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My Position - Given the Fed's recent and widely disseminated remarks about exiting QE3, it should be clear that margin debt is unsafe for any investor, especially those who have made recent purchases on margin. If you've borrowed money to buy stocks, you should consider both sides of this argument very carefully. Under subheading "Caveats," please find reasons I could be wrong as well as links to opposing opinions from Seeking Alpha authors.

My Theory - When the Fed announces an exit from QE3, the exit plan will probably target a completion date of September 2015, due to budget-deficit projections which fall significantly each year until 2015, but then rise-up to re-visit $896 billion in 2023. As explained below, only the most bullish of investors believe that even a slow reduction in liquidity can be neatly replaced by private investors in a surging economy, suddenly unfettered by the unseen chains of QE3.

The "unseen chains" of QE3 are discussed in my May 24, 2013 essay, "Why The U.S. Stock Market Is Headed Into A Brick Wall" under the sub-heading "Toxic Effects of QE".

Discussion

(1.) According to the May 2013 Congressional Budget Office (CBO) estimates, Federal spending is expected to increase from 2013's $3,450 billion to 2023's $5,850 billion. This spending is expected to spawn 2013's $642 billion estimated deficit, and lead-up to 2023's $896 billion estimated deficit.

Currently, the Fed's QE3 program is flooding the bond market with $85 billion per month, helping the U.S. Treasury successfully issue $70 billion in T-bonds each month at low rates.

When the Fed starts reducing QE3, the U.S. Treasury will either (1) find the necessary funds within a surging economy, and/or (2) be forced to offer higher interest rates to attract a dwindling number of available dollars. The U.S. Treasury absolutely-positively must raise the necessary funds. If interest rates do increase, the stock market will have to compete by lowering prices, or hope that fewer people wish to sell shares.

So, let us assume that the Fed announces the QE-exit will start immediately in June 2013 and is expected to be completed in September 2015. Each of the millions of investors will have an opinion on what the S&P 500 is worth in June 2013 based on its estimated value 2 years hence, or 4 years hence, etc., using every shred of data investors can obtain. Investors will place orders to buy or sell based on these thoughtful opinions, and thus move the value of the S&P 500 to the consensus valuation price.

The S&P 500's future value (in the mind of each investor) will be based on what the economy is expected to look like after the exit from QE3 is complete and the economy is standing on its own, under the increased weight of the U.S. national debt which is $16,000 billion, $17,500 billion and $22,900 billion in 2013, 2015 and 2023, respectively. Investors' opinions may change back and forth a lot, but presumably the June 2013 consensus value will only vary slightly once the initial consensus is cast.

This is why the stock market is expected to drop significantly even if the Fed announces a seemingly small monthly reduction in QE3's $85 billion per month, such as $3 billion per month, each month, or less. (With a reduction of $3 billion per-month each-month, QE3 will reach zero in roughly 28 months, i.e., 3 x 28 = 84. However, there may be a minimum amount of QE necessary to prevent the money supply M2 from contracting "naturally" due to "natural" deleveraging. If and when the banks start lending in earnest, "natural" deleveraging will be offset by new bank loans, as is the normal situation in a normal economy.)

There will probably be only one drop in the valuation of the stock market solely due to the announced wind-down of QE3. This is not a dip, nor a correction; it is a paradigm shift because, in other words, "the punch bowl's still here, but the party's over, because the punch (in the punch bowl) is dwindling down to nothing."

(2.) Unemployment is still very high. U3 is the official unemployment rate that everyone has been gushing good news about. But U6 is the better measure of unemployment because it reports the true but larger proportion of a true but larger population of workers who are idle. When a relatively high proportion of the work force is idled, tax revenues are relatively down and welfare expenditures are relatively up.

In the time it takes "U3" to fall from 7.7% to 6.5%, the statistic "U6" is expected to drop equivalently from 13.9% to 10.4%. In other words, we are further away from a true recovery than is indicated by U3.

(3.) Growing Medicare, Social Security and Obamacare obligations are already included in the CBO's May 2013 deficit projections, and these are some of the primary reasons why the deficit rises quickly after 2015, and inexorably pushes up interest rates that might possibly choke off a recovery. That's an "in house" issue that we can control (in theory). However, potential fallout from eurozone problems may put further unforeseen demands on our bond market to raise money for a euro-bailout. That's an "out-house" issue which we cannot control, and yet cannot ignore.

Nota Bene - Mario Draghi's July 2012 promise to "do whatever it takes" quickly calmed the financial markets, a surprising effect. Yet more surprising is fact that "Super Mario" Draghi was new in office and didn't actually have the power "to do whatever it takes" until weeks later. Seems like they were literally dying for good news, and that doesn't sound like a rational market at work.

(4.) Rational investors realize that the Fed is conducting new economic policies that will require finesse to withdraw from. The Fed has capability to be quite nuanced technically, but is blundering with communication, causing potential confusion and possible panic. For instance, in December 2012, a staff writer of Forbes wrote a misleading article which erroneously tied the 6.5% unemployment rate (U3) to triggering an exit from QE. The Fed let the error stand and be repeated, which may have misled millions of investors, such as myself, into believing such a promise exists.

The Fed has yet to mention any correction, and some of us may be unpleasantly surprised when the Fed breaks its so-called promise. Yet, even if the Fed never made that promise, if the market believes the promise was made, the Fed might have a large problem on their hands. Such a non-existing promise would be like the so-called implicit promise behind Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). If the market believes there is a promise, the Fed has a problem. Treasury Secretary Henry Paulson stated several times during the unfolding Crisis of 2008, that there was no guarantee of Fannie Mae or Freddie Mac, none. None. Yet, the market ignored Paulson, and the government eventually gave up and honored the non-existent implied guarantee. It's a different situation now, but similarities abound.

(5.) As you read this, the so-called "bloated" money supply (M2) is being reduced automatically as T-bills held by the Fed mature, and the Fed suddenly has cash backing-up part of the money supply rather than the (now-matured) bond. The cash paid to the Fed by the U.S. Treasury to retire the bond is money leaving the money supply.

The Fed's portfolio of assets (primarily bonds and mortgage backed securities (MBS) have an average maturity of 10 years. The money supply is "naturally" shrinking for similar reasons when mortgages amortize or loans are repaid. The Fed can not reduce QE to zero until banks start lending in earnest and thereby offset the "natural" deleveraging of the money supply. But how much QE is needed to offset the natural contraction in the money supply? That can only be estimated.

And estimates are only the first (1) of three problems faced by the Fed. Monetary actions are well-known to have (2) hard-to-predict time lags and (3) effectiveness variability. Any miscue by the Fed can cause the market to become stalled with interest rates that are mistakenly too high. The Fed is bound to make mistakes, and we are bound to have a bumpy return to normality.

(6.) The never-ending, always-growing smörgåsbord of worries:

(a.) Too-Big-To-Fail (T.B.T.F.) banks are now even bigger, and worse, they're not demonstrably safer. Even the best and brightest T.B.T.F. CEO, Mr. Jamie Dimon of J.P.Morgan, dropped his pants in public while being dragged through the mud when the previously mythical and rumored "London Whale" suddenly lost its nerve, unwound its positions with headline-splashing losses and thus beached itself for all to see, and gawk, with wonder and astonishment.

(b.) The Wealth Effect can be a reliable and powerful market force, but it is a psychological feature of the market, and yet, surprisingly, it isn't fooled easily, it requires solid evidence and convincing. She's no push-over.

(c.) There are a number of market reactions that have feedback loops, making forecasting highly unreliable, and perhaps confounding the Fed. Chaos Theory can describe why forecasts are unreliable in theory, but cannot make more-reliable forecasts. (gee, thanks.)

(d.) The stock market seems to be hitting new heights every other day, but perhaps that's due to the smooth flow of liquidity and the blunderingly-numb hand of government which has grown to the point which begs the question, is there a price to pay when government becomes such a large factor in the market?

(e.) GDP also seems to be hitting record heights but when adjusted for (i.) inflation, (ii.) the growth in the true working-population (presumably close to 2% per annum), and (iii.) growth in the blunderingly-numb hand of government ... and then presented on a per-person basis, is it still so impressive? I wouldn't think so but, admittedly, I have yet to calculate it, because I'm certain it isn't.

Summary - Hopefully, as QE's bond-market-support winds-down, the wind-down is neatly offset by support from a resurging economy that springs back to life, ready and willing to invest more and more each month in the bond market, as the Fed reduces QE3 from $85 billion per month to zero. This, indeed, is possible: the economy might well benefit from pent-up demand, a euphoric exuberance for promising new ventures in high technology, and a reassuring "Super Mario" Fed who stands ready to do what-ever-it-takes to guide the economy back to normalcy, but is never needed, because the economy is humming. But, unfortunately, all this is too unlikely.

The Fed is going to exit QE soon, but slowly, over perhaps 20 or 30 months. It is my guess that the Fed will take 27 months, ending in September 2015 as discussed in my aforementioned (and linked) article dated May 24, 2013. Even if the Fed does successfully reduce QE slowly over 27 months without a major hiccup, stock market prices should predictably experience a big drop in anticipation of a new paradigm of less and less liquidity as the months wear on ... and not revisit today's highs until the economy fully recovers, which might take years, and might not be possible at all, unless the Federal Government gets its fiscal house in order.

My expectation is that the Fed's not going to rescue the stock market (by re-instating QE) unless there's more than a significant drop. That's because the Fed already knows a significant drop is highly probable and unavoidable if a return to normality is ever to be attempted. And it's arguable that the Fed has already tried to gently prime (i.e., "warn") the market for such an event. So, I'd bet the Fed plans to do nothing unless the stock market tanks at least 10%, and they probably plan to do very little if the drop were 15%. That's not much of a drop compared to the strides the stock market has made in the first 5 months of 2013 alone.

The Fed has foretold us of changes coming soon. Foretold is forewarned. This drop would not be a "dip" that smart money would pounce on. It'd be the result of a "paradigm shift". Smart money would wait for the carnage to end. Then they'd wait some more. Then they'd pounce.

Any investor who has margined shares is subject to margin calls whenever the price of a margined stock falls in value. Most margin calls are satisfied by selling stock, and since all such sales are highly likely to occur about the same time, such sales can easily cause another drop in the price, and another round of such sales. Mr. Mike Williams (linked below) has reported that prior to the 2008 Crisis, our margin debt was 2.75% and that it is now 2.57%. In my opinion, there's no way to call that "comfortable".

Caveats

I could be wrong. The S& P500 may already have the effects of a QE3 exit announcement already factored into its current price. That would be a wonderful testament to the "Rational Expectations Theory" of markets, as everyone ought to know that QE can not go on forever, and no reminder is necessary. However, every time the Fed even mentions that it had a mere discussion of a QE exit, the bond market and stock market have knee-jerk reactions with dips that are offset the same day, presumably by the so-called smart-money. But when the Fed announces the QE exit plan, smart money will not volunteer to offset a paradigm shift.

Opposing view - Mr. Mike Williams' recent article, "About That Margin Debt Everyone's So Worried About", June 3, 2013.

Support for the opposing view - Mr. Robert Wagner's recent article, "Higher Interest Rates Don't Necessarily Mean Lower Equity Prices - Seeking Alp", May 23, 2013.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Beware The Paradigm Shift, Especially If You're Margined