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The US stock
markets were quick to rally after the Federal Reserve did nothing at
its policy meeting this week. Traders love the endless dovishness
gushing forth from this Yellen Fed. But their complacency is very
misplaced. It was epic Fed easing that fueled the stock-market
levitation of recent years. So the Fed shifting away from these
extraordinary policies is a major downside risk for these
Fed-inflated stock markets.
The Federal
Reserve has utterly dominated stock-market sentiment in
recent years, to a truly shocking degree. From the Fed?s Federal
Open Market Committee policy meetings every 6 weeks or so, to the
subsequent Janet Yellen press conferences and FOMC members? economic
projections, to the endless speeches by Fed officials, the great
majority of important stock-market moves have been driven by the
Fed.
These include
plenty of sharp rallies out of pullback lows. This Fed has shown an
uncanny ability to spin up the dovish rhetoric at critical times to
short-circuit in-progress selloffs. Many of the larger stock-market
rallies to new highs in recent years were also a direct consequence
of Fed actions or jawboning. Unfortunately this tight
cause-and-effect relationship is only apparent when watching markets
in real-time.
As a full-time
speculator and student of the markets, I?ve long been blessed with
the opportunity to observe all day every day. Every morning I get
up at 5am to catch up on Asian and European action, and don?t stop
watching until well after the US stock markets close. And since
early 2013, it?s just been flabbergasting how many key intraday
rallies were directly driven by dovish talk or actions from
the Fed.
For over a dozen
years now, I?ve documented every trading day?s action in much detail
in our popular weekly newsletter for speculators. I?m tempted to
wade through the 127 of these newsletters I?ve penned since early
2013 and quantify exactly how many trading days, and how many index
points on the benchmark S&P 500 stock index (SPX), were a direct
result of Fed actions or jawboning. It would be shocking.
But you don?t have
to take my word for it. The research department at the St. Louis
Federal Reserve bank publishes literally hundreds of thousands of
data series. Buried deep in this treasure trove of information is
the size of the Fed?s balance sheet. Comparing that to the
remarkable progress the SPX has made in recent years is very
telling. It all but proves these lofty stock prices are a
Fed-conjured aberration.
First some
background is in order. Back in October 2008, the SPX plummeted a
gut-wrenching 25.9% in just two weeks! This was the first
full-blown stock panic the American markets had witnessed since
1907, a century earlier. The Federal Reserve panicked too, fearing
that the wealth effect that leads people to spend less when stock
markets fall would drag down the entire US economy into a new great
depression.
So the Bernanke
Fed aggressively slashed the benchmark Federal Funds Rate it
controls. While this is a market for commercial banks to lend money
to each other overnight, it is the core short-term interest rate
from which most others are set. Between October and December 2008,
the Fed cut its FFR by 200 basis points to zero. This marked
the dawn of the Fed?s first-ever zero-interest-rate policy in its
95-year history.
But once the Fed
had gone full ZIRP, it was zero-bound. It could ease no more by
conventional means of cutting rates. So the Bernanke Fed decided to
implement the extreme monetary policy known as quantitative easing.
That simply means creating brand-new money out of thin air to use to
buy bonds. Known throughout history as debt monetization,
this highly-inflationary tactic turns bonds into new money.
This money is then
injected into the economy as bond sellers, who obviously need the
funds, quickly spend it. When the Fed wishes up new money to buy US
government bonds, Washington soon spends every last dollar on the
usual transfer payments to American citizens, government salaries,
and debt service. So QE is direct monetary inflation. And
all those bonds the Fed monetizes go to its balance sheet.
Ominously for
today?s lofty stock markets, the SPX?s progress has closely mirrored
the ballooning Fed balance sheet since the dawn of the QE era in
late 2008. This first chart superimposes the SPX over the Fed?s
balance sheet, and also notes when the Fed launched major new QE
campaigns. Discussing each QE ramping is beyond the scope of this
essay, but I?ve written much on QE history in
past
essays.
For the legions of hyper-complacent American stock traders who think
the Fed?s policy shifts away from QE and ZIRP are no big deal, this
chart is a shocking wake-up call. The entire massive bull run in
the S&P 500 since early 2009 appears to have been largely driven by
the Fed?s mushrooming balance sheet! Many of the trillions of
dollars created out of thin air to buy bonds found their way
into stocks.
In the 6.3 years
since the last cyclical bear bottomed in March 2009, the SPX has
blasted an incredible 215.0% higher at best! This was an
anomalously outsized and long-lived bull. The average size and
duration of stock bulls at this stage in the great
stock-market
cycles is a mere doubling over just 2.9 years. Something goosed
this bull to enormous proportions, and it was the Fed?s
extraordinary levels of easy money.
The stock markets
only rallied when the Fed was aggressively monetizing debt and
adding to its bond holdings. Compare the blue SPX line with the
orange and red Fed-balance-sheet lines. The former shows the Fed?s
total bond-bloated balance sheet, while the latter shows its
Treasuries QE specifically. The stock markets only powered higher
when the Fed was rapidly adding to its massive bond holdings!
And their growth
since late 2008 has been nothing short of mind-boggling. In the
first 8 months of 2008 before that stock panic and the first-ever
large-scale quantitative easing in the Fed?s century-long history,
its balance sheet averaged $875b. As of mid-February 2015, it had
exploded to $4474b. That?s incredible 411% growth in just 6.5
years, literally a quintupling! This $3598b wished into
existence had to go somewhere.
And some major
fraction sloshed into the stock markets. How is that
possible since the Fed was buying bonds, not stocks? Just as the
Fed used ZIRP to force short rates artificially low near zero, it
used QE to bludgeon long rates to artificial lows. The Fed has
always been very forthright and open about QE?s goal of actively
manipulating interest rates. For years, every FOMC statement
actually acknowledged this mission!
The Fed?s QE
Treasury buying battered long rates so low that US corporations were
unable to resist the cheap debt costs. So they rushed to borrow
literally trillions of dollars to take advantage of the
epically-low rates, and then plowed the vast majority of that into
gargantuan stock
buybacks. That was the major source of stock demand in
recent years, and pushed the SPX inexorably higher. It was
ultimately Fed-fueled.
QE?s indirect
impact on stock prices through this debt-fueled stock-buyback binge
is readily apparent in this damning chart. Not only did the SPX
only rally considerably when the Fed?s money-printing machinery was
spinning the fastest, the only major selloffs in recent years
happened during lulls in QE debt monetization between specific QE
campaigns. As soon as that money printing abated, stocks fell.
This led to a
16.0% SPX correction in mid-2010 as QE1?s new buying ended, and
another 19.4% one in mid-2011 as QE2?s bond purchases wound down.
This stock bull was looking tired and toppy, with many major
technical and sentiment indicators pointing to its imminent failure,
back in late 2012. But then the Fed launched QE3, which proved
wildly different from QE1 and QE2 in that it was totally
open-ended.
While QE1 and QE2
had set sizes and end dates determined at launch, QE3 was a monthly
campaign with no predetermined size or end date. And the uber-dovish
Fed used the resulting uncertainty that surrounded QE3 to actively
manipulate stock traders? psychology. Whenever stocks started to
sell off since early 2013 when QE3 shifted into full swing, the Fed
would soon step up and jawbone about easing.
Fed officials
often implied, and sometimes outright said, that they were ready to
ramp up QE3?s size if the US economy weakened. Stock traders
interpreted this just as the Fed intended, that this central bank
would ramp QE3 if necessary to arrest any material stock-market
selloff. So they figured the Fed was effectively backstopping
the stock markets, thus they threw all caution to the wind to
buy with reckless abandon.
And the result is
readily evident above, an extraordinary Fed-driven levitation in the
US stock markets since early 2013. It perfectly mirrored the Fed?s
ballooning balance sheet under QE3. And since the FOMC announced it
was ending QE3?s new buying back in late October, that balance-sheet
growth has stalled out. The Fed?s balance sheet has actually been
modestly shrinking since mid-February, which is ominous!
If the epic record
Fed easing is indeed responsible for the extraordinary stock-market
rally of recent years, then the ongoing and upcoming major Fed
policy shifts are almost certainly going to slaughter this
artificial stock bull. After ending new QE bond monetizations late
last year, the Fed is on track to end ZIRP later this year.
And the ramifications for these lofty and
very overvalued
stock markets are super-bearish.
Without QE and
ZIRP, the stock markets are long overdue for a serious reckoning.
They are extremely overextended and hyper-complacent, which this
next chart reveals. This means once stock traders start to realize
the remarkable Fed tailwinds of recent years are abating, the
selling pressure is likely to be fierce. That realization will
mount in intensity as we get closer to the Fed?s first rate hike in
a whopping 9 years.
Before the dawn of
the extraordinarily-manipulative QE3 in early 2013, this cyclical
stock bull was on a normal trajectory. Bulls surge dramatically
initially out of deeply oversold and undervalued conditions at the
end of the preceding bear. Then as they march higher in the
subsequent years, the pace of those gains moderates. This stock
bull was topping in late 2012 before the Fed pulled out all
the stops with QE3.
That led to a
dramatic Fed-driven decoupling of the stock markets from
normal bull-market behavior. And the subsequent Fed-fueled
stock-market levitation was wildly unprecedented on multiple
fronts. In normal healthy bull markets, corrections arise about
once a year or so to bleed away excessive greed that builds
within uplegs. These periodic 10%+ selloffs in the S&P 500 are
essential to keep sentiment balanced.
Incredibly the
last full-blown correction ended in early October 2011, fully 3.6
years ago! All kinds of major technical and sentiment indicators
showed the SPX was ready to correct again on schedule in late 2012,
but the open-ended QE3?s impact on stock traders? sentiment short
circuited it. And the stock markets have been magically levitating
ever since, basking in a Fed-conjured fiction where stock prices
never fall.
This dangerous
span since the last correction-magnitude selloff has been one of the
longest ever on record for the US stock markets. Since such big
selloffs are inevitable and essential, artificially delaying the
next one is like stretching a rubber band. Just as its odds of
snapping grow the farther it is pulled apart, so do the odds for the
next 10%+ stock-market selloff the longer it has been since the
previous one.
And since this
incredibly anomalous stock-market levitation of recent years was the
direct result of the Fed?s radically-unprecedented easy money, the
end of that era is likely to shatter it. Fed officials are making
it more and more clear that they are itching to end ZIRP. They
realize it has created tremendous economic distortions, and holding
rates at zero leaves the Fed no rate-cutting ammunition for future
crises.
Make no mistake,
despite the dovish FOMC meeting and rate projections this week the
Fed is going to have to start hiking rates soon. If it
doesn?t, the bond markets will force its hand. And whether that
first rate hike comes at the FOMC?s September, December, or even
March 2016 meeting, stock traders will start worrying about it long
before it becomes reality. And that means a serious stock-market
selloff is looming.
Thanks to the
Fed?s gross market distortions, it?s been an incredible 4 years
since the last correction-grade selloff in the US stock markets.
And stock traders as a herd are rightfully notorious for their
short-term memories. The SPX has been levitating for so long that
they?ve forgotten how bad real selloffs feel. So as the Fed?s next
rate-hike cycle nears and stocks fall, complacent traders? fear will
surge faster than usual.
This second chart
above replaces the S&P 500 with its flagship SPDR S&P 500 ETF, SPY.
That?s the most-widely-used vehicle to gain direct exposure to this
elite flagship index. And since it?s been so long since the stock
markets experienced a normal healthy selloff thanks to the Fed, I
suspect most traders don?t realize how serious today?s downside risk
is. Selloff levels in 10% increments are noted on this chart.
A mere 10% SPX
selloff, the minimum to qualify as a correction, would take the US
stock markets back to mid-2014 levels. That would wipe out nearly
an entire year?s progress! Can you imagine that not
seriously scaring complacent traders? At a full-blown 20%
correction, which is all but certain, the SPX would be dragged all
the way back down to mid-2013 levels. The last two years of the
SPX?s progress would vanish.
But since the
aberrant stock-market rally in recent years was fueled by extreme
Fed easing that is going away, since this resulting bull is so
abnormally large and old, since these stock markets are so
seriously
overvalued, since complacency is off-the-charts high as the
super-low VIX
fear gauge reveals, and since it has been so incredibly long
since the last correction, I doubt any selloff would conveniently
stop at 20%.
Before the Fed
brazenly attempted to eradicate stock-market cycles, traders
understood that bear markets inevitably follow bull markets. The
stock markets are forever cyclical, an endless series of
bulls followed by bears. And there are very high odds the next bear
looms as the Fed starts tightening. A 30% selloff would drag the
SPX all the way back to early-2013 levels, erasing the entirety of
the Fed?s QE3 levitation.
At 40%, which is
nothing special as far as bear markets go, the stock markets would
retreat all the way back to early-2011 levels. And at 50%, which is
the average size of bear markets at this stage in the great
stock-market cycles, the SPX and SPY would plunge all the way back
down to late-2009 levels! Even though such 50% full bear markets
take a couple years to unfold, the devastation would be
breathtaking.
So don?t drink the
Kool-Aid with the euphoric stock traders and blind yourself to the
dangerous realities of today?s lofty and overextended markets! QE?s
new buying is done and the Fed?s balance sheet has already started
to shrink. And the end of ZIRP is rapidly approaching. The most
extreme easing in the history of the Federal Reserve that so buoyed
and goosed US stock markets is rapidly coming to an end.
With the Fed?s
late-2014 shift in QE policy already underway and its upcoming
late-2015 shift away from ZIRP looming, this central bank is
becoming a major downside risk for these stock markets. Only
fools would willingly buy high in such a hazardous environment
fraught with peril. Rather than piling into stocks high, smart
contrarian investors are looking elsewhere to deploy capital in
deeply-out-of-favor assets.
Their destination
of choice is the despised precious metals, trading near major
lows. Not only are the
gold seasonals
bottoming, but gold
actually thrives
in rising-rate and higher-rate environments since they are so
damaging to stocks. That rekindles demand for alternative
investments, which are led by gold. During the Fed?s last rate-hike
cycle between June 2004 to June 2006, gold blasted 50% higher!
That was despite
the Fed more than quintupling the Federal Funds Rate to 5.25%
over that span! And in the 1970s when the Fed had to reverse course
from an earlier less-extreme easing, it was forced to hike its FFR
from 3.5% in 1971 to an astounding 20.0% by early 1980! And gold
skyrocketed 24.3x higher over that span. Gold, silver, and
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The bottom line is
the Fed?s massive policy shift from record easing to tightening is a
huge downside risk for today?s lofty, overvalued, and overextended
stock markets. The Fed has already stopped its new QE bond buying,
and its balance sheet that the stock markets closely mirrored in
this bull has started to shrink. And despite the dovish FOMC this
week, the first rate hikes near that will pound the nails in ZIRP?s
coffin.
These
Fed-levitated stock markets that have almost magically avoided
significant selloffs thanks to QE, ZIRP, and the associated Fed
jawboning are in serious trouble when this next tightening cycle
arrives. It will prove an extraordinarily-risky time for
extraordinarily-anomalous markets. So sell high while you still
can, and redeploy some of that capital by buying low in the precious
metals which are set to soar.
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