Will the Market Fall off Its Treadmill?

As an analyst, I look for situations in which I am at odds with the consensus. Last week, I found one and I think it highlights a continued risk to stock valuations. The consensus appears to be that the Fed's latest "extraordinary" policy action simply wasn't extraordinary enough. I disagree. I think the market's expectations show a notable disregard for economic reality. That gap between perception and reality is a potential source of volatility in an already highly uncertain environment.

In the run-up to the Fed's two-day meeting last week, the market was ostensibly anticipating another round of QE (quantitative easing -- an outright expansion of the Fed's balance sheet through bond purchases) and was thrown for a twist instead. The market manifested its displeasure the following day, with the S&P 500 putting up its second-worst daily performance of the year.

How and why to twist
What is the Fed trying to achieve with an extension of Operation Twist, which has the central bank selling shorter-maturity Treasuries and buying equal amounts of longer-dated Treasuries? According to the statement it released, this "should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative." And what is the goal of such maneuvering? "To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate."

Will it work?
Can we expect lower long-term interest rates to spur economic activity? The notion appears fanciful. Last month, the 10-year Treasury yield fell to its lowest level since 1946. Mortgage rates are at all-time lows and U.S. corporations are already able to borrow long term at yields not seen in nearly 50 years (see the following two graphs of Aaa and Baa corporate bond yields, respectively). If the strength of the recovery is weak and flagging, it's hard to believe the current cost of money is a primary cause. Instead, I'd suggest it has more to do with the deleveraging process and the extraordinary uncertainty that clouds individuals' and businesses' outlooks when they consider investment and financing choices, much of which is attributable to policymakers, incidentally (particularly Congress).

Take the mortgage market, for example. Last week, the Financial Times reported that the number of refinancings is well below the level one would expect in light of historically low rates:

Uncertain upside, certain risks
While targeted programs such as the one now being implemented by the Bank of England on behalf of corporations and individuals might expand credit, the benefits of extending Operation Twist look highly nebulous. The risks of prolonging extraordinary monetary policy measures, on the other hand, look very much more genuine. As Fed Chairman Ben Bernanke himself pointed out during the Fed's press conference:

One explanation
In balancing a nebulous upside with certain costs, it's difficult for me to understand how the current situation meets the test for extending Operation Twist (much less further quantitative easing). Nevertheless, I think the Fed's choice to do something, all the while denying the market's expectation for even greater monetary accommodation, may signal two things:

• The Fed is ready to support the functioning and stability of financial markets -- which are at risk from a deterioration in the eurozone crisis.

• However, the central bank wants to manage down the market's expectations regarding its ability to spur economic growth and its appetite for enacting massive monetary accommodation.

Indeed, as the market has become inured to central bank interventions, the magnitude of central bank policy measures required to produce the same result inevitably increases: This is the expectations treadmill, which is an unstable process.

Perception vs. reality
In the context of political gridlock, it's not surprising the market is focused on the Fed. However, investors will ultimately need to recognize that the central bank is already at or near the absolute limit of what it can do for the "real" economy and what it is willing to do for financial markets (barring an acute crisis). As this gap between the market's perception and reality closes, you can expect a downward rerating in risk assets.

The correction that could be
As such, I think U.S. equities are vulnerable to a correction. Shareholders in the Vanguard S&P 500 ETF (NYS: VOO) , SPDR S&P 500 ETF (NYS: SPY) , Vanguard Small-Cap ETF (NYS: VB) , iShares Russell 2000 ETF (NYS: IWM) , and, indeed, all investors who own U.S. stocks, should be prepared for that outcome (psychologically, that is -- no need to alter a long-term allocation to stocks).

I don't really like to put a number out there because I don't want to compete with numerologists, but I wouldn't be at all surprised to see the S&P 500 test 1,200 during the second half of the year -- roughly 10.2 times the $118.19 in expected earnings per share for 2013. This is the same forward multiple (relative to 2012 EPS) the index achieved when it bottomed at 1,099.23 last October.

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The article Will the Market Fall off Its Treadmill? originally appeared on Fool.com.

Fool contributorAlex Dumortierholds no position in any company mentioned.Click hereto see his holdings and a short bio; you can follow him onLinkedIn. The Motley Fool has sold shares of SPDR S&P 500 short.Motley Fool newsletter serviceshave recommended shorting iShares Russell 2000. The Motley Fool has adisclosure policy.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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