247Bull.com Editor: The performance of US stock markets is one of the few things the Fed can point to as proof that their policies are working. As a result, if the correction turns into something worse, we can expect further stimulus measures from the Fed.
On rare occasions I make specific, near-term market predictions, most recently in Q3 last year, when I called for a modest equity market correction. As it happened, only a tiny correction occurred, followed by a large subsequent rally taking the S&P500 index to 1,550 this week. Now I am making a similar if bolder prediction: A larger correction, possibly a crash (20%+), appears imminent. There are various fundamental and market technical reasons for this view but these all follow from the same ultimate cause: policymaker activism. The Fed and other major central banks ‘own’ this rally. If a crash occurs, and takes the global economy down with it, let’s place blame where it belongs.
THE ROAD TO RECORD HIGHS
The old adage, “Don’t fight the Fed,” is one that many investors learn first-hand by taking losses. The printing press can be a powerful thing. But like most if not all powerful things, it has its limits. Think of a chess player able to choose which piece goes where. That might seem quite a power until faced with checkmate, when no further moves are possible.
Having stimulated a large increase in money and credit growth through QE in the second half of last year, the Fed now faces checkmate. Why is this so? Because the surge has now reversed as velocity has plummeted. Year to date, both broad money and private sector credit growth are zero even through the monetary base is growing at nearly a 70% annualised rate.1 The Fed is, therefore, pushing as hard as ever, but still pushing on a string. Moreover, following on by far the largest amount of artificial fiscal and monetary stimulus ever thrown at the US economy, including during the Great Depression, the string is far longer than that which existed back in 2008.
THE MONETARY BASE HAS SURGED OF LATE…
…BUT BROAD MONEY AND CREDIT GROWTH HAVE SUDDENLY SLOWED TO ZERO
Although they will not admit this, the Fed is now essentially out of options. Recent talk about negative interest rates is just that: talk. As the NY Fed research staff have already noted, they could not work in practice.2 Some will argue that there remains an arrow in the quiver, namely the power to outright monetise debt, public and private, and pro-actively debase the dollar. But this would end the dollar’s reserve currency status, something that would greatly reduce the Fed’s power in any case, and it would most probably lead quickly back to some form of global gold standard.3 (While I and many other sound money advocates would endorse such a policy, I am well aware that the current Fed leadership abhors the thought of wearing a monetary straightjacket.)
It would not be accurate to claim, however, that the previous surge in money and credit growth did not impact the economy. Most probably it prevented the H2 2012 global growth slowdown from being larger than it was. More obvious is that strong growth in money and credit balances changed investors’ risk preferences, such that they decided to hold proportionately more equities than bonds. This has pushed up valuations for the former. Rotation out of bonds has had relatively little impact on prices, however, as the Fed has been buying large amounts of Treasuries and, importantly, primarily in longer maturities, where their buying activities have a much greater price impact as this compresses term premia. (Short-maturity bond prices are primarily a function of short-term interest rates, which are set by the Fed and which have been essentially zero since 2008.)
CELEBRATION ON LIBERTY STREET?
So notwithstanding the slowing economy, the Fed has engineered a large stock market rally. No doubt Fed officials are celebrating. Some investors might also be pleased, but it primarily benefits those who want to cash out at high valuations. Corporate insiders, for example, are selling at the fastest rate in years. Many companies are raising capital through either initial or secondary offerings. Such activity is a sign of a market top, however, and should concern the far larger ‘buy-and-hold’ crowd seeking to increase their wealth through a sustained rally.
There are several other reasons to be seriously concerned. First, consider valuations. Naturally a crash is more likely from elevated valuations than from depressed ones. Where are we now? Well, at 1,550, the S&P500 index is valued at around 14x forward earnings. That is not far above the post-1980 average, so may not appear lofty to some, but consider: This historical period includes many years of bubble-like valuations, including 1987, 1997-2000 and 2005-07. Depressed years, such as 1981-82 are less well represented in this sample.
Second, relying on forward earnings may be problematic as they are notoriously overstated relative to realised reality. In the present instance, forward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long.4
ELEVATED PROFIT MARGINS UNSUSTAINABLE
Third, the current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to some research suggesting that a ‘wall of cash’ has been pushing the market higher. (In any case, cash cannot directly push prices higher as for every cash buyer there is also a seller.)
Finally, let’s return to our starting point: Money and credit growth were strong in H2 2012 but this got little traction in actual economic activity. So what has this money and credit been used for? There is much evidence that it has been used as leverage to purchase shares. For example, margin interest on the NYSE is unusually high, at a level associated with previous market crashes.
- To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
- For a thorough discussion of the NY Fed paper on negative interest rates please see PAR FOR THE PATHOLOGICAL COURSE, Amphora Report vol. 3 (September 2012). The link is here.
- This is, in fact, the central thesis of my 2012 book, THE GOLDEN REVOLUTION, available on Amazon here.
- For an excellent discussion of the dangers of relying on forward earnings estimates please see this article by John Hussman here.