I've written exhaustively about the real purpose behind the Fed's quantitative
easing strategy. So one more time for those who still don't get it; the primary
goal of QE is to bolster banks' balance sheets through the process of re-inflating
equity and real estate prices. If investors look back at the history of QE
they will be able to clearly see what happens when the Fed steps on the monetary
gas; and also what occurs once it takes the foot off the pedal.
For example, even though interest rates were already near zero percent, the
Fed felt it necessary to begin purchasing massive amounts of bank assets in
late 2008 to get the money supply and stock prices moving in the positive direction.
The Fed announced a $500 billion Mortgage Backed Security purchase program
(QE1) on November 25th 2008. The central bank then followed up on March 18th
2009 with a $300 billion plan to buy long-term Treasury bonds. The total amount
of $800 billion in planned QE did exactly what was intended-the U.S. markets,
not so coincidentally, ended their massive decline and then started a huge
secular advance in March of that same year.
Most investors now agree that massive QE can be extremely positive for asset
prices. But most on Wall Street either are not aware, or refuse to acknowledge,
what occurs when the central bank stops printing. Therefore, a brief history
lesson seems especially prudent at this juncture.
QE1 ended on March 31st 2010. The market soon after headed south, and just
over three months later the S&P 500 dropped by 12.6%. The second round
of QE ($600 billion) ended on June 30th 2011. This time, stocks began to decline
within days after the last bond was purchased, and after three months went
by investors experienced a correction of 16.7%. In both instances, a subsequent
new round of QE came to the rescue of stock prices, just about when the depth
of the correction extended into the double-digit range.
Now that the Fed's QE3 is officially ending, asset prices have lost most of
their momentum. The Dow Jones Industrial Average is only up just over 2 percent
and most other major averages are either flat to up low single digits so far
this year. This is true even though we are over half-way through 2014; and
compares to the 30 percent gains experienced last year.
It is important to note that QEs 1 and 2 ended abruptly, whereas QE3 is only
being slowly wound down. Therefore, the mere announcement of the Fed's taper
back in January of this year did not cause a similar market reaction to that
of the other QE terminations. Also, the correction from QE2's end was more
profound than that of the first, because equity values become more disconnected
from economic fundamentals with each round of intervention.
So investors need to ask why the stock market would be immune from the Fed
getting out of the QE business this time around. The truth is that asset bubbles
have become more inflated and debt levels have greatly expanded during each
iteration of QE. Given this progression, the end of QE3 should bring the major
averages down somewhere in the neighborhood of at least 20 percent about three
months after QE3 ends in the fall.
However, before the Fed launches yet another QE rescue program like it did
after QEs 1&2 failed to generate solid growth, it would have to admit that
the previous five years and $3.5 trillion worth of QE have been a complete
failure; and that the U.S. economy is addicted to continuous central bank credit
expansion. This might not come to fruition as quickly as most on Wall Street
now believe it will, and could exacerbate the percentage of the selloff.
Up until now, the perennially-weak economic growth experienced since the Great
Recession ended just didn't seem to matter for the stock market. The reason
for this was that interest rates were falling from a benign level that already
offered little competition for equities. And, the central bank had an overwhelming
desire to increase the size of its balance and launch another round of QE at
the first sign of falling asset prices.
Contrast that with the situation today. The Fed has become distressed over
the amount of bonds it already currently holds and wants completely out of
the QE business. In addition, interest rates have ended their decline and must
increase along with the rising rate of inflation and the end of Fed bond market
manipulation-unless of course rates fail to rise because of a deflationary
collapse of the economy.
The overwhelming consensus on Wall Street is that the economy
will illustrate vastly improving economic growth during the second half of
2014, in the context of low inflation and quiescent interest rates. And the
pervasive belief is also that the end of QE will not have the negative effect
on stock prices that it did after the last two rounds ended. Given that this
scenario is already fully priced into markets, investors would be wise to maintain
a very defensive posture during the next few months.
