Markets Will Crash With or Without the Federal Reserve

The Fed will not stop U.S. stocks from crashing. While for the last seven years the U.S. stock market has tracked the Fed's balance sheet, the market has also simply tracked the recovery in employment. The Fed, financial news media, brokers, and much of the rest of the wall-street establishment has lulled unsuspecting investors into believing a lie. The lie is that the Fed can always stimulate the stock market. The truth is the Fed cannot prevent downturns in the economic cycle or the coincident draw-downs of investor wealth.

Initial claims data are foreshadowing the coming recession. A key indicator for tracking the most recent health of the employment market is initial claims. Initial claims is a measure of the amount of people applying for jobless benefits. When initial claims are rising, people are losing their job. Claims bottom at the crest of an economic wave and top-out at the trough. As illustrated in the chart below, initial claims reached an all-time high in October of 1982 at 695,000 and ~500,000 is the max amount of claims at the typical recessionary trough. Historically, claims bottom around 300,000. Clearly, claims indicate peak levels in this current iteration of the almighty business cycle. In fact, the peak is likely already in as claims have risen relative to the same period in the prior month (month-over-month) for 10 of the last 12 weeks.

Stocks fall as initial claims rise and vice versa. The fall in stocks is typically significant and rapid, along with the violent rise in claims. To illustrate the improvement in the labor market over the course of the current cycle, we measure the change in the spread between the all time high level of ~700,000 in initial claims and the four week average of claims. Stocks have followed this indicator almost perfectly over the last six years. 

Over the last six years the economy recovered and so did the operations of companies and the expectations around the future performance of those companies. Stocks went up.

While the labor market improved, the Fed created new reserves (printed money) through the purchase of intermediate to long-term dated bonds. The press called this Fed action "quantitative easing, or "QE." It is not clear whether QE creates wealth, but it does grow the Fed's balance sheet. It is, however, clear that for periods of time the change in the stock market correlates to the change in Fed assets (rising assets = QE).

Stocks will go down if the economy goes down. The Fed printed tons of money in the last recession, but stocks did not recover until the labor market recovered. We are on the precipice of a downturn in employment and the Fed will not be able to boost the stock market as the recessionary employment data becomes more evident.

Following the 2008 recession, employment improved and the stock market recovered. Our analysis of over 50 years of economic data clearly suggests that the strength in the labor market, as indicated by initial claims data, and the performance of the stock market are linked. The Federal reserve is a much less reliable factor to stock market performance than the economic cycle. Our view is that the current cycle is on the verge of collapse and, as a result, so too is the stock market. Over the next days and weeks, we will reveal more of our analysis on the current cycle.