It appears that the time has finally come. After over four years of nearly continuous support, it seems that monetary policy makers at the U.S. Federal Reserve are finally moving toward phasing out asset purchases over the next few months. While investment markets have already been reacting with consternation to varying degrees over this idea in the last few months, the phasing out of QE3 should be the least of investor worries. For as we look out into the long-term, the new Fed leadership starting in January will eventually find themselves dealing with a potential mess that could prove most difficult to clean up. Unfortunately, the potential outcomes once asset purchases end bode ill for the stock market outlook.
What Hell Hath The Fed Wrought?
The U.S. Federal Reserve first embarked on its unprecedented monetary policy program now known as quantitative easing starting back in late 2008 in the wake of the financial crisis. Having already lowered short-term interest rates to 0%, the Fed began purchasing assets with longer maturities in an effort to lower interest rates further out the yield curve. At first, the initial stated intent of this program was to prevent the economy from imploding including the avoidance of a deflationary spiral. By April 2010, the global financial system had successfully been pulled back from the brink and the Fed's QE program had drawn to a close.
The Fed could not leave well enough alone. What followed over the next few months in the summer of 2010 was some understandable market volatility as the financial system was being left to stand on its own for the first time since the outbreak of the financial crisis. But instead of allowing the markets to work through these natural adjustments and get back on its feet, the Fed quickly returned with more policy support in the form of QE2, which was effectively announced at Jackson Hole in late August 2010. But instead of rescuing the global financial system, the implied intent of continuing these extraordinary monetary policy measures was to artificially inflate asset prices in the hopes of creating a wealth effect that would be supportive of economic growth. With this action, what was once extraordinary became ordinary. And over the three years since, we have had two Operation Twists and yet another asset purchase program in QE3. Today, what was once extraordinary has become not only ordinary but also demanded by a now addicted marketplace. Unfortunately, the withdrawal from addiction is never a pleasant experience.
The inflation of the stock market (SPY) has yielded little sustainable advantage. Yes, the Fed has succeeded in lifting stock prices back to fresh new highs. But any benefit associated with this effort has not flowed through to the bottom line for the U.S. economy. Not only is U.S. Real GDP growth mired at levels well below the long-term historical average, but the pace of economic expansion has also been increasingly fading for the past two years.
Unfortunately, the effort to boost the economy by inflating asset prices has come at a potentially great cost that may prove difficult to recover in the years ahead. Prior to the outbreak of the financial crisis in late 2007 and early 2008, the size of the Fed's balance sheet at less than $900 billion represented roughly 6% of nominal GDP. But with the advent of the QE era, this percentage has risen dramatically in recent years. Today, the Fed's balance sheet has ballooned to a total of $3.64 trillion that is nearly 22% of nominal GDP. And even if the Fed announces the intention to begin tapering asset purchases in September, the balance sheet will continue to expand and is likely to breach the $4 trillion level, or nearly 25% of nominal GDP, before it's all said and done.
Thus, the U.S. Federal Reserve through it persistently aggressive monetary policy has now effectively printed money that amounts to one-quarter of the entire U.S. economy. Had the Fed shown restraint back in the summer of 2010 and not plunged back into the QE pool, the money printing would have peaked at just over 15%, which is still a notably high number. But the more the Fed has opted to pursue QE, the greater the risks facing financial markets in the end.
So What's Really The Big Deal?
So the Fed has printed a lot of money. So what? The U.S. economy is generating lackluster but still positive growth, inflationary pressures remain subdued and financial markets appear generally stable. If all of this money printing is such a big problem, why are we not seeing any evidence of it? To answer this question, it is worthwhile to reflect on the words of Fed Chairman Ben Bernanke himself during his 60 Minutes interview from March 2009.
"Well, I do remember one conversation I had where I was addressing a caucus of congressmen. And a congressman said to me, 'Mr. Chairman, you know, I'm talking to bankers in my town. I'm talking to shopkeepers in my town. And they say things are normal. Nothing's going on. We don't see any problem.' And I turned to him and I said, 'You will,'"
-U.S. Federal Reserve Chairman Ben Bernanke, 60 Minutes, March 2009
While the topic on which Mr. Bernanke was speaking at the time was entirely different, the spirit of his answer is most relevant today. Just because things are normal, nothing's going on and we don't see any problem does not mean that significantly disruptive forces are not building underneath the surface. When Mount St. Helens erupted in May 1980, it had been dormant for over 120 years and didn't even begin to show signs of instability until just two months prior in March 1980. And instead of fearing the situation, many mountain property owners were pressuring authorities and demanding access to their homes up to the day of the eruption. Hopefully investment markets are not met with such a similar surprise.
The critical issue facing the U.S. economy and financial markets going forward is the following. The U.S. Federal Reserve has printed a total of $2.75 trillion since the outbreak of the financial crisis. And they stand to print at least another $350 billion to $500 billion if not more over the coming year. At present, roughly $2 trillion of this money is currently sitting as excess reserves on the balance sheets of major U.S. financial institutions. But this money is not going to stay there forever. Instead, it is eventually going to go in one of two places.
1. It is going to be lent out into the economy, which has the potential to become massively inflationary given the amount of these excess reserves relative to the overall size of the economy.
2. It is going to be drained back out by the U.S. Federal Reserve, which has the potential to become disinflationary if not outright deflationary given the amount of money major financial institutions will need to return back to the Fed.
One outcome leads to sharply rising inflation. The other outcome leads to potential deflation. Neither outcome implies the price stability of low and stable inflation. This is highly problematic for investment markets, since price stability is a critical element in supporting sustainably rising asset prices including stocks. Conversely, unstable prices almost always result in falling stock prices.
Looking back over the last century highlights this point. During periods of price stability where the inflation rate was stable between 0% and 5% (highlighted in yellow in the chart above), the valuations for stocks as measured by the cyclically adjusted price-to-earnings ratio steadily increased. However, when inflationary pressures spiked above 5% or when deflationary forces broke out with the CPI moving into negative territory, stock valuations plummeted.
This is problematic for stocks today for the following reason. Stock valuations remain elevated by historical standards. And with a cyclically adjusted price to earnings ratio at 24, valuations are still multiples above the 5 to 10 range that historically has marked the end of past secular bear markets, this suggests that quite a bit of air could come out of stock prices if an outbreak of pricing instability suddenly presents itself. And if it turns out that earnings on the S&P 500 have also been artificially inflated by persistently aggressive monetary policy, this would only add to the downside pressure for stocks if such a pricing episode were to take place, as the "E" in the P/E ratio would be falling at the same time that the "P" is going down, keeping valuations elevated despite falling stock prices.
All of this might help to explain why we have seen the prices across so many asset classes come off sharply in recent months. For the transition from asset purchase dependence to the stark reality of eventual withdrawal of stimulus and potential pricing instability stands to be a challenging experience not only for stocks but investment markets in general to say the least. The following is a list showing the magnitude of the corrections from recent peaks across key asset classes since the beginning of May when the indication that Fed asset purchases may soon be drawing to a close first surfaced:
Emerging Market Stocks (EEM): -14%
High Yield Bonds (HYG): -5%
High Yield Munis (HYD): -13%
Preferred Stocks (PFF): -8%
REITs (VNQ): -17%
Long-Term U.S. Treasuries (TLT): -17%
U.S. TIPS (TIP): -10%
National Municipal Bonds (MUB): -8%
Investment Grade Corporate Bonds (LQD): -9%
Clearly, the damage across asset classes has been both deep and widespread. And the extreme damage to gold (GLD) and silver (SLV) going back to January has also been well documented. But one category is conspicuously missing from the list above. It is the U.S. stock market, of course, which is down less than -4% on the S&P 500 Index from its all time high reached only a few weeks ago.
The lack of downside participation by the U.S. stock market presents a considerable downside risk for investors going forward. Unfortunately, the only investment category to which most people pay attention is the U.S. stock market. As long as U.S. stocks are hanging in there, many simply assume that everything must be OK. But with so much downside occurring outside the stock market in recent months, it is highly unlikely that the U.S. stock market is right and so many other asset classes are wrong, particularly when stocks have historically lagged in their timing to the downside during major corrections. And the wider this performance disconnect becomes, the more pronounced the subsequent correction in stocks is likely to be.
This is particularly troublesome given the seeming inability of stock investors to tolerate any downside at this point. The fact that a recent -3% decline in stocks already has commentators and analysts rolling back out the "taper tantrum" banners again is notable. For if -3% is already causing unease, how will a stock decline in the -10% to -20% range like so many of the categories shown above impact already fragile investor psychology. It will be interesting to see, but it has the potential to build upon itself quickly, particular with margin debt back at all time highs.
For all of these reasons, a high degree of caution in managing investment portfolios is warranted at this juncture. For if the Fed does decide to go ahead with scaling back its QE asset purchase program starting in September, the recent decline in stocks may only be the tip of a very large iceberg.
Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.