They’ve called it a “beautiful deleveraging” and a “perfect normalization.” What analysts are referring to is the extraordinary monetary policy known as “quantitative easing” (QE) that was imposed in the wake of the credit bubble collapse in 2008. First adopted by the US Federal Reserve and then quickly mimicked by European, Japanese, and British central banks, QE has allowed the economy to heal from its debt crisis over the last nine years without the catastrophic wipeout of assets that occurred in the Great Depression. For almost a decade investors have wondered when, and how, the policy will be wound down. Now a plan has been laid out for its quiet end.
The Federal Reserve, through its unique ability to create money out of thin air, created cash that was then used to purchase government bonds and mortgage-backed securities from the financial sector. This brought the bonds onto the Fed’s “balance sheet,” and put the cash into the hands of the banks, brokerages, and insurance companies in the hopes that it would be invested productively to reduce unemployment and raise asset prices. The balance sheet started out at $900 billion in 2007 and ballooned to about $4.5 trillion by the end of 2014. At that time they stopped outright purchases of bonds, but reinvested all income and principal payments, keeping the balance sheet from shrinking and providing a firm source of demand for bonds.
In June, the Fed announced plans to shrink its massive holdings of bonds by slowly stopping the reinvestment of maturing principal payments. The idea is that when a bond on the Fed’s books matures, the cash it gets back will not be used to go out and buy another bond to replace it.
The slowing of reinvestment will be phased in over time. The Fed will start to shrink its bond holdings at the rate of $6 billion a month by letting that amount of principal mature without replacement. That maximum will then be allowed to rise by $6 billion every three months over the course of a year until it hits $30 billion (of non-replaced principal repayments) a month. There is a similar scheme for the mortgage-backed securities on its books, which will be allowed to mature, without replacement, beginning at $4 billion a month, and rising to $20 billion over the next 12 months. Thus, at its upper limit, the Fed could be “shrinking” the balance sheet by potentially $50 billion a month, but that rate would occur only in late 2018. While these numbers sound huge, remember that the Fed was buying $85 billion of bonds monthly when QE was running hot and heavy in 2013-14.
Central banks are trying to communicate that a change is in the wind. Mark Carney, head of the Bank of England, signaled that the long period of easy money is drawing to a close, saying that it anticipates raising interest rates at a faster pace than investors currently expect. Fed chair Yellen also hinted at an over extended financial cycle, noting rapid growth in stock market valuations that look “rich” by historical standards. And Mario Draghi, head of the European Central Bank, stated that the risks surrounding the Eurozone have “shifted away from deflation.” In a nutshell, central banks are clearly signaling to markets that they may have become far too complacent about the expectation for continued easy monetary policy, and the financial instability that that complacency invites.
What are the likely side effects of this “quantitative tightening” (QT)? We have maintained for years that the majority of Wall Street’s gains since 2009 were driven by a flood of liquidity into the markets. But plans for QT make that process work in reverse, albeit more gradually. Like a car’s tire with a tiny air leak, QT may be unnoticeable at first, but over time may slow the forward momentum of both the market and the economy.
First, investors can look forward to gradually rising interest rates as QT progresses. Short-term rates have already risen from their near-zero levels as the Fed raised rates several times since the end of 2015. And although long-term yields have spent this year drifting irregularly downward, they are well above the 10-year low reached just prior to the presidential election. At some point, higher yields will offer real competition for stocks, something that was laughably dismissed when rates hugged the zero line. That will draw demand away from stocks. Moreover, rising yields will offer some relief to traditional CD and money market investors who have paid the highest cost for quantitative easing over the last eight years.
But the biggest unknown side effect will be on stock prices. Stocks have benefited mightily from the liquidity surge brought forth by QE. Market analyst Tom McClellan perceptively wrote that only two things matter for stock prices: How much money is out there, and how badly does it want to be invested? Over the last eight years the answer to the first question was “a lot,” and the answer to the second was “pretty badly.” If these answers change under QT, investors can look forward to a much less forgiving stock market in the years ahead.
The intense desire to be invested has been exemplified by the fact that stocks have had only the smallest of pullbacks over the last few years, and those that occurred were quickly met with buying. Indeed, the market’s proverbial “fear gauge” known as the volatility index, or VIX, reached an all-time record low of 8.84 in late July, underscoring the complete lack of fear among stock investors today.
Stock market bulls can justifiably point to strength that has been a long time in coming for their confidence. For the first time since 2011, America’s biggest corporations are on track to report two straight quarters of double-digit profit growth. Total earnings for these companies are up 11% from the same period last year on 6% higher revenues. This would follow 13.5% earnings growth on 7% revenue growth in Q1. Americans also enjoyed a ten-year high in their personal financial standing in the second quarter, according to the AICPA’s (Assoc. of International CPAs) Personal Satisfaction Index. This index rose to 24.1, its highest reading since the end of 2006. With European and Asian economies also growing, there is a virtuous circle of global reflation occurring.
All of which gives central bankers an opportunity to normalize monetary policy with less worry about causing a recession. And while global economies are in the pink, it is the main beneficiaries of QE, the financial markets, that present the prickliest problem for monetary policy due to three factors: over-valuation, over-leverage , and overly bullish sentiment.
As stocks have climbed, valuations have followed suit, and they have become very expensive on almost any metric one can name. The bulls cite robust earnings growth to explain high stock prices, and while true, stocks have increased faster than earnings, and valuations have become even more stretched.
The chart below, available at www.DShort.com, has appeared many times in the Market Outlook. It is a composite of four different valuation metrics, and seeks to measure how far away we are from the average historical readings of valuation. Unfortunately, there is no single accepted way to measure value in stocks. These, however, are traditional approaches to market valuation, (mostly) unpolluted by modern accounting trickery. Thus, a major advantage to this approach is that the readings can be calculated back 117 years, to 1900.
We want to point out a very important observation: today’s valuations have now reached the second highest levels in the 117 year history of this measure. It is now second only to the all-time, blowout high extreme reached in 1999-2000. It is flashing bright red for all to see, and we recommend investors not ignore this slow-moving, but very real, measure of risk.
Over-leverage in the markets is evidenced by the high level of margin debt, published by the NYSE and updated through June 30th. While it dipped slightly from its all-time high in April, the latest reading still stands at a daunting $540 billion.
Leverage, of course, helps magnify gains on the way up, but also magnifies losses on the way down. With the relentless rally since Trump’s election, investors seem to have thrown caution to the wind, as if the “bears” are in permanent hibernation. When the bears return is anyone’s guess, but current high levels of margin debt will surely be an accelerating factor of any sell-off.
Finally, investor bullish psychology has surged again to high levels. The Investor’s Intelligence sentiment survey now shows 60% bullish advisors against a very low 16.2% bearish ones. Neither is a record, but they are both close. The implication of high bullishness is that investors, feeling good about the market, have put all their excess cash to work by buying stocks, leaving little “fuel” (i.e. cash) left to drive stocks higher. High levels of margin tell us that not only has the excess cash been used up, but even more has been borrowed to ride the bull higher.
There is an old Wall Street saying that markets “climb a wall of worry.” Today’s highly bullish psychology implies that there is very little worry left among investors.
Given the triple hazards of valuation, leverage, and bullish sentiment, the Federal Reserve faces a very delicate balancing act as they try to quietly end the extraordinary monetary policies of the last eight years. To their credit, they have telegraphed their intention clearly and indicated they will use a soft touch with quantitative tightening. But it would be naïve to assume there will be no adverse reaction in the stock and bond markets. With some patience, skill, and a little bit of luck, quantitative easing will end not with a bang, but a nice quiet passage into the history books.