Stocks have moved dramatically higher off the 2009 lows based in part on the belief in the Fed's QE policy and in part based on very solid earnings growth. However, the Law of Diminishing Returns is readily apparent as it relates to QE. We just aren't seeing much impact on the two benchmark metrics the Fed asserts as the ones that must show improvement in order to begin the process of unwinding their balance sheet. Those two metrics are inflation and unemployment. Here is the chart of CPI:
(click to enlarge)
What we see is that QE 1 had a significant impact on inflation but each successive attempt to spur inflation and push it up to the desired 2% level has failed. The most recent data point on the chart shows that we are technically in deflation territory at this point as the rate is below the 0% line. In fact we've struggled to stay in positive territory through 2012 and 2013 as we have dipped below the 0% line 4 times.
Keynes explained the concept of a "liquidity trap" as a condition where policy efforts to expand money supply and in so doing to stimulate growth were effectively stymied by the propensity of individuals and businesses to hoard cash. In other words, if monetary or fiscal policy measures attempt to flood the system with liquidity and that excess money is spent to buy goods and services we grow the economy.
On the other hand if we don't spend that money we are in a "liquidity trap" and that produces a deflationary effect as the chart above indicates we are seeing today. The problem isn't the Fed's lack of effort - rather the problem is the underlying fear that we haven't really solved our problems and that fear means cash is hoarded.
Perhaps the most stunning chart one can look at today is the following chart of checkable deposits held by corporations:
(click to enlarge)
I have often thought the most astonishing chart one could look at was the massive increase in the level of excess reserves held by banks and we will look at that in a minute but the chart above speaks volumes about where we are today and what the prospects are for moving into a period of significant economic growth. The chart above is even more dramatic and significant in its implications and shows that corporate America has been the single beneficiary of monetary and fiscal policy and they are offering nothing in return as they are simply sitting on the massive transfer of wealth created by these policies.
When you see a chart that looks like the one above you must admit that history is useless in terms of predicting the future. The truth is we have never seen what we are seeing today. Does this chart suggest to you that corporate America is confident of the future or scared to death and hoarding cash to brace against what is to come?
Let's take a look at the most recent chart on excess bank reserves:
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The chart above shows that banks are in the same camp as corporations with no propensity to make bank loans. It can't be argued that the Fed hasn't done their part to feed the system with excess liquidity. We've never seen a surge in excess reserves like we've seen since the end of the Great Recession. The banks just aren't lending and there is a reason - no faith in the efforts of the government to stimulate the economy with fiscal and monetary policy. The banks remain fearful and therefore they are not making loans - loans we need to see in order to expand M2 and in so doing produce the inflation rate the Fed so desperately wants and needs.
The Fed insists that QE will continue - at least in some form - until we reach their targets on inflation and unemployment levels. We've already seen that QE is simply ineffective as far as inflation is concerned - in particular if banks won't lend and corporations won't spend. The chart below is the headline unemployment rate and the U6 unemployment rate:
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Granted we have seen some progress in this area but we are still substantially higher today than we were pre-recession. Perhaps the issue with unemployment is more structural than anyone wants to admit. In other words productivity advancements have been so dramatic that we simply don't need as many workers. After all a machine can paint a car better, faster and cheaper than a person and one clerk who can use an Excel spreadsheet with proficiency can crunch more numbers than dozens of clerks before the invention of electronic spreadsheets.
A look at the chart below demonstrates that corporate America has been the beneficiary of productivity advancements:
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The redline shows capacity utilization and the green line shows corporate profits using 2007 as a base year. Looking at this chart it is hard to argue the fact that corporate America hasn't taken full advantage of technological advancements since the end of the Great Recession. The problem is we are killing the goose that lays the golden eggs - the goose in this case being the middle class worker. In other words productivity advancements can result in short-term profits but at some point the demand destruction created by eliminating workers means that no further gains are possible and in fact profits must necessarily fall.
The following chart simply reinforces the point that we are in a liquidity trap:
(click to enlarge)
Total M2 expansion that has occurred substantially through the impacts of QE has been significantly outpaced by that portion of M2 that is held in savings and money saved is not money spent and does little to boost GDP growth or corporate sales. More troubling though is what the following chart demonstrates:
(click to enlarge)
The chart above shows that at the onset of the Great Recession personal savings spiked higher. It was a fear induced move that resulted in less spending and more saving. It seems logical to infer from the chart that as unemployment surged higher the total dollar amount of savings and the amount of savings as a percent of disposable income began to fall and the reason wasn't the result of a resumption of spending at a rate that existed prior to the recession but more the result of consumers needing to tap savings or reduce savings to meet basic living needs.
How QE has created a divergence between stocks and the economy
The argument that stocks can go higher is a 2 part argument. Part 1 has to do with QE and Part 2 has to do with corporate profits. We've dealt with Part 1 and the only conclusion we can reach based on an objective review of the efficacy of QE is that it has created an environment that has pushed investors into a high risk, yield chasing frame of mind. It cannot be said that the Fed has been effective at reaching their inflation and unemployment targets as they clearly have not and in fact there is a valid argument for why QE is actually counterproductive at this point. We need to discuss QE a little further in order to establish what the Fed has done to push stocks to all time highs but first let's take a look at Part 2 - corporate profits.
Lance Roberts does an excellent job of putting things in context with his article - Analyzing Earnings As Of Q3 2013.
Here is what Lance has to say on the matter:
In order for profitability to surge, despite rather weak revenue growth, corporations have resorted to four primary weapons: wage reduction, productivity increases, labor suppression and stock buybacks. The problem is that each of these tools create a mirage of corporate profitability which masks the real underlying weakness of the overall economic environment. The problem, however, is that each of the tools used to boost EPS suffer from diminishing rates of return over time.
The following chart is useful as a way of demonstrating the validity of the argument Lance makes:
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The chart above dates back to the 2009 lows and validates the claim that earnings have grown without a commensurate rate of growth in top line sales. Stocks during this period have appreciated by roughly 170% but the point is that in order to achieve such spectacular earnings growth without a commensurate growth in sales it is necessary to reduce costs and in so doing increase margins. All the data we have looked at in the first part of this article suggests that is exactly what corporations have done and of course that brings us back to the issue of diminishing returns going forward.
Can we continue to grow profits without growing sales as the prospects for growing sales don't look very promising? And is there any way we can grow sales if we continue to cut labor costs to expand profit margins? In other words we are back to the goose and the egg. If we kill the goose - American workers - then how do we expect those same workers to fuel sales growth?
From the Fed's perspective the only way to impact GDP growth resulting from their ill conceived "wealth effect" policy is for investors who have created new wealth from their ownership of stocks to convert those profits into cash and spend it. In other words if investors sold $850 billion in stocks and took the proceeds and spent 100% of that for goods and services we would see a 5% jump in GDP assuming a status quo in all other metrics. That of course translates to a modest jump in the top line sales of publicly traded companies.
The sad truth is that QE is just not growing the economy but it is clearly pushing stock price multiples higher and higher. In other words the Fed is creating inflation but only in risk assets. We will look at the transmission mechanism that is in play and pushing money into stocks through QE in a minute but first let's look at another of the charts Lance uses to demonstrate the smoke and mirrors efforts corporations are making to squeeze a little more out of per share earnings:
(click to enlarge)
The extremes corporations will go to in order to create the illusion of organic growth is unprecedented. What the above chart shows is that corporations see no other use for their balance sheet cash and are therefore willing to make a balance sheet move to expand earnings per share. Mind you this move doesn't increase corporate earnings and has nothing to do with the income statement at all. They are simply debiting the outstanding shares line item on the equity portion of the balance sheet and crediting the cash line on the asset portion of the balance sheet and in so doing they magically get a spike in earnings per share.
What seems most illogical in this strategy is the extremely short-term nature of the move. Clearly these companies are buying their stock back today at all time highs at a time when - based on their cash hoarding tendency and forward guidance - they see prospects for the future as weak. Does this make sense?
To fully appreciate the smoke and mirrors being used to push stock prices ever higher with a reckless abandon consider the following chart - again from Lance Roberts:
(click to enlarge)
Here is what Lance had to say about forward estimates:
The use of forward, operating estimates, is only beneficial to Wall Street analysts who need to create a "valuation" story when none really exists. Overly optimistic assumptions about the future spurs faulty analysis in the present as sliding earnings leads to sharp valuation increases.
The Fed seems determined to create an asset bubble in stocks
The real question is not whether the Fed will or won't create a bubble in stocks or even if we are currently in a bubble. The real question is how far the Fed will go with this insanity. And related to that question is this one - do they really have any choice at all but to continue with QE at this point?
The answer to the second question is yes they do have a choice but if they stop QE at this point stocks will fall dramatically and it can be reasoned that the economy will also be impacted negatively. On the other hand to continue to inflate stocks without the benefit of real organic growth is a very dangerous policy indeed.
Here is the problem and a problem that is different from times past. Earnings growth has been based almost entirely on cost cutting strategies and not real economic growth based on high employment, GDP growth, modest inflation and top line sales growth.
What is problematic is that the increase in the value of stocks has actually been based more on earnings growth at this point than multiple expansions but the growth rate is falling and has been for a while now meaning that the only way we've been able to push stocks higher in 2013 has been through multiple expansion. Even more important is the fact that the earnings growth realized by cost cutting appears to be fully exhausted in terms of further gains going forward.
That said the Fed's QE transmission mechanism could continue to drive stocks higher by adding more and more QE cash that is being re-employed by investing in stocks. For those who don't understand the transmission mechanism that drives money into stocks through the monthly purchase of bonds and mortgage backed securities let me explain.
Here is how it works - the Fed buys an asset from a primary dealer bank or in the alternative from a non-bank investor. If the purchase is from a primary dealer bank it increases the bank's cash balance in the form of expanding excess reserves held by the Fed. In this instance the cash doesn't expand M2 - it is just an asset exchange.
However, if the bank then uses the cash to buy a security from a non-bank investor that expands bank deposits and therefore M2. The non-bank investor will then use those cash deposits to buy another security - either stocks or bonds. In that fashion the Fed's transmission mechanism is driving money into stocks each time they buy a security and that pushes stocks higher.
The second possibility is that the Fed goes directly to a non-bank holder of the security they wish to purchase. The effect is the same but more direct. The Fed uses newly created money to buy the security and when that happens the seller has a new deposit that goes into the bank increasing M2. The problem is that the seller of the security will not end up spending that newly created money in the economy but use the money to buy another risk asset - in other words stocks.
The point is none of the Fed's money is moving into the economy as it would if a bank were to make a loan to a business or a consumer. In that instance the borrower would use the loan proceeds to expand GDP but what the Fed is doing instead is creating a situation where the system is being flooded with new dollars and almost none of those dollars are going into the economy - rather they are going into stocks and pushing stocks ever higher.
There is almost no benefit at all to the broad economy as a result of QE. The transmission mechanism works like this - the Fed buys a security with newly created money and the seller of that security buys a new security with that new money. Next month repeat process and push stocks a little higher. The month after that repeat process and push stocks a little higher. And the next month the same and the month after the same - apparently with no end in sight.
QE is doing nothing at all for the real economy and therefore almost no impact to GDP, inflation, corporate sales, employment levels or any other metric we use to measure real economic growth. No metric we look at is responding to QE except stocks. What that leaves us is a situation where top lines sales actually begin to fall and corporate profits begin to fall as stocks continue to rise.
What really bothers me
There are a number of things that really bother me about the current state of affairs and it has absolutely nothing to do with missing out on the rally as so many in the bull camp suggest. The truth is I was a little early in turning bearish stocks in 2007 and also a little early in turning bullish the market. I got bullish stocks around 900 in late 2008 when the Fed first embarked on QE so I missed the bottom a little but did ride the bull wave until September of 2012 when the Fed moved to QE3 at roughly 1475 on the S&P 500 (SPY).
And those who suggest I am talking my position don't know my position. I have been bearish since September of 2012 and based on the fact that QE is not working and that the economy didn't respond to policy stimulus this time unlike times past. To me that is prudent as I think capital preservation trumps short-term opportunity loss.
My strategy has been to employ a very small amount of money in percentage terms in out of the money put options in selected stocks and VIX ETFs. My losses playing the short side in this manner are highly leveraged and involve very small amounts of cash in relative terms and I will continue to follow this strategy. It is a strategy that produces a series of small losses and at some point one really big gain.
So I am not an angry bear. What bothers me though is that the Fed is persisting with a policy that is clearly not working and in so doing pushing investors into very high risk trades. This can't end well as we have no support under this market other than the Fed and once the Fed does make the decision to stop manipulating stock prices the sell off will be significant and rapid. More important - what policy moves - either fiscal or monetary are left if we do go back into recession?
What we have today is nothing more than a corner on the market and anyone who attempts this in the private sector is in violation of the law. According to Sec. 9 of the Securities Exchange Act of 1934 manipulation is addressed as follows:
Prohibition Against Manipulation Of Security Prices
Sec. 9. A. It shall be unlawful for any person, directly or indirectly, by the use of the mails or any means or instrumentality of interstate commerce, or of any facility of any national securities exchange, or any member of a national securities exchange -
(2) To effect, alone or with one or more other persons, a series of transactions in any security other than a government security, any security not so registered, or in connection with any security based swap or security based sway agreement with respect to such security creating actual or apparent active trading is such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.
Few doubt the Fed's direct attempt to manipulate stocks by driving investors out of fixed income and into equities. The Fed has acknowledged as much in numerous statements - both written and verbal. It is worth noting that the Act distinguishes between "a government security" and other securities and for good reason as one of the Fed's mandates is to control interest rates to effect price stability and the Fed - through the FOMC - has always manipulated bond prices to achieve the desired end as it relates to interest rates.
What the Fed has never done before is initiate a policy designed to manipulate stock prices and in fact it can be argued that the Fed's current policy - at least if it were being carried out by a private actor - would be in direct violation of the Act. Even though the Act makes no exclusion for the Fed in the language as it relates to manipulation one can rest assured the courts would figure out a way to absolve the Fed were a charge ever made against them.
We all have to play it as we see it and there will be those reading my comments that will disagree with my views. Some will assert that I have been wrong for the entire year and that paying attention to my views has cost them. No defense to that claim as I have failed to call a top but then my guess is that few - if any - bulls called for a high in the S&P of 1800 for the year 12 months ago or even 6 months ago.
We are now up 34% off the November 2012 lows. As of November 1, 2012 the Cyclically Adjusted P/E ratio was 20.89. Today it is 25.41. Looking at the more traditional trailing twelve-month as reported P/E ratio we have moved from 16.12 to 19.84. It is hard to say that the rally in stocks over the last 12 months has anything at all to do with earnings or economic growth and everything to do with an irrational, Fed induced blow off top.
I readily admit I don't know how much further we have to go on the upside at this point. I really believed common sense would take hold long before now so I will defer to the bulls who constantly criticize me for presenting data that supports the idea that stocks should sell off and ask them to offer up some evidence in support of higher prices and preferably something other than the idea that the Fed will continue to blow the bubble larger and larger or that stocks can go higher simply because we are still a little below the most extreme P/E highs.