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Music to the Markets’ Ears

Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate - primarily the trend in interest rates and Federal Reserve policy - is the dominant factor in determining the stock market's major direction. - Martin Zweig

After raising the Fed Funds rate by 0.25% to a range of 2.25% - 2.50% in December, Federal Reserve chairman Jay Powell suggested monetary tightening might take a breather during a speech given to the American Economic Association on Friday January 4th. “With the muted inflation reading that we’ve seen coming in, we will be patient as we watch to see how the economy evolves.” The message from Mr. Powell was music to the stock markets ears and largely contributed to the major indexes rallying by more than 3-4% on the day.

All else equal, equity markets favor increased liquidity. Whether it arises through lower interest rates, easy credit terms, or increased leverage – excess money creation through credit expansion often finds itself placed in investment assets.

Stanley Drukenmiller, one of the most highly regarded investors today, takes this theory a bit further stating, “Earnings don’t move the overall market; it’s the Federal Reserve Board... focus on the central banks and focus on the movement of liquidity... most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”

As an ex-government bond and interest rate derivatives trader, I am inclined to view markets through a similar lens as Mr. Drukenmiller. However, easy credit and increased liquidity should eventually find its way onto corporate balance sheets, which in turn can be a net positive for corporate earnings. From a macro markets (top-down) perspective, greater liquidity and easier credit lead to greater corporate profitability, and hence higher average stock prices. Simply put, more liquidity leads to more profits.

It is in this vein that I thought to pass along an article published on Bloomberg by Charles Lieberman, who is CIO of Advisors Capital Management. Mr. Lieberman looks at markets from a more traditional perspective but arrives at roughly the same constructive conclusions as I have.

In the near-term however, volatility will likely stay higher than investors have become accustomed to. Adjusting asset allocations, so that investment portfolios realize an acceptable amount of variability is half the battle to achieving long term goals. In other words, investors should be careful not to overestimate their willingness to assume risk, as the prospect of being pushed out of the market at the absolute worse time becomes more likely.

Additionally, many traders and investors may have become trapped by the price action over the past few months. Using history as my guide, there could be a good number of Nervous Nellies anxiously waiting to let go of shares at higher prices above. It wouldn’t hurt to give the market a little time to work off this near-term imbalance before sounding the all clear signal.


The Positives Now Outweigh the Negatives for Stocks

By Charles Lieberman, January 7, 2019

It won’t take much for equities to react positively if earnings only meet expectations rather than beat them.

The stock market had a dismal fourth quarter, resulting in the biggest down year for equities since 2008. So it is natural that all the prognosticators of doom would come out of the woodwork to project an impending recession. These forecasts garner headlines and visibility, which may be their real motives, since it doesn’t appear their objective is correctly forecasting economic or market developments.

When sentiment turns this gloomy, if bad news does not follow, a sharp rebound in stock prices can come in response to any of a sizable number of possible positive events. And right now, the list of potential positive catalysts is long, starting with the big rally on Friday in response to a better-than-expected monthly jobs report.

A recent television interview with Jeremy Siegel of the University of Pennsylvania’s Wharton School was telling. The host noted that Siegel tends to be optimistic about the outlook for stocks, but the host also mentioned that Siegel had been correct in his optimism over the past several years and questioned whether such optimism remained appropriate. Contrast that with the perma-bears, who are always forecasting doom and gloom and, like a stopped clock, are correct once every several years. Bearishness may pay off in the form of more TV interviews, but optimism pays off in the stock market.

What could go right? The primary issue is the health of the economy. Bears expect weakness — as they always do — but there’s a big difference between slower growth and recession. Even though I expect a sizable slowdown, from around a 3 percent pace to about 2 percent, I’m bullish on stocks. From 2010 through 2017, growth oscillated around 2 percent, which was sufficient to drive the unemployment rate down from 10 percent to less than 4 percent.

The decline in unemployment provides evidence that growth during that period was above trend, so 2 percent is arguably a bit above a sustainable pace of growth. But what if monthly job growth continues at a pace of about 175,000 or more? Growth would continue, albeit a bit more slowly, while corporate profits would ramp higher. At some point, rising earnings become impossible to ignore.

A second focal point of investor attention is the U.S. trade conflict with China. Neither wants a trade tiff to undermine its economy. President Donald Trump has a legitimate beef with China’s theft of intellectual property and its glaring bias in favor of its own companies. China understands it must play fairer but will do so only to the extent necessary to make this issue disappear. Some sort of compromise remains highly likely, although it will take some time to reach an agreement.

Other issues have also been raised by the bear camp, such as falling oil prices signaling economic weakness. This inference requires ignoring job growth, household spending and developments in the energy industry, notably falling production costs and insufficient infrastructure to transport increased production of oil and gas to market. Natural gas is being flared at the wellhead or selling for peanuts due to inadequate pipeline capacity to bring it to market.

Oil storage is very high for the same reason, and there’s a large price gap between oil in Cushing, where it is stored, and Houston, where it can be processed and sold. Energy prices are low due to high levels of production, not due to weaker demand. That’s why OPEC is conspiring to curtail output. In fact, U.S. gas exports are setting records, and America is now a net energy exporter. Exports will be even higher once new facilities come on line.

An inverted yield curve is supposed to signal recession, but it takes more than two years on average for recession to follow an inversion — if a recession follows at all. And the absolute level of interest rates remains low, as are rates relative to inflation. Monetary policy remains accommodative.

Yes, the political scene is a mess. Democrats hope to tie up Trump with investigations for the balance of his term. An impeachment effort remains a possibility. Trump will continue tweeting. It is unlikely Democrats and Republicans will start getting along anytime soon. Such developments make headlines, but they are unlikely to alter the economy’s trajectory meaningfully.

Lastly, price earnings multiples are quite low, with more than 100 members of the S&P 500 Index trading below 8 times forecast 2019 estimates, and the entire benchmark trading below 15 times (and less than 13 times excluding the “FAANG” group of stocks.) Fourth-quarter earnings reports will start soon and with expectations declining, it won’t take much for stocks to react positively to profits that only meet expectations. It is rare for stocks to decline for two years running during economic expansions.


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Justin Kobe, CFA Founder & Portfolio Manager


Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated.Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond marketis subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.

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