Sowing The Seeds Of The Next Stock Market Crash: The Failure Of QE, Decoupling Equities, Economic Vulnerability, And Escalating Risks

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Includes: DIA, EPS, IVV, LLSP, RSP, RWL, RYARX, SDS, SFLA, SH, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SSO, UPRO, VFINX, VOO
by: Caiman Valores

Summary

Equity prices and the ongoing strength of the stock market do not represent economic reality.

Economic indicators highlight that the Fed's unconventional monetary policy of ZIRP and QE has failed to drive real economic growth.

There are signs that equity markets have decoupled from economic reality.

This decoupling has increased the vulnerability of equities to external shocks, increasing the likelihood of a severe market correction or even crash.

The growing multitude of economic, social, geopolitical risks is magnifying the likelihood of a sharp correction or a crash occurring.

It hasn't been plain sailing for the financial markets since the global financial crisis, with the world economy engulfed by a multitude of threats that has created considerable risks for markets and asset prices. This has triggered considerable volatility across financial markets with investors reacting sharply to any news that is perceived to be either good or bad.

Such an increase in volatility has added to the shroud of uncertainty surrounding the economy and markets in general, making it increasingly difficult to decipher the direction in which they will move.

Nevertheless, despite investors hating uncertainty, the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA) continue to defy gravity, with them now trading at close to record highs. This is quite surprising given the lack of significant improvement in the real economy and the basic economic fundamentals that support growth in equities.

These risks and failed fundamentals run the full gamut of the risk spectrum ranging from the failure of quantitative easing, declining corporate earnings, mounting global economic uncertainty and escalating geopolitical instability. Each risk probably does not have the singular ability to trigger a market crash, but with asset prices now decoupled from economic reality along with growing economic vulnerability, there is the real likelihood of another market crash.

Let's take a closer look at what has created this vulnerability and why it is priming the stock market for the next major correction or even market crash.

ZIRP, QE and the failure of unconventional monetary policy

No matter which way you cut it, the attempts of the Fed to resuscitate economic activity through the use of unconventional monetary policy have failed. This unconventional and extreme monetary policy, which we have become accustomed to, emerged from the global financial crisis when the Fed realized it needed to take urgent action to stimulate economic activity in order to prevent the next Great Depression.

The central planks of this policy are zero interest policy, or ZIRP, and quantitative easing, or QE. Both of these had common aims, to stimulate economic activity by increasing the money supply and encouraging banks to pump money into the economy.

To do this, the Fed set the headline rate at zero, making it incredibly attractive for businesses and consumers to borrow funds. Then, it implemented a strategy of buying assets such as government bonds from banks using electronic cash that didn't exist, in order to swell bank reserves, thereby encouraging them to lend more money.

All of this looked great in theory, and the performance of the stock market since the GFC with it trading at close to record levels certainly vindicates this.

However, upon digging a little deeper, it becomes apparent that unconventional monetary policy in the form of ZIRP and QE has failed. Even the Fed has admitted in a 2015 working paper that the link between economic growth and its policy is tenuous at best.

In fact, vice president of the St. Louis Fed, Stephen D. Williamson, found a range of faults with the central tenets of the policies implemented by the Fed in the wake of the global financial crisis. Key among his criticisms was that artificially low interest rates coupled with massive asset buying programs, which has swelled the Fed's balance sheet to $4.4 trillion, has had no tangible effect on boosting real economic activity.

Williamson went on to state in the working paper:

There is no work, to my knowledge, that establishes a link from QE to the ultimate goals of the Fed-inflation and real economic activity. Indeed, casual evidence suggests that QE has been ineffective in increasing inflation.

The failure of the Fed's policy and the deleterious effects that it is having on equity markets become apparent when considering a range of indicators that formed the basis of Williamson's appraisal.

The growing addiction to easy money

You see, markets are now addicted to the cheap money made available by QE, and it is this that has helped to push stocks ever higher despite a range of factors, including declining corporate earnings, failing to support this.

As the chart shows, as the Fed's assets have grown since the GFC, so too has the value of the S&P 500, underscoring just how addicted the stock market has become to the volumes of cheap money being pumped into the economy by the Fed as part of its QE program.

Click to enlarge

Source: Federal Reserve Bank of St Louis.

But the same can't be said for indicators of real economic activity, and this has caused asset prices to decouple from reality; just looking at the trajectory of the S&P 500 compared to corporate earnings confirms this.

The S&P 500 continues to move upward towards new heights whereas U.S. corporate profits, which logically are a key driver of stock market performance, are in decline.

Click to enlarge

Source: Federal Reserve Bank of St Louis.

This is quite a strange phenomenon because it highlights that equity values are decoupling from fundamentals.

The key culprit is the unconventional monetary policy that formed the strategy initiated by the Fed in 2008 to rescue the U.S. from its greatest economic catastrophe since the Great Depression.

Nonetheless, this strategy, or more specifically ZIRP, and QE have failed to stimulate real economic activity with the fundamental economic indicators highlighting that the real economic growth has not kept pace with the growth in equity values.

While the stock market has powered ahead since the crisis and the introduction of ZIRP and QE, inflation, a key indicator of economic activity, remains suppressed.

Click to enlarge

Source: Federal Reserve Bank of St Louis.

Despite being conditioned to believe that low inflation is a good thing, in this case, it certainly is not. In reality, inflation is an important indicator of economic activity, and low inflation indicates that the economy is not growing as strongly as it should.

In fact, U.S. inflation has rested permanently below the Fed's 2% target despite the protracted period of zero interest rates and the Fed's injection of $3.5 trillion into the economy as part of its asset buying program.

This is a bad thing because the lack of inflation is a key trigger for stagnant wage growth, which, as the graph indicates, is well below pre-crisis levels.

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Source: Federal Reserve Bank of Atlanta.

This lack of wage growth is resulting in weak consumer demand and consumption with consumer expenditures still well below pre-crisis levels as the chart shows:

Click to enlarge

Source: Federal Reserve Bank of St Louis.

This is a worrying trend because consumer spending accounts for 70% of GDP, so any downturn in consumption will have a sharp impact on real economic growth, feeding a vicious cycle of low inflation and sub-par wage growth, leading to weaker consumption.

The ongoing slump in consumption can also be attributed to a lack of confidence in the economy, which has caused consumers to save more, and stagnant wage growth, which has left them with proportionally less disposable income.

All of these factors are contributing to a lackluster U.S. economic growth, which, as the graph shows, remains relatively flat over the last six years and is trailing behind the rapid growth of the value of the stock market.

Click to enlarge

Source: Federal Reserve Bank of St Louis.

These factors highlight that the stock market's meteoric rise can only attributed to the vast sums of money pumped into the economy by the Fed's QE program and not because of any significant gains in economic activity. If anything, these traditional fundamentals, including declining corporate earnings, weak economic growth, stagnant wages and flat consumption, show that the economy is struggling.

Equities are extremely vulnerable to external shocks

This means that with equities continuing to move to new highs, regardless of weak economic fundamentals, they have decoupled from economic reality, making them particularly vulnerable to external shocks.

Some of the most obvious are changes in the Fed's policy with the market reacting sharply to news such as rate hikes and the tapering of QE. This is because that would stultify the pool of cheap money available that has in part been used for speculative activity and driven asset prices to unsustainable values that don't reflect underlying fundamentals.

Then, there are the range of external shocks that could easily derail the stock market and trigger a sharp correction because of its vulnerability to changes in monetary policy. Many of them center on the parlous state of the global economy, including:

  • Spill over from a hard landing in China;
  • the deep economic slump in the eurozone, which is showing little sign of improving despite the ECB's implementation of its own form of QE;
  • the impact of the Brexit, which, at this time, is difficult to quantify;
  • significant and growing instability in the Middle East;
  • an increasingly belligerent Russia; and
  • the sustained weakness of commodities, which is having a destructive effect on the majority of commodity-dependent emerging economies.

Then, there are the considerable number of emerging geopolitical risks, which on their own would have little long-term impact on financial markets, but in concert with the vulnerability of equities, the fragile state of the economy and growing global economic volatility, could trigger a correction that would cascade into a market crash.

Final musings

Investors are facing a brave new world where equity prices are being driven predominantly by the Fed's policy rather than economic fundamentals. The key reason for this is that markets have become addicted to the easy money virtually created by the Fed as it sought to rescue the economy from the GFC and stimulate economic growth through artificially low interest rates and a massive trillion-dollar asset-buying program.

Yet, despite the record highs of the stock market, the Fed's unconventional monetary policy has failed to drive any substantive growth in the real economy, leaving equity prices decoupled from economic reality. If the gap between equity valuations and economic fundamentals fails to close, the stock market remains extremely vulnerable to a market crash that could be triggered by the plethora of economic and geopolitical risks that exist globally.

One concluding meditation, regardless of the recognized failure of QE in the U.S., the same strategy is being played out across the world, in any place where central banks are determined to stimulate economic growth, magnifying the risks faced by the global economy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.