Fed & ECB to now Strangle the Extraordinary Stock Bull they Nurtured
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, the stock bull 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!
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. – Adam Hamilton