The Coming End Of Quantitative Easing And The Ensuing Market Correction

by: Nick Eliovits

US equities have passed irrational valuation levels across the bulk of sectors and the market has become uncomfortably close to an unsustainable level that is ripe for a sizable and likely volatile correction. Where we are today is a direct result of the Federal Reserve's quantitative easing program instituted to date.

As a background, the current quantitative easing program is summarized as follows:

The Federal Reserve (a semi-private / quasi-governmental institution) creates credit (essentially printing money) to buy mortgage backed securities and treasuries.

The following flow/cycle then takes place:

  1. Interest rates are kept artificially low as a result of the Fed purchases (the Fed can't simply lower rates anymore as they are "zero bound," so this is the only other policy option. It is also worth noting that this strategy has never been employed by any other Fed chairman, so the uncertainty of the eventual outcome provides a unique opportunity for the diligent to have profited from the artificial rise in liquidity, yet avoid or even profit yet again from the impending correction).
  2. Housing prices begin to artificially recover as the banks offer unsustainably low rate government insured loans to customers (Fannie single-family home loans since 2009 now represent 69% of their total outstanding single-family home loans).
  3. Consumer spending is strengthened (or prevented from weakening further in the case of this particular crisis at inception) as borrowing remains artificially cheap.
  4. Bond investors start buying corporate bonds instead of competing with the Fed for artificially low yield treasuries and mortgage-backed-securities.
  5. Yields on corporate bonds thus decline to artificial levels as bond investors turn their attention to the corporate market to find value.
  6. The dollar is artificially weakened.
  7. Dividend yields and stock appreciation become more attractive to both domestic and foreign investors as a result of the above.

The catalyst that will lead this asset bubble to burst is when the market anticipates that the Fed finally plans to indeed end its quantitative easing policies. I am not a soothsayer, so I can't predict when this will happen. However, the Fed has said that the easing will go on until inflation reaches 2.5% or unemployment reaches 6.5%. The latter is projected to be reached by Q1 2014 at the current pace of +/- 0.1% unemployment reduction per month. The Fed also can and has changed its targets several times since 2008 when QE1 began. In fact, as each of QE1, QE2, and QE3 drew to a close, the Fed determined that if they stopped creating artificial credit to buy additional securities, the bubble they had formed to date would have burst rapidly and sharply, thus QE4 and potentially even QE5++. The Fed is simply playing an economic guessing game to avert a second market crash at this point, and the Fed will likely continue to purchase almost $100B in assets each month until the chairman becomes satisfied that the economy will not burst into flames upon the program's halt. How long can the Fed keep buying assets with newly fabricated dollars? Forever, theoretically, or at least until congress stops the Fed, the Fed decides to stop, or market movements force the Fed's hand.

Oddly enough, what continues to happen is nothing more than a transfer of sugar-coated toxic assets and a manipulation of asset prices to extract capital from those with savings and divert them to borrowers, especially the Fed, which is using an infinite credit facility to buy such assets at risk/reward rates of return that reflect manipulated security valuations and will surely result in later losses.

If one believes that the Fed can successfully end quantitative easing, and that the market will simply go on as usual with the Fed just having simply absorbed over $2 Trillion++ in securities, not including whatever else they buy until their moving targets are reached, then the market correction should indeed be averted or delayed. However, that is simply wishful thinking, as upon the end of this program, the cycle will reverse quite rapidly (albeit slower than the change in market perception which is what really matters to affect equity prices) and:

  1. Almost $100B of monthly buying power will be sucked out of the market.
  2. Interest rates will precipitously rise.
  3. Yields will rise (bond values will fall).
  4. Equities will quickly become less attractive to asset allocators.
  5. The dollar will actually appreciate (albeit temporarily as there are fewer dollars being kept in circulation, since the Fed's artificially created dollars are no longer buying up assets).
  6. US exports will thus become less competitive.
  7. The housing market recovery will come to a halt and perhaps even reverse trend again.
  8. Foreigners will begin to liquidate US equities alongside domestic equity holders.

Among the worst anticipated sufferers in the US equity market from the impending correction/possible precipitous crash will be the countless companies with clearly downward trending or even prospectively illegal businesses that have maintained unjustifiable valuations or soared higher as a direct result of the massive amount of liquidity in the market:

GameStop (NYSE:GME), Pandora (NYSE:P), Group, Inc. (WWWW), JC Penny (NYSE:JCP), Best Buy (NYSE:BBY), Sears (SHLD), Coinstar (NASDAQ:CSTR), MajicJack (NASDAQ:CALL), Safeway (NYSE:SWY), Dun & Bradstreet Corp. (NYSE:DNB), and of course: Herbalife (HLF). Herbalife is a pyramid scheme. I have reviewed Ackman's case against the company in detail and the Herbalife business model in detail. It may take over a year from now to be exposed or it could happen sooner, but the stock will eventually collapse along with the business model.

These companies are all arguably trading at grossly over-valued capitalizations as a result of nothing more than excess liquidity, short squeezes that have exploited the massive short interest in such companies, limitations instituted on naked shorting by the SEC since the crash, massive stock repurchase plans in some cases, and the overall lack of remaining high quality investments with practical projected growth rates and sufficient market capitalization/volume to absorb sizeable capital investment. In fact, the average 1 year return as of May 2013 for the top 20 shorted stocks in the S&P 500 was 17.8% vs. 16.22% for the index itself. There is so much liquidity, that the worst companies that top fund managers and analysts have shorted are even outperforming the market as a whole.

Fundamentals appear to be of insufficient consequence to counter the massive trillions of dollars of liquidity injected into the capital markets since 2008 that has inflated asset prices across the board. All the Fed will have done when QE# is over is compounded the problem and transferred wealth from solvent parties to individual investors and entities that not only failed, but would have gone bankrupt or been reduced to zero value years ago. Every market participant will lose excess value upon this correction as a result, and the bailout benefactors will be in the same boat as the rest of the market.

Valuations in various over-invested sectors like fast casual dining (Chipotle (NYSE:CMG), Panera Bread (NASDAQ:PNRA), Buffalo Wild Wings (BWLD), etc.) will be hit particularly hard as well. These companies trade today at irrational multiples to earnings and will correct sharply in the first correction/liquidation round and especially in the rush to liquidity that follows. Ask yourself this question: Has any private restaurant in the world ever sold for 25+ times earnings? Has the S&P every maintained a P/E ratio above 20 without a correction to follow? No and No.

The housing sector also warrants a close look. Housing sector companies have performed exceptionally well as a result of the below conditions that have persisted in response to the crash in 2008:

· Manipulated "zero bound" interest rates

· Home-buyer tax incentives

· Loan work-outs

· The Fed's massive buying of mortgage backed securities

· The thriving rental market, which is also unsustainable as rent increases are outpacing income growth. (Side note: the economics of low borrowing costs have led to massive investments by family offices, wealthy individuals, and corporates like Blackstone to borrow at "zero bound" rates and buy homes out of foreclosure in bulk, while profiting from both the rental income / mortgage expense spread as well as the asset appreciation driven by the above polices.)

As such, the big winners that are being valued at unsustainable growth rates will underperform once again. Profit taking is ripe for companies like Home Depot (NYSE:HD), Lowe's (NYSE:LOW), KB Home (NYSE:KBH), Lennar (NYSE:LEN), and many others in the sector.

If you are investing in US equities, simply make sure that you only leave behind high growth stocks and stocks with very conservative earnings multiples and near-term earnings growth projections in your portfolio. There are still a plethora of both attractive high-volume and lesser-traded equities available at today's valuations (NYSE:CVRR), (NASDAQ:JMBA), (NASDAQ:ZNGA), etc.

Just remember a few things: The market will not correct sharply when the Fed ends quantitative easing, but when the market perception is such that the Fed is actually going to end quantitative easing. Pay close attention to every Fed move if you want to liquidate or perhaps even profit at that time. Most importantly, be extremely cautious and very limited as to what you keep or buy at this point, as the coming rush to liquidity (as evidenced in the 2008 crisis) will be asset-class agnostic.

Disclosure: I am short GME. 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.