.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services.

The stock market’s eye-popping returns last year flummoxed many investors, considering the global economic backdrop was, at best, mediocre. “The fundamentals did not justify that level of appreciation,” they say.

In recent years, as asset prices de-linked from traditional economic barometers such as GDP growth, industrial production and corporate earnings, macro and fundamental analysis had fallen to a state somewhere between “somewhat unreliable” and “completely irrelevant.”

The good news is that conditions are changing, and ETFs ranging from the iShares S&P 500 Growth ETF (IVW | A-92) to the Pimco 0-5 Year High Yield Corporate Bond ETF (HYS | C) are looking like sensible choices. I’ll get into those ETFs and others, but first let’s look more closely at the big picture.

Now that the Federal Reserve is tapering its large-scale asset purchase program, markets are beginning to trade more on fundamentals and less on monetary policy.

Exhibit A: Stocks

For a few years, the marriage between equities and economics was on the rocks, though recently the couple moved back in together.

The chart below shows the correlation between the S&P 500 and The Conference Board Leading Economic Index for the U.S. (LEI).

Historically there had been a strong positive correlation between the two. However, that correlation started breaking down during the first round of the Fed’s quantitative easing (QE1). The line didn’t begin falling until April 2010, but it’s displaying data accumulated over the prior 12 months, which includes QE1. The correlation fell to nearly perfectly negative levels for a while, though recently it’s been climbing back.


Source: Bloomberg as of March 31, 2014

The LEI incorporates such economic factors as consumer expectations, interest rate spreads, jobless claims, building permits, manufacturing activity, stock prices and other components.

Note that the S&P 500 is itself one of the 10 components of the LEI, resulting in correlation numbers that are slightly overstated. However, if we were to back out the S&P 500 Index from the LEI numbers before calculating the correlations, this process wouldn’t change the overall conclusion. And that conclusion is that correlations went from hugely positive to hugely negative and back to hugely positive. In other words, correcting the methodology’s bias would provide a distinction without a difference.


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