The US stock
markets have suffered their worst early-year losses in history in
young 2016, an ominous proof that a major trend change is underway.
The Fed’s new tightening cycle is already slaying recent years’
extraordinary easy-Fed-fueled stock-market levitation.
Unfortunately the only possible reckoning after such a record
artificial stock boost is a long-overdue major bear market that is
finally awakening.
Just a month ago,
the stock markets looked radically different. The Federal Reserve’s
Federal Open Market Committee that sets monetary policy mustered the
courage to hike rates, ending exactly 7 years of a record
zero-interest-rate policy. Stock traders rejoiced, interpreting the
first rate hike in 9.5 years as a sign the Fed had great confidence
that the US economy was improving. So they bid stocks higher that
day.
The benchmark S&P
500 stock index (SPX) surged 1.5% to 2073 the afternoon of the Fed’s
first-ever ZIRP-ending rate hike. That was merely 2.7% under the
SPX’s all-time record high seen just 7 months earlier in late May.
Euphoric Wall Street strategists spent the next couple weeks calling
for that powerful bull market in stocks to continue in 2016, with
plenty of predictions for the SPX climbing another 10%+ this year.
But something
snapped as this new year dawned, unleashing waves of selling.
Enough stock traders worried that an anomalous stock bull fueled by
the Fed’s ZIRP and quantitative-easing money printing might not fare
so well without ZIRP and QE. Since that first rate hike
since June 2006 was so close to the new year, they waited to 2016 to
realize their big gains which delayed their taxation for an entire
year.
So instead of
rallying in recent weeks in line with early years’ strong upside
bias on new capital inflows from pension funds and year-end bonuses,
the stock markets have plunged. The SPX has lost a truly
breathtaking 7.5% in 2016’s mere 8 trading days as of the middle of
this week! The massive selling that is necessary to drive such a
drop has been relentless yet orderly, with insufficient fear to mark
a durable bottom.
As I warned last
June just weeks after the SPX’s record high as euphoria reigned
supreme, the Fed
shift is a major stock-market risk. The US stock markets had
perfectly mirrored the Fed’s increasingly-bloated balance sheet
since the dawn of the wildly-unprecedented QE and ZIRP era in late
2008 in response to that year’s stock panic. Whenever the Fed was
actively monetizing bonds with QE, stock markets rallied.
But when both QE1
and QE2 ended, the stock markets corrected hard. Popular greed had
grown so epic that the end of the final QE3 bond-buying campaign in
October 2014 was shrugged off. Yet the SPX’s QE-fueled momentum
soon stalled out anyway, with this flagship index peaking less than
7 months later. While the new bond monetizations ended with QE3,
the Fed hadn’t started selling its gargantuan holdings.
As recent weeks
are proving, the final nail in the Fed stock levitation’s coffin was
the end of ZIRP less than 14 months later in December 2015. But the
Fed-boosted stock bull was already in topping mode. During that
long span between the Fed ending QE’s new buying and executing its
initial rate hike, the SPX only edged 3.1% higher. The end of ZIRP
is even more ominous for stock markets than the end of QE.
The 7 years of
ZIRP and QE had openly manipulated short and long interest
rates to record lows. Corporations took advantage of the deluges of
cheap money to borrow with a vengeance. But instead of using these
vast amounts to actually grow their businesses and hire people, the
great majority of it went into pure financial engineering.
It was used to buy back stocks, boosting share prices and
apparent profitability.
According to the
Fed, US non-financial corporations spent a staggering $2.24t buying
back their stocks since 2009. And the Fed reports they borrowed
$1.9t to do this, so over 5/6ths of all the stock buybacks of the
ZIRP era were debt-financed! Without record-low interest
rates, the economics of such stock buybacks crumble. And they have
been recent years’ overwhelmingly-dominant source of stock demand.
The 2015
stock-market action reflected the dire implications of the end of QE
and ZIRP, which euphoric traders foolishly chose to ignore. As this
first chart shows, the US stock markets stalled out before rolling
over to form a giant rounded topping pattern in the past year
or so. That gradually eroded all the bullish psychology enough to
start breaking it in early 2016. But the flagship VIX fear gauge
shows no bottom in sight.
Stock traders are
notorious for their myopic shortsightedness. Their opinions on
market outlook are just dominated by the latest action from recent
days and weeks. But much-longer-term context is necessary to
understand why a major stock bear is awakening. And to the
great peril of everyone who refuses to study the bigger picture, the
serious stock selling seen so far in 2016 is only the very tip of
the iceberg.
Despite the vast
distortions caused by QE and ZIRP, the stock markets behaved
normally between 2009 and 2012. They had just plummeted in a
once-in-a-century stock panic in late 2008, so a major cyclical bull
market was due as I
predicted in early
2009. By September 2012 just days before the Fed launched QE3,
the SPX had powered 112.5% higher in 3.5 years. Its bull-market
trajectory to that point was totally normal.
The stock markets
would rally for a year or so, and then correct. These 10%+ declines
in stock prices are normal and healthy in bull markets, as they
rebalance sentiment before greed grows too excessive. It’s
provocative to note though that both major corrections in the SPX in
that era ignited right after the Fed’s massive QE1 and QE2
bond-monetization campaigns ended. So the Fed was already
distorting stocks.
But in September
2012, the Fed birthed its wildly-unprecedented QE3 campaign. It was
very different from QE1 and QE2 in that it was open-ended,
with no predetermined size or end date. QE3 was soon more than
doubled in December 2012 to an $85b-per-month pace of conjuring
new money out of thin air to buy bonds. Fed officials deftly used
QE3’s undefined nature to actively manipulate stock traders’
psychology.
Every time the
stock markets threatened to sell off since early 2013, top Fed
officials would rush to their microphones to declare they were ready
and willing to expand QE3 if necessary. This was interpreted
by stock traders exactly as the Fed intended. They started to
believe an effective Fed Put was in place, that the Fed would
quickly ramp its record easing if necessary to arrest any material
stock-market selloff.
So the stock
markets started levitating, decoupling from their normal bull
trajectory. Not wanting to fight the Fed, traders began ignoring
all conventional sentimental, technical, and fundamental indicators
to aggressively buy every minor dip. This Fed-spawned psychology
along with the extreme debt-financed corporate stock buybacks
courtesy of ZIRP drove the most extraordinary stock-market
levitation ever witnessed!
Nearly all the
stock-market action since early 2013 is a Fed-conjured illusion
that never represented the underlying real-world fundamentals as
we’ll discuss shortly. That indicators-be-damned buying without any
normal selling to rebalance sentiment resulted in one of the longest
correction-less spans in stock-market history, an incredible 3.6
years. That only ended with the SPX’s brutal 10.2% 4-day plunge in
late August.
That extreme
selling was a big warning shot across traders’ bows that the markets
were topping and rolling over into bear mode, as I
warned again
just days after that plummet. While China’s surprise devaluation of
its yuan was credited as that plunge’s cause, that revisionist
history isn’t true. That yuan devaluation came on August 11th,
which was fully 7 trading days before that intense
stock-market selling began.
The real catalyst
for August’s sharp correction was the release of minutes from the
latest FOMC meeting the afternoon before that big selling
hit. They were more hawkish than expected, with most of the FOMC
members agreeing that conditions had almost been achieved for hiking
rates at their next meeting in mid-September. So it really wasn’t
China that blasted US stocks in late August, but
Fed-rate-hike fears!
Of course that
very global stock selloff the hawkish Fed spawned stayed its
hand in September. But at the FOMC’s next meeting in late October,
the Yellen Fed hellbent on finally hiking warned that it would
likely happen at the next mid-December meeting. And so it came to
pass. Though the end of ZIRP that had enabled the debt-financed
stock buybacks that levitated stock markets was wildly bearish,
stocks held on.
The Fed’s first
rate hike in nearly a decade happened just a couple trading days
before Christmas week which many traders take off entirely. But
during the two trading days between the hike and that holiday week,
the SPX plunged 3.3%. The writing was on the wall for anyone who
cared to read it, as I
warned again
that very day. But with year-end so near, traders nervously sat on
their hands to avoid realizing gains.
Then as 2016
dawned and all those capital-gains-tax bills would be pushed an
entire year into the future, all hell broke loose. Again China was
blamed, with its ongoing yuan devaluation and limit-down
stock-market closes under brand-new circuit breakers apparently
driving heavy American stock selling. But underneath it all was the
super-bearish ramifications of the Fed’s
first tightening cycle in a decade underway.
Then just this
Wednesday, the blame-China excuse for the horrendous early-year US
losses imploded. On a day with the best economic news out of China
in some time, a big upside surprise in exports, the US stock markets
opened higher. But they soon started to sell off on no news
whatsoever, collapsing to a huge 2.5% loss which made for the
worst trading day of 2016. And this year, that’s sure saying a lot!
Make no mistake,
China is a peripheral issue to the dire implications of the new Fed
tightening cycle on stock markets levitated for years by epic
record Fed easing. And the selling isn’t over even on a near-term
basis. Check out the definitive VIX fear gauge above, which
measures the implied volatility on 1-month S&P 500 index options.
The higher the VIX, the greater general fear which is necessary for
a bottoming.
Even during the
Fed’s levitation, durable bottoms after major selloffs never
occurred unless the VIX shot above 40. During the SPX’s
16.0% correction in mid-2010 following the end of QE1, the VIX
rocketed as high as 45.8 on close. During the next 19.4% correction
a year or so later after the end of QE2, the VIX soared as high as
47.5 on close. And in late August 2015’s sharp correction, the VIX
hit 40.1 on close.
The near-term
selling in the stock markets is very unlikely to end in the
magnitude of plunge we’ve seen so far in 2016 without a VIX read up
above 40. As of Wednesday, the VIX’s highest close of the year was
merely 26.4 last Friday. Even Wednesday’s sharp 2.5% SPX plunge saw
the VIX merely hit 25.0. There is simply not yet enough fear
to see a durable bottom, as the selling has been big and relentless
but orderly.
And even when that
40+ VIX inevitably arrives and a major short-covering rally is
unleashed, the stock markets aren’t out of the woods by a longshot.
They remain overdue for the major bear market that was
artificially delayed by the Fed’s record easy money spewing from QE
and ZIRP. While extreme central-bank manipulations can temporarily
distort market cycles, history has proven they can’t be eliminated.
Before we get into
the fundamental proof of why a major stock bear is awakening,
consider the sheer damage it will wreak in the chart above. Bear
markets start at a 20% SPX loss off of the preceding bull’s peak,
which would drag this benchmark index to 1705. That would erase all
the stock-market gains since mid-2013, the majority of the Fed’s
stock-market levitation! Even 20% would devastate stock-trader
sentiment.
But it’s going to
get far worse than that, as bear markets tend to cut stock prices
in half! And that average comes after garden-variety bulls that
haven’t been artificially extended by central banks. A 50% overall
drop is likely very conservative for this new bear underway. Yet
even that would drag the SPX all the way back to 1065 within a
couple years or so, blasting this index back to late-2009 levels
just after the stock panic!
The bigger this
long-overdue bear market grows, the more it’s going to scare stock
investors into selling and running for the exits. And the more they
sell, the bigger this bear will grow. Bear markets, just like
bulls, are self-feeding beasts. So selling is only going to
intensify as 20%, 30%, 40%, and even 50% total declines in the S&P
500 are seen. Naive investors trapped unaware in this are going to
lose fortunes.
While the end of 7
years of QE and ZIRP is exceedingly dangerous for Fed-levitated
stock markets, this risk is compounded greatly by the resulting
extreme stock-market valuations. This next chart looks at the
average trailing-twelve-month price-to-earnings ratio of all 500 SPX
component stocks. Weighted both simply and by companies’ market
capitalizations, this terrifying valuation data guarantees an
outsized bear.
The stock markets
move in great third-of-a-century cycles I call
Long Valuation
Waves. Their first halves see mighty secular bulls where stock
prices are bid up far faster than underlying corporate earnings, so
valuations soar. This necessitates second-half secular bears, which
see stock markets grind sideways on balance for long enough for
profits to catch up with lofty stock prices. We remain deep in a
secular bear.
It started in
early 2000 as the last secular bull peaked, and consisted of a
series of shorter cyclical bears and bulls. The former indeed cut
stock prices in half, while the latter doubled them back up to
breakeven again. Thus for fully 13 years ending in late 2012, the
SPX slowly meandered within a giant secular trading range between
roughly 750 support to 1500 resistance. That typical pattern was
very healthy for stocks.
As these blue SPX
P/E lines reveal, stock-market valuations gradually mean reverted
from bubble levels over 28x earnings as the last secular bull peaked
down towards normal levels. The century-and-a-quarter fair-value
level for US stock markets is 14x earnings, and we were well
on our way back there before the Fed’s brazen open-ended QE3
campaign reached full steam in early 2013. Then stocks soared to a
breakout.
The SPX blasted
above its secular-bear 1500 resistance in January 2013 on the Fed’s
we’ll-expand-QE-if-we-need-to jawboning and never looked back. But
this sentiment-driven stock levitation truly had no fundamental
foundation. Stock-market P/E ratios soared with stock markets,
proving that earnings were not justifying recent years’ big gains.
By last month, the SPX’s P/E of 26x was
back near 28x bubble levels!
Such
extreme
valuations demand a stock bear to bring them back in line with
norms, which is why one is guaranteed. And it’s even more
remarkable to see near-bubble stock prices considering recent years’
epic ZIRP-fueled stock buybacks. Buying back stocks reduces
outstanding share counts, which spreads overall profits across fewer
shares. This boosts the earnings per share used to calculate
P/E ratios.
So without the
radical stock-buyback binge the Fed fomented, valuations would now
be well into bubble territory at today’s stock prices! And
they’re actually heading higher if stock prices don’t drop sharply
to bring them back in line. Overall US corporate earnings are now
projected to fall in the fourth quarter of 2015, up to 5%. Lower
profits will force valuations even higher, further ensuring one heck
of a bear.
Based on the
latest trailing twelve months of earnings for all the elite S&P 500
component companies, and that’s current to the third quarter, the
SPX would have to fall all the way back down under 1100
merely to hit historic fair value at 14x earnings! The white line
above shows where the SPX would be trading at 14x fair value. Just
getting there would require a 48.5% bear market, right in line with
historic averages.
But today’s
situation is much worse than that. We remain mired deep in the
secular bear which started in early 2000, and tend to run for 17
years. While the SPX’s nominal peak near 2125 last May was a
lot higher than March 2000’s near 1525, if you
adjust the latter
using CPI inflation it works out to about 2100 as well in early-2015
dollars. So ever since 2000, the stock markets really have ground
sideways on balance.
Secular bears
don’t end at fair value of 14x earnings, but persist until stocks
are trading at half that level or 7x before they finally yield to
the next secular bull. In order to push valuations down that far
based on today’s corporate earnings, the SPX would have to see an
astounding 74% bear market that would crush it under 550! Since
bears take a couple years to unfold, stock prices won’t have to go
that low as profits rise.
But this still
illustrates how scary-extreme these stock markets are in
fundamental valuation terms due to the wild distortions the Fed
unleashed through QE and ZIRP. Given the extraordinary stock-market
levitation fed by epic record Fed easing leading into this awakening
bear, I’d be shocked if it stops at a mere 50% loss. Traders are
going to pay an awful price as these markets mean revert lower and
overshoot.
All the Fed’s
record monetary inflation
ballooning its
balance sheet and record-low rates accomplished was artificially
extending a long-in-the-tooth cyclical bull market within a secular
bear. And with QE and ZIRP done and a new tightening cycle upon us,
the gross stock-market excesses are only just starting to unwind.
Investors and speculators alike trapped unaware in this resulting
bear are going to get slaughtered.
But the prudent
can still thrive during stock bears. The coming S&P 500 downside
can be directly bet on with puts in the leading SPY SPDR S&P 500
ETF. Investors can also use SPY puts to hedge their long stock
investments. But since the vast majority of stocks get sucked into
bear markets, a far better option is selling investments and parking
capital in cash. Cash is king in bears, going beyond
preserving wealth.
Investors who
wisely go fully in cash early in a bear can literally buy back
twice as many shares in their investments after the bear runs
its course and cuts stock prices in half. Then they can use this
much-larger base to rapidly multiply their wealth in the next bull.
And gold is even better, because unlike cash it
rallies during
stock bears as falling stock prices kindle gold investment
demand for portfolio diversification.
Just like during
the last two cyclical stock bears that cut the markets in half in
the early 2000s and again in the late 2000s, Wall Street is going to
deny this current selling is a new bear all the way down. Since it
earns vast percent-of-assets management fees, Wall Street’s mission
is to keep people fully invested no matter what. In order to
understand what’s really going on, you have to cultivate contrarian
intelligence sources.
That’s what we’ve
long specialized in at Zeal. We really walk the contrarian walk,
buying low when few others will so we can later sell high when few
others can. We publish acclaimed
weekly and
monthly
newsletters that draw on our decades of exceptional experience,
knowledge, wisdom, and ongoing research to explain what’s going on
in the markets, why, and how to trade them with specific stocks. If
you want to not only survive but thrive in this bear, you need to
subscribe today
and get informed!
The bottom line is
a major stock bear is awakening. The new Fed tightening cycle marks
the end of the most extraordinary record easing in history. Its
combination of record-low interest rates and record-high money
printing unleashed vast deluges of stock buying resulting in recent
years’ artificial levitation. But it was totally unjustified
fundamentally, with stocks soaring far faster than profits leading
to near-bubble valuations.
With those extreme
Fed tailwinds suddenly shifting to headwinds, the Fed-fueled
stock-market levitation is rapidly starting to unwind in this young
new year. And this selling is just getting started, as nothing
short of a full bear market will force extreme valuations back down
to fair value. The chickens are finally coming home to roost for
the Fed’s radical stock-market distortions, and the reckoning ain’t
gonna be pretty!
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