From Taper to Tap Out, the Fed’s About to Tighten
A few months ago, everyone was bullish on the stock market, but that view is changing. No fewer than seven billionaire investors have come out stating the market is overvalued and that investors should be cautious. Investment banks and analysts are starting to join the chorus by warning their clients to start moving out of equities. Yet the public doesn’t seem to hear these calls as they see every fall in equity prices as an opportunity to buy. Few think the stock market can ever go down again. It’s amazing to me how quickly people have forgotten how stock prices even got here.
It all began ten months ago with the hope that fiscal stimulus, tax cuts, healthcare reform, and corporate deregulation bills would be passed by the end of 2017. Analysts seized this opportunity and lowered their outlook on corporate earnings, to announce to their clients that corporations were beating earnings expectations.
Behind the scenes, corporations were borrowing like mad to fund aggressive stock-buyback programs and to fund executive bonus programs. Earnings per share (EPS) went up and the public bought in droves. Meanwhile, corporate profits fell in the first quarter of 2017, but nobody seemed to mind. The buying spree was on, except for the executives who were cashing out their stock in record numbers.
Some are starting to question how EPS (earnings per share) in the second half of the year will look as corporations scale back on their stock purchase programs. Since corporate stock purchases have been driving the stock market up for the past ten years, now that those stock purchase plans are waning, stock prices should start to fall. Just like in 2007 before the market peaked, the public has once again gone all in.
What I can’t understand is why everyone is suddenly so starry-eyed over the stock market. Leverage, or the amount of money that has been borrowed to buy stocks, is at a record high. The market is so leveraged right now that if something were to shock it, it would have a massive unwind. That unwind would be so big and so fast that people will struggle to believe it’s happening. Everyone is bullish until the market goes down.
This week I read that a company who markets a cell phone application to Millennials, allowing them to trade stocks commission-free, called Robinhood, started allowing their customers to buy a premium account to buy stocks on margin. Since the premium account was released last September, enrollments have been growing at twenty percent per month. Those Millennials are going to learn the hard way during the next market correction on what it means to buy on margin. I have a hunch that after they get burned, that it will forever change their view of taking risk in the stock market. This is just another example of how a rising stock market has fueled leveraged investing.
Everywhere you look there’s weakness in the economy. Retail sales numbers were reasonably good the past couple months, but only because promotions and incentives are near record high levels. But when you look at the raw, or non-seasonally adjusted number, you will find that last month’s raw number was -0.8% versus the government’s seasonally adjusted +0.6%. That’s a big divergence.
New cars are piling up on dealership lots, while used car prices have fallen to where they were in 2010. With nearly four million vehicles with leases ending next year, used car prices are expected to continue their downward spiral. And we’re not even in a recession. When the recession does happen, used car prices are likely to fall below their 2009 lows. This will put a huge amount of stress on the banks that lent against these leases because they will end up losing the difference between the residual value and the actual value of the leased vehicles.
It’s hard to think how this will end well. This week the New York Federal Reserve announced that credit card delinquencies were starting to reach 2009 levels. They also pointed out that this month a new record in automobile, credit card, and student loan debt was reached. That doesn’t seem like something to brag about. And experts wonder why restaurant traffic and sales have been falling since February 2016. Consumers have less discretionary money, especially since bank credit has contracted at the largest rate outside of any recession.
Eight years ago, the Federal Reserve set out to rescue the economy at a cost of over four trillion dollars. All they asked for was wage growth which never materialized. Ever hopeful, the Fed keeps waiting for wages and inflation to rise, which they believe will happen by the end of the year. In the next couple of months, the Fed is expected to announce the phase out of their bond-purchase program.
A bit of a back story, when the Fed started Quantitative Easing (QE) 1-3, it involved purchasing U.S. Treasury bonds. When the government issues debt, it is bought by the banks and resold to investors. During QE, the Fed would buy bonds from the banks before they could be sold to investors. While it may seem strange, the Fed can’t buy U.S. Treasuries directly from the government. At the end of QE 3 the Fed decided to continue reinvesting the dividends of their $4.5 trillion bond portfolio by continuing to purchase U.S. Treasuries with the dividends.
While most people don’t realize it, the Fed has been engaged in easing conditions, which expands the money supply, by continuing to buy U.S. Treasury bonds. The Fed has been hinting that this year or early next year they will start phasing out the reinvestment of those dividends to slowly let the total bond portfolio wind down.
When the average person hears the Fed is going to reduce and eventually end their bond-purchase program, they always assume this means interest rates are going to go up. While their view does have merit, interest rates are more likely to fall at the end of the bond purchase program. Before we get too far, it’s important to understand the purpose of QE and how it affects interest rates.
During the Great Financial Crisis of 2007-08, the banks nearly failed which would have led to a collapse of the entire financial system. To recapitalize the banks, the Fed needed to get the non-performing loans off the banks’ balance sheet. The Fed bought U.S. Treasuries on the open market under the QE programs and swapped U.S. Treasuries for the bad loans. The banks were paying the Fed 0.25% per year to the Fed on the swapped U.S. Treasuries while our government was paying the banks about 3% per year in dividends; the banks were making money without having to do anything. To incentivize the banks to lend, the Fed lowered the Federal Funds rate to 0%, which eventually spurred bank lending. Once the Fed had recapitalized the banks, the Fed wanted to boost the value of the stock market to create a wealth effect, so they continued to buy U.S. Treasury bonds.
When the Fed buys U.S Treasuries on the open market they do that to expand the money supply. It also reduces the number of Treasuries that investors can buy. This extra money in the system needs some place to go and this time it went into stocks. With stock prices rising faster than bond prices, investors sold their bonds to buy stocks. When investors sell bonds, interest rates rise.
On Wednesday, August 16, the Fed released their July meeting notes, which indicated they are planning to announce the unwinding of their bond-purchase program at one of their upcoming meetings. When the Fed reduces, and eventually ceases buying U.S. Treasuries, it has the effect of contracting the money supply, because the debt still must be bought. When the government issues debt, it must be purchased. When the debt is purchased, it has the effect of pulling money out of the money supply, which causes asset prices, such as stocks, to fall. Within seconds of the Fed announcing they were planning to reduce their balance sheet, both stocks and interest rates fell.
As I have mentioned in prior updates, when the money supply contracts, the economy and asset prices must also contract. If half of our money supply disappeared tomorrow, then the economy and asset prices would also shrink by half. When the Fed is going to implement policies to contract the money supply, which usually causes the economy to recess, investors look to move out of risk assets, such as stocks, and into safe assets, such as U.S. Treasuries. That move out of stocks and into bonds causes stock prices and interest rates to fall.
While it’s hard to say why the Fed is talking about unwinding their balance sheet at a time of weak economic growth, understanding their dual mandate will likely shed some light on that. The Fed has two mandates: to maximize employment and stabilize prices. With the unemployment rate near historic all-time lows, it’s safe to say the Fed has met that mandate. The second is more subjective, but prices have been stable. At this point the Fed has to be thinking that they achieved their goals, which means it’s time to start undoing the easy-money policies they implemented back in 2008.
The problem with expanding the money supply long after it has been needed is that it creates asset bubbles. The longer the expansion, the bigger the bubble. Inevitably when the bubble bursts, it wreaks havoc on the economy and the financial system. The bigger the bubble, the worse it is. While the Fed doesn’t believe there are any asset bubbles, they and the other central bankers around the world have created asset bubbles in the stock market and in the real estate market. And when those bubbles pop around the world, it will be damaging to the global economy. The damage will be big, as legendary investor Jim Rogers says, “It will be the worst recession in our lifetimes.” If history is a guide, he will be correct.
The Fed has already started contracting the money supply when they raised interest rates. This is evident in bank lending, which has had a huge year-over-year contraction, which normally happens during recession. With bank lending contracting and the money supply contracting, if the Fed does start unwinding their balance sheet, it will accelerate the contraction and push the economy into a recession. Not that the economy needs a push. I and a very small number of people don’t think the Fed will have the opportunity to start unwinding their balance sheet because we think the economy will be in a recession before the end of this year. That view is supported by a continuation of weakening economic data each month.
The Fed is about to contract the money supply into an economy that’s already contracting. This is how the Fed will quickly go from taper (contracting the money supply) to tap out (expanding the money supply). Since central banks came into existence, they have been responsible for every expansion and recession, and the Fed is about to do it once again. But this time, they’ve created the biggest bubble in history.
Video Topic of the Week
I discuss the recent massaged government data and how I think it’s misleading investors. I talk about my views on the broad equity market, gold and gold miners, and agricultural commodities. Last, I tough on how QE 4, when it eventually comes, will affect interest rates and U.S. Treasuries.
Chart of the Week – S&P 500 vs Trailing 12-month EPS
This year analysts have been citing earnings as the reason equities are rising. As I’ve said before, earnings are below their 2014 high. This chart shows the S&P 500 price index versus its 12-month Earnings Per Share (EPS). Mean reversion to its earnings will put the S&P 500 down 30% from its current value.
Client Update – will use this section as my weekly commentary going forward
Portfolio Shield™ Update
Morningstar® has granted me permission to use their logo on the Investment Detail report! Updated report is attached. Website is under construction.
I will eventually phase Portfolio Shield™ into client accounts. New clients will be going straight into the model. Long-time clients will still get the opportunity to benefit from the move in the gold market when the global economy goes bust.
The big news this week was the broad equity market took a big drop on Thursday. This is not a signal that the equity rally is over, but it’s not a sign of strength. It’s still a market being held up by a few large cap stocks, while the rest of the market is selling off. Trends like this don’t hold for long. Sentiment on the equity market is under 50% which is a bearish signal, which is likely to lead to a bigger sell off. If there is a big enough one or two day drop, in the 10-15% range, it will likely nudge what’s left of the economy into a recession.
If the S&P 500 has a weekly close below 2,400, it will give us an opportunity to build short positions. Based on 12-month trailing earnings, the S&P 500 should be trading around 1,800 or 30% below current values. This should create some opportunity for us. My plan would be to start small with the higher risk models and build from there.
Short Volatility – DO NOT TRADE
Short volatility dropped 15% on Thursday. Very risky. It is trading 20% below its all-time high and forcing speculators to prop up their positions to keep the market from falling apart.
International & Emerging Markets
Both took a big drop on Thursday. There are no safe havens there. While money is moving into international markets, it’s simply because they are undervalued when compared to the US equity market.
Interest rates were down and bond prices were up as the equity market sold off. They are working as expected. Sentiment is slightly over 50%, meaning a rally in bonds could come soon.
Looking for the 10-year Treasury yield to fall below 2.1%.
Prices have dropped this week, but buyers are stepping in towards the end of each trading day. This is a positive sign that the downward price action is short term.
I checked in with the company I hired to provide momentum research and they said the price action is not reflecting in momentum, meaning they view the recent drop in price as corrective in nature and short term.
Futures traders have moved into heavy short positions as they believe commodity prices are going to multi-decade lows, but there is a growing group that view these low prices as long-term buying opportunities.
Last, sentiment on commodities is low, which usually means there’s a trend change coming soon. My plan for the moment is to sell the next rebound unless there’s a breakout to the upside.
Gold touched $1,300/oz. for the third time, which many said would lead to a breakout. Markets quickly rejected that price, for now.
The gold and silver miners have not made the same upward move as their corresponding metals. I am watching these very closely. Will look to build positions here if a break out to the upside occurs.