This
epic central-bank-easing-driven global stock bull is starting to be
strangled by the very central banks that fueled it. This week the
European Central Bank made a landmark decision to drastically slash
its quantitative easing next year. That follows the Fed’s new
quantitative-tightening campaign just getting underway this month.
With CBs aggressively curtailing easy-money liquidity, this stock
bull is in serious trouble.
The
US flagship S&P 500 broad-market stock index (SPX) has powered an
incredible 280.6% higher over the past 8.6 years, making for the
third-largest and second-longest bull market in US history! The
resulting popular euphoria, a strong feeling of happiness and
confidence, is extraordinary. So investors brazenly shrugged off
the Fed’s September 20th QT and the ECB’s October 26th QE-tapering
announcements.
That’s a grave mistake. Extreme central-bank easing unlike anything
witnessed before in history is why this stock bull grew to such
grotesque monstrous proportions. Without QE, it would have withered
and died years ago. Central banks conjured literally trillions
of new dollars and euros out of thin air, and used that new money to
buy assets. This vast quantitative easing inarguably levitated the
world stock markets.
QE
greatly boosted stocks in two key ways. Most of it was bond buying,
which forced interest rates to deep artificial lows nearing and even
under zero at times. This bullied traditional bond investors
looking for yield income into dividend-paying stocks. The
record-low interest rates fueled by QE were also used to justify
extremely-expensive stock prices. QE aggressively forced legions of
investors to buy stocks high.
The
super-low borrowing costs driven by QE’s crushing downward pressure
on interest rates also unleashed a vast corporate-stock-buyback
binge unlike anything ever witnessed. Corporations borrowed
trillions of dollars and euros to use to buy back their own
stocks, boosting their stock prices. QE both enabled and provided
the incentives for this anomalous extreme financial engineering,
indirectly levitating stock markets.
Stock traders’ apparent belief over this past month that the Fed
starting to reverse its QE through QT and the ECB greatly slowing
its QE will have no meaningful impact on QE-levitated stock prices
is absurd. The simultaneous reversal and slowing of QE in the
States and Europe is a hellstorm relentlessly bearing down on
hyper-complacent traders. It’s the financial equivalent of a
Category 5+ super-hurricane, a juggernaut.
This
Thursday the ECB announced it is slashing in half its ongoing
QE bond monetizations from their current €60b-per-month pace to €30b
per month for the first 9 months of 2018. After that the ECB’s QE
will likely cease entirely, since it is running out of available
bonds to buy because the ECB’s total QE has been so vast. That
means ECB QE will collapse from €720b this year to €270b next year,
a radical 62.5% plunge!
The
idea that stock markets won’t miss €450b of ECB bond buying next
year is ludicrous. The ECB has been monetizing bonds continuously
with at least a €60b-per-month pace since March 2015. That
will make for colossal total QE from then to December 2017 exceeding
€2040b, growing to over €2310b by September 2018. €60b per month
falling to €30b for most of next year and then likely zero will have
a huge impact.
At
current exchange rates, that €450b drop of ECB QE from 2017 to 2018
translates into $530b. That is likely enough all alone to tank
global stock markets reliant on aggressive central-bank QE like
crack cocaine. But add that on top of the Fed’s first-ever
quantitative tightening now getting underway, and 2018 will see the
greatest central-bank tightening in history. How can that
not drive an overdue stock bear?
I
discussed the
Fed’s new QT campaign and likely market impact in great detail a
month ago right after it was announced. While the Fed’s own QE bond
buying formally ended in October 2014, it held all those bonds on
its balance sheet until this month. Starting this quarter, the Fed
is allowing $10b per month to roll off as they mature. That
effectively destroys the money created to buy those bonds,
removing QE capital.
$10b
per month isn’t much initially, but the Fed is slowly ramping that
to a target of $50b per month by Q4’18. The math is simple.
Total Fed QT in 2017 will only run $30b, a rounding error relative
to the vast size of QE’s trillions of monetized bonds. But in 2018
that Fed QT will add up to $420b. Add that to the $530b of ECB QE
here in 2017 but not coming in 2018 due to the taper, and markets
face $950b of CB tightening!
Can
the world’s two most-important central banks collectively withdraw
almost a trillion dollars of liquidity in 2018 alone without
blowing a gaping hole in these lofty stock markets? Not a freaking
chance! And 2019 looks even worse. Total ECB QE will likely run at
zero, down from €720b this year. That translates into $850b. And
the Fed’s QT will run at its terminal full speed of $600b annually.
That adds up to $1450b!
So
on top of 2018’s $950b less of ECB QE and new Fed QT compared to
this year, 2019 faces another $1450b of collective tightening from
the Fed and ECB relative to 2017. That means $2.4t of central-bank
liquidity that exists in this record stock market year will vanish
over the next couple years. I can’t imagine a more-bearish
omen for excessively-large QE-inflated stock bulls than such a vast
reversal of CB flows.
This
first chart ought to shatter the Wall Street myth that today’s
monster stock bull was driven by profits instead of extreme
central-bank QE. It superimposes the SPX over the Fed’s balance
sheet, which is where those QE-financed bond purchases rest. This
is the most-damning chart in the stock markets, no mean feat at such
extremes. Fed QT and far-less ECB QE is the stuff of nightmares for
QE-inflated stock markets!
While the Fed initially birthed QE back in late 2008’s first stock
panic in a century, QE’s primary impact on the stock markets started
in early 2013. That was soon after the Fed first launched and then
quickly more than doubled its third QE campaign. QE3 was radically
different from QE1 and QE2 in that it was open-ended, with no
predetermined size or duration. That gave it a gargantuan impact on
stock psychology.
Whenever the stock
markets started to sell off, Fed officials would rush to their
soapboxes to reassure traders that QE3 could be expanded anytime if
necessary. Those implicit promises of central-bank intervention
quickly truncated all nascent selloffs before they could reach
correction territory. Traders realized that the Fed was
effectively backstopping the stock markets! So greed flourished
unchecked by corrections.
This stock bull
went from normal between 2009 to 2012 to literally
central-bank-conjured from 2013 on. The Fed’s QE3-expansion
promises so enthralled traders that the SPX went an astounding
3.6 years
without a correction between late 2011 to mid-2015, one of the
longest-such spans ever! With the Fed jawboning negating healthy
sentiment-rebalancing corrections, psychology grew ever more greedy
and complacent.
QE3 was finally
wound down in October 2014, leading to this Fed-evoked stock bull
soon stalling out. Without central-bank money printing behind it,
the stock-market levitation between 2013 to 2015 never
would’ve happened! Without more QE to keep inflating stocks, the
SPX ground sideways and started topping. Corrections resumed in
mid-2015 and early 2016 without the promise of more Fed QE to avert
them.
2013 was the
peak-QE3 year, when the Fed monetized a staggering $1020b in bonds
through QE. Such vast central-bank liquidity injections catapulted
the SPX 29.6% higher that year! The Fed tapered QE3 in 2014, which
added up to $450b of additional bond buying that year. And the SPX
only rallied 11.4%. Fed QE dropped by 56% between 2013 and 2014,
and stocks’ rallying shrunk 62%. That’s certainly no coincidence.
Then in 2015 when
Fed QE was zero, the SPX slipped 0.7%. See the pattern here? The
more QE from central banks, the more the stock markets rise. Those
vast capital injections from the Fed levitated the US stock markets
by forcing yield-starved bond investors into stocks and facilitating
immense corporate stock buybacks. This QE-driven stock bull peaked
in mid-2015 soon after the Fed ceased its own QE!
The bear market
that follows every stock bull should’ve started in late 2012, but
the Fed warded it off with its massive open-ended QE3 campaign.
That ultimately totaled $1590b before it ended in late 2014,
when the delayed stock bear should’ve begun. Indeed it looked like
it had, as the SPX started rolling over without Fed QE boosting it.
The SPX suffered its first corrections in 3.6 years in mid-2015 and
early 2016.
There’s a stellar
probability the dominant reason the overdue stock-market bear didn’t
arrive in 2015 was the ECB started its own QE campaign in March that
year. The ECB effectively took the QE baton from the Fed,
keeping world stock markets levitated through massive liquidity
injections. ECB QE levitated European stock markets through the
same mechanisms as the Fed QE had earlier levitated the US ones.
The global stock
markets are heavily interconnected. Both rallies and
selloffs in either the United States, Europe, or Asia often create
the psychology necessary to drive similar moves in the other
markets. So the ECB’s QE directly buoying European stock markets
bled into US stocks, fending off the overdue bear that the end of
the Fed’s QE should’ve awoken. It was hopes for more ECB QE that
rekindled this tired bull.
The Fed’s QE3 bond
buying was tapered to zero in November 2014. From that announcement
in late October that year, the SPX would rally another 7.3% into May
2015 on sheer momentum and euphoria. After that it drifted sideways
to lower for the next 13.7 months,
suffering two
corrections. It wasn’t until July 2016 that a new bull high was
finally seen. That was soon after the UK’s surprise Brexit vote to
leave the EU.
That June 2016
referendum stunned European leaders, potentially threatening their
entire project to unite Europe. Thus the ECB’s central bankers
rushed to vociferously promise to do anything necessary to maintain
market stability through the Brexit process. So the SPX only broke
out of its mounting bear trend thanks to hopes for more ECB QE!
That rally soon fizzled until Trump’s surprise victory unleashed
Trumphoria.
This extreme
Trumphoria stock rally since early last November was driven by
euphoric hopes for big tax cuts soon, not central-bank easing. But
without the ECB’s colossal
€720b or the equivalent of $850b in QE over the past
year since the election, odds are this Trumphoria rally would’ve
either been far more muted or never even existed. The Fed’s QT and
ECB QE tapering are grave threats to QE-inflated stock
markets.
The
chart above proves how heavily dependent the SPX is on the Fed’s
balance sheet, which has never materially shrunk before
2018. The European stock markets have seen a similar phenomenon as
the ECB’s balance sheet ballooned under QE. Germany’s flagship DAX
stock index is Europe’s leading one. In 2016 the DAX rallied 6.9%
on over €720b of ECB QE. So far this year the DAX is up 12.8% on
€600b of QE YTD.
There is absolutely no doubt these global stock markets are greatly
reliant on extreme central-bank QE to keep levitating to new
record highs. So the stock markets are in world of hurt in 2018 and
2019, with total central-bank liquidity from the Fed and ECB falling
by $950b and $1450b respectively relative to 2017! There’s probably
never been a greater bear-market catalyst than record QE being
thrown into reverse.
If
the Fed’s QT and the ECB’s QE taper proves so devastating to stocks,
won’t these central bankers simply stop doing it? They certainly
don’t want to tank stock markets, as both the US and European
economies really need high stocks’ wealth effect to thrive. If
stock markets fall enough to spawn some real fear in Americans and
Europeans, they will pull in their horns on spending which hurts the
real economies.
Still I suspect the Fed and ECB won’t and can’t stop their
new tightening campaigns for several reasons. Both central banks
are doing everything they can to be as gradual and transparent as
possible to avoid spooking markets, which is wise. Such slow
rampings of the Fed’s QT and the ECB’s QE taper aren’t likely to
spark a sharp stock-market plunge. They’ll just gradually turn the
screws to stocks, slowly forcing them lower.
Major bear markets tend to cut stock prices in half, although worse
losses are likely after such extreme fake central-bank-goosed
bull-market toppings. But these bears that inevitably follow bulls
generally play out over a couple years. There are about 250
trading days per year, so a 50% loss spread across two years works
out to a trivial average of 0.1% per day! No one will panic if CB
tightening slowly boils the bulls.
And
the reason both the Fed and ECB are tightening is to reload
easing ammunition for the inevitable next financial crisis. The
more QE the Fed can reverse with QT, and the less the ECB’s balance
sheet bloats, the more room they will have to relaunch QE when they
get scared again in the future. Central bankers know it’s critical
to slow, stop, and unwind QE so they rebuild room to aggressively
ease again later.
Finally both the Fed and ECB spent long months if not years
preparing traders psychologically leading into these CBs’ QT and QE
tapering. If either central bank chickens out and pulls back in
response to stock markets slowly rolling over, that itself
risks igniting intense selling. The only reason the CBs would slow
their crucial normalizations from extreme QE is if they feared
another looming massive financial crisis.
Traders would read any course change to less tightening by either
central bank as an admission of serious problems in global
markets, and rush for the exits. Not carrying through on these
carefully-laid tightening plans would also severely hobble these
CBs’ credibility, and thus their future abilities to calm markets in
a crisis. The die is cast on Fed QT and ECB QE tapering, it can’t
be changed without creating big problems.
If
this radically-unprecedented transition from extreme easing
to extreme tightening was happening in normal fairly-valued stock
markets, it would still ominously portend a major bear. But thanks
to these goofy central banks artificially enlarging and prolonging
this stock bull through their QE, stocks have soared way up to
bubble valuations! The extreme overvaluation rampant in stock
markets today greatly magnifies the risks.
This
last chart looks at the average trailing-twelve-month
price-to-earnings ratio of the 500 SPX stocks, both in
simple-average and market-capitalization-weighted-average terms.
The past year’s Trumphoria rally on big-tax-cuts-soon hopes
catapulted valuations into nosebleed bubble territory. Such
extremes would herald an imminent bear market even if the most
extreme CB easing in all of history wasn’t reversing.
This
is a complex chart with dire ramifications for investors, which I
last discussed in
depth in late June. For our purposes today on central banks
starting to strangle this extreme bull they’ve nurtured, look at the
blue SPX-valuation lines. The average SPX-component P/E ratio in
both simple and MCWA terms is now over 28x. At Zeal we
calculate this crucial valuation data each month-end, so September’s
is the latest.
Weighted by market capitalization, the SPX stocks’ average P/E in
late September was 28.7x earnings! In simple-average terms, it
looked even worse at 29.3x. These numbers are conservative too,
because we cap all trailing-twelve-month P/E ratios at 100x to avoid
outliers skewing the overall average. Amazon alone with its insane
250x P/E would catapult these up to 31.7x and 29.6x respectively.
Valuations are extreme.
The
US stock markets’ average trailing P/E over the past century and a
quarter is 14x,
which is fair value. Double that at 28x is formally a bubble,
where we are today. Euphoric traders get so excited about
stock markets rallying forever that they are willing to pay any
price to get in, eagerly buying stocks high instead of prudently
waiting to buy low. The higher the prevailing valuations, the
greater the downside risk stocks face.
While valuations aren’t a market-timing tool, bubbles always
eventually pop. There are no exceptions to this rule in history.
When bubbles fail stocks fall sharply, entering major new bear
markets. In order to trade at 14x fair value based on today’s
corporate earnings, the SPX would have to literally be more than
cut in half to 1225ish! The white line above shows where the
SPX would trade at that historical 14x fair value.
Even
more ominous, valuation mean reversions following stock prices
getting too high in bulls never just stop at the mean. Instead
momentum carries them through 14x to a proportional overshoot
below that to undervalued levels. So there’s a high probability the
inevitable next stock bear won’t bottom until stocks are trading
well under 10x earnings, which would make for a bigger-than-50% bear
from today’s bubblicious levels.
The
key point here is stock markets are exceedingly risky on bubble
valuations alone after central banks’ unprecedented extreme
easing forced them so high for so long. Even if the Fed wasn’t
embarking on QT to reload for future easing, even if the ECB wasn’t
tapering QE because it’s running out of bonds to buy, a new stock
bear would be a near-certainty on extreme valuations alone. Bulls
are always followed by bears.
But
throw in Fed quantitative tightening and ECB quantitative-easing
tapering on top of that, and we are set up for one of the worst
stock bears on record after one of the biggest and longest bulls
ever. Truly these central banks that fostered this monstrous bull
are now starting to strangle it. The next couple of years are going
to see literally trillions of dollars less CB liquidity than
the markets have enjoyed in 2017!
Again between Fed QT ramping and ECB QE tapering, 2018 is on track
to see a colossal total $950b less capital injected from the Fed and
ECB compared to this year. And based on the Fed’s and ECB’s current
plans which are hard to slow or stop without destroying market
confidence, 2019’s CB liquidity will come in at another $1450b lower
than 2017’s. We are talking about $2.4t of effective tightening
over the next 2 years!
There is zero chance stock markets will be able to ignore such
radically-unprecedented CB tightening. $1.2t a year is a
devastating hit to liquidity. Remember in 2013 the SPX soared 29.6%
on $1020b of Fed QE via QE3. What’s going to happen to stock
markets in 2018 when that reverses to -$420b with Fed QT alone, or
2019 at another -$600b with Fed QT running full speed? Add ECB
tapering on top of that.
The
unpopular hard truth euphoric investors don’t want to hear is stock
markets ain’t gonna be pretty under Fed QT and ECB QE tapering. For
the love of all things good and holy, take this seriously!
Just like in all past stock-market toppings, greed and complacency
are extreme so traders have no fear of this imminent
central-bank-tightening threat. But it’s a Category 5+ hellstorm,
unprecedented in stock-market history.
Investors really
need to lighten up on their stock-heavy portfolios, or put stop
losses in place, to protect themselves from the coming valuation
mean reversion in the form of a major new stock bear. Cash is
king in bear markets, as its buying power increases as stock prices
fall. Investors who hold cash during a 50% bear market can double
their stock holdings at the bottom by buying back their stocks at
half price!
Put options on the
leading SPY S&P 500 ETF can be used to hedge
downside risks. They are cheap now with
euphoria rampant, but their prices will surge quickly when stocks
start selling off materially. Even better than cash and SPY puts is
gold, the anti-stock trade. Gold is a rare asset that tends to move
counter to stock markets, leading to
soaring
investment demand for portfolio diversification when stocks
fall.
Gold surged nearly
30% higher in the first half of 2016 in a new bull run that was
initially sparked by the last major correction in stock markets
early last year. If the stock markets indeed roll over into a new
bear in 2018, gold’s coming gains should be much greater. And they
will be dwarfed by those of the best gold miners’ stocks, whose
profits leverage
gold’s gains. Gold stocks rocketed 182% higher in 2016’s first
half!
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and get ready before CB tightening crushes stocks!
The
bottom line is the Fed and ECB have started strangling this
extraordinary stock bull they nurtured. After being levitated for
years by trillions of dollars and euros of quantitative easing,
these central banks have started tightening. The Fed has birthed
quantitative tightening, which will increasingly reverse its own
extreme QE. On top of that the ECB will radically slow its own QE
next year, for unprecedented tightening.
This
is the death knell for QE-inflated stock markets driven to extreme
bubble valuations by epic central-bank monetary injections. The Fed
and ECB are finally taking away their easy-money punch bowls, with
truly-dire implications for stock markets. Trillions of dollars and
euros of tightening in the next couple years will finally unleash
the long-overdue stock bear delayed by QE, which will likely prove
proportionally oversized. |