Fed Abandons Stock Markets In 2015, Watch Out

Summary

• The powerful rallies of 2013 and 2014 were driven by extreme Fed money printing to buy up bonds, and the Fed's associated implied backstop for the stock markets.
• But with QE3’s new buying terminated and any QE4 a political impossibility with the new Republican Congress, 2015 is going to look vastly different without QE.
• With the Fed’s balance sheet and zeroed interest rates finally starting to normalize in 2015, the lofty and overvalued Fed-levitated stock markets are in for some tough sledding.

The seemingly-invincible US stock markets powered higher again last year, still directly fueled by the Fed's epic quantitative-easing money printing. But 2015 is shaping up to be radically different from the past couple years. The Fed effectively abandoned the stock markets when it terminated its bond buying late last year. So this year we will finally see if these lofty stock markets can remain afloat without the Fed.

Mainstream stock investors and speculators are certainly loving life these days. The flagship S&P 500 stock index enjoyed an excellent 2014, climbing 11.4%. And that followed 2013's massive and amazing 29.6% blast higher! The last couple years were truly extraordinary and record-breaking on many fronts, with the US stock markets essentially doing nothing but rally to an endless streak of new nominal record highs.

Such anomalously-one-sided stock markets naturally bred the extreme euphoria universally evident today. Greedy traders have totally forgotten the endlessly-cyclical nature of stock-market history, where bear markets always follow bulls. They've convinced themselves that these stock markets can keep on magically levitating indefinitely, that major selloffs of any magnitude are no longer a threat worth considering.

But extrapolating that incredible upside action of 2013 and 2014 into the future is supremely irrational, because its driver has vanished. The past couple years' mammoth stock-market rally was completely artificial, the product of central-bank market manipulation. The Federal Reserve not only created vast sums of new money out of thin air to monetize bonds, but it aggressively jawboned the stock markets higher.

Virtually every time the Fed made a decision, or its high officials opened their mouths, the implication was being made that it wouldn't tolerate any material stock-market selloff. The Fed kept saying that it was ready to ramp up quantitative easing if necessary. Stock traders understood this exactly the way the Fed intended, assuming the American central bank was effectively backstopping the US stock markets!

This short-circuited the normal and healthy way stock markets operate, cyclically. In normal times when stock traders grow too greedy and bid stocks up too high too fast, corrections periodically arrive. They drag overextended stocks back down, kindling fear and restoring critical sentiment balance. But with the Fed convincing stock traders it was ready to arrest any significant selling, they naturally lost all fear.

With the Fed printing money with reckless abandon, every minor stock-market dip was quickly bought. But with no significant selloffs to rebalance sentiment, greed flourished out of control. That eventually forced the stock markets to today's immensely overextended and overvalued levels, which stock-market history shows are exceedingly dangerous. The Fed distortion in these markets is extreme beyond belief.

And it has to end badly. The material selloffs in ongoing bull markets that the Fed foolishly chose to suppress keep sentiment balanced. They prevent greed from growing so extreme that it sucks in too much near-future buying. If euphoria pulls enough buying forward, there aren't enough new buyers left to continue propelling the bull higher so it collapses under its own weight. We're reaching that point.

Wildfires are a fantastic analogy. The longer a forest grows without suffering any significant fires to clear out flammable underbrush, the greater the conflagration when some wildfire inevitably erupts. Fire-suppression efforts, however noble, simply ensure the wildfire fuel sources will balloon to dangerous proportions. Stock markets are like the forest, and periodic corrections are like smaller fires that burn away fuel.

By aggressively inflating its balance sheet through money printing, the Fed artificially suppressed all the normal healthy stock-market selloffs that should have rebalanced sentiment. But back in late October, it ended its latest QE3 bond-monetizing campaign. And with this new year ushering in a new Congress dominated by anti-Fed Republicans, it is politically impossible for the Fed to launch any kind of QE4.

So the Fed's wildly-unprecedented balance-sheet growth of recent years is over. 2015 will actually be the first year since 2007 without any quantitative easing! And as this stacked chart of the Fed's balance sheet shows, a year without monetizing bonds is going to be a big shock to stock traders. Orange is the total balance sheet, red is monetized US Treasuries, and yellow shows the Fed's mortgage-backed securities.

Today's stock-market mess began with 2008's epic once-in-a-century stock panic. In its dark heart that October, the benchmark S&P 500 stock index (NYSEARCA:SPY) plummeted a sickening 30.0% in a single month! The Fed, fully realizing stock-market levels exert a huge influence over national economic activity, panicked. It slashed interest rates to zero in December 2008, and started printing money hand over fist to buy bonds.

In the first 8 months of 2008 before that stock panic, the Fed's balance sheet averaged $875b. But by the end of 2008, it had skyrocketed 154% higher to $2218b. Once it put its foot on the money-printing pedal, the Fed was terrified of letting off. So it converted its temporary QE buying during the stock panic to quasi-permanent holdings of US Treasuries and MBS bonds. This helped its balance sheet keep on ballooning.

QE1's debt monetizations were born, and soon expanded. After its pre-announced buying fully ran its course, the Fed followed the same pattern in QE2 and the so-called Operation Twist. That campaign shifted Fed capital from short-term Treasuries to longer-term ones in an attempt to manipulate interest rates lower. And finally QE3 came along, which proved far different from those other QE campaigns before it.

QE1, QE2, and Twist, despite their expansions, all had pre-announced levels of Fed money printing and debt monetization. But QE3 didn't. QE3 was totally open-ended, which was wildly unprecedented. With no pre-determined limit, the psychological impact of QE3 on stock traders was vastly greater. The Fed kept implying it was ready to expand QE3 anytime if stock markets needed help, and traders believed it.

The cyclical stock bull following the preceding cyclical bear climaxing in 2008's stock panic was totally righteous before QE3 came along in late 2012. Between the March 2009 cyclical-bear bottom and early September 2012 before the Fed announced QE3, the SPX powered 112.5% higher over 42 months. This was right in line with average mid-secular-bear cyclical-bull precedent of a doubling in 35 months.

The Fed's balance sheet was flat in 2009 as it shifted temporary stock-panic QE into enormous MBS and Treasury purchases. The SPX rallied 23.5% higher that year, which is totally expected after a panic-grade selloff. Then in 2010 when the Fed birthed QE2 which initially just converted MBS holdings into Treasuries, its balance sheet grew 9%. And the SPX's strong gains tapered off to a more normal 12.8%.

But in late 2010, QE2 was effectively tripled to include massive new Treasury buying. And most of that happened the following year, which led the Fed's balance sheet to balloon by 21% in 2011. Yet despite that, the SPX was dead flat and looking increasingly toppy in early 2012. So in September that year, the Fed birthed the unprecedented open-ended QE3. This was subsequently more than doubled shortly later in December.

Since QE3 didn't ramp up to full speed until early 2013, the Fed's balance sheet was flat in 2012. Yet the SPX was still able to muster a 13.4% gain on a still-normal-yet-maturing cyclical bull market. Up until about SPX 1500 in early 2013, the stock-market gains from the early-2009 bear-market lows were totally righteous. The Fed's extreme QE3 distortions began to manifest in early 2013, and have greatly worsened since.

2013 was the only full year of QE3, and it witnessed incredible monetary inflation as you can see in the chart above. That year the Fed's balance sheet rocketed up by a staggering 38%! That was its biggest percentage increase by far since that 2008 stock-panic year. And in absolute terms, 2013's $1107b of Fed balance-sheet expansion nearly rivals 2008's crisis $1345b! 2013 was an exceedingly-anomalous year.

That gargantuan money printing, and the associated Fed jawboning about backstopping stock markets, catapulted the SPX 29.6% higher in 2013! The correlation between the soaring stock markets and the soaring Fed balance sheet was nearly perfect, as the next chart below reveals. The vast sums of money the Fed was creating out of thin air to monetize debt were effectively finding their way into the stock markets!

The Fed started to wind down QE3's new buying in 2014, which reduced its balance-sheet growth to a 12% pace. But starting from such supremely-inflated levels, that was still another $486b of new money conjured from nothing! And there's no doubt 2014's still-massive monetary expansion was the primary driver of last year's strong 11.4% SPX up year. The Fed goosed the stock markets in 2013 and 2014.

But even this hyper-dovish Keynesian Fed gradually realized it can't print hundreds of billions of new dollars a year forever and not trigger massive and serious inflation. So it finally shut down QE3's new buying in recent months, although it still plans to roll over money from maturing bonds. In the relatively-short 6.3-year span between late 2008 and today, the Fed has more than quintupled its balance sheet to $4472b!

To put that into perspective, the Fed started publishing its balance-sheet total in November 1990. In the 17.8 years between then and the dawn of late 2008's stock panic, the Fed's balance sheet merely grew by 3.1x. Compare that to the 5.1x in the QE era since then which is only just over a third as long! There has never been a remotely comparable extreme period of new money created in the Fed's entire 101-year history.

And while all that inflation didn't filter down to normal Americans and catapult general price levels higher, yet at least, it did deluge into the US stock markets. This next chart is incredibly damning, and reveals the terrible problem the stock markets face in 2015. When the SPX is overlaid on top of the Fed's balance sheet, the correlation is incredibly high. Without more Fed inflation, these stock markets are in serious trouble.

Even though the cyclical stock bull between early 2009 and late 2012 was righteous, the powerful SPX advance still mirrored the Fed's balance sheet remarkably well. When the Fed was printing money to buy Treasuries, ramping up its total holdings, the SPX surged higher. But whenever the Fed's balance sheet merely stalled out, first between QE1 and QE2 and later between QE2 and Twist, the SPX corrected hard.

Provocatively the only two full-blown corrections, 10%+ selloffs, of this entire cyclical bull happened when the Fed's balance sheet stopped growing in mid-2010 and mid-2011. The SPX corrected 16.0% in 2.3 months in the first one, and 19.4% in 5.2 months in the second. Those are enormous selloffs by the standards of the past couple years, when the Fed's extraordinary QE3 stock-market levitation was in force.

Since the Fed birthed QE3 in late 2012 right before that year's critical US elections, there have been no correction-magnitude selloffs. The extremely-greedy popular sentiment fomented by the Fed has never been rebalanced away, like tinder-dry undergrowth in a forest. The biggest pullback of the past couple years' Fed-driven levitation is merely 7.4% climaxing in October 2014, which was far too small to do any real good.

In normal healthy bull markets, correction-magnitude selloffs erupt about once a year or so on average. As of the latest SPX nominal record high this week, it has been an astounding 39 months since the end of the last correction! The Fed's implied backstop for the stock markets through QE3 is solely to blame for this extreme anomaly. Such a long sans-correction span in such lofty euphoric markets is a recipe for disaster.

If the Fed hadn't effectively suppressed any stock-market selloff serious enough to bleed away greed and kindle some real fear, things would look far different today. The stock markets would be nowhere near as high, and today's universal euphoria would be far less extreme. Like those wildfires, the longer that correction-magnitude selloffs are suppressed, the bigger and meaner the inevitable rebalancing one will be.

The already-mature stock-market cyclical bull was in the process of topping in 2012 before the Fed chose to goose the stock markets with its unprecedented open-ended QE3. Ever since then, the SPX's advance has been super-highly-correlated with the Fed's balance sheet. A nearly-ironclad argument can be made that everything since 1500 in the SPX in early 2013 was nothing but Fed-blown hot air.

Stock-market valuations reveal that the great majority of the past couple years' extraordinary SPX rally was the result of multiple expansion, not higher earnings. Stocks were not bid higher because their underlying corporations were earning larger profits relative to their share prices, but due to the Fed's strong psychological incentives to buy high in a surreal correction-less market. Those have now vanished.

While the Fed announced the end of QE3 in late October, its balance sheet has still grown gradually since. The fact the stock markets haven't corrected yet has led many bulls to believe the end of QE3 is no threat to the euphoric stock markets. But history certainly doesn't support that cavalier dismissal of the post-QE3 risks. The last stock-market corrections in 2010 and 2011 erupted when the balance sheet started retreating.

That's on the verge of happening again today for the first time since 2012, before the QE3 levitation. Although the Fed has pledged to keep rolling over QE-purchased bonds into new ones as they mature, there is bound to be some modest balance-sheet shrinkage for technical reasons. And it will be very interesting to see if the stock markets can continue rallying when that happens, as history argues they likely can't.

Without QE or even the prospect of QE in 2015, the Fed's implied backstop for the US stock markets no longer exists. Sooner or later some selling catalyst will arrive, probably out of Europe like back in 2010 and 2011. And as investors and speculators start to exit stocks, that selling will cascade as there will be insufficient quick buy-the-dip capital inflows with the Fed no longer actively convincing traders to flood back in.

And the Fed abandoning the stock markets in 2015 with QE's new buying gone is only part of the big Fed-driven risks these lofty overvalued stock markets now face. Sooner or later the bond markets are going to force the Fed's hand in hiking interest rates from zero, where they've remained continuously since those temporary crisis levels were imposed in late 2008. Rising rates are super-risky for expensive stock markets.

And make no mistake, the SPX is very expensive today with its 500 elite component stocks trading at an average trailing-twelve-month P/E ratio of 25.1x late last month! Historical fair value is just 14x, far below current Fed-inflated levels. Today's very expensive valuation multiples are the result of both the Fed's QE3 stock-market levitation and manipulated artificially-low interest rates. Rate hikes will change everything.

As rates rise, overvalued stocks are hammered on multiple fronts. Rising rates make bonds relatively more attractive, so conservative investors sell overpriced stocks to return to bonds. And rising rates also directly hit profits, making stocks look even more expensive. They increase borrowing costs at the same time they retard sales as companies' customers are forced to cut back on their own spending. So stocks get hit hard.

Thanks to the Fed, the SPX's cyclical bull has soared an astonishing 209.0% higher over 5.8 years, far beyond historical averages. This propelled the stock markets to their highest nominal levels since their last secular bull peaked in early 2000. And couple that with stocks priced near 25x earnings, not far from the 28x historical bubble level, and rising rates along with a shrinking Fed balance sheet is a huge problem.

The last time the Fed raised its main federal-funds rate was way back in June 2006. So 2015 will be the first time in about 9 years that the stock markets have had to deal with rate hikes, right at the time they are the highest and most vulnerable. The smart bet to make in such a scenario is certainly the contrarian one, that no QE, a shrinking Fed balance sheet, and higher rates are going to lead to major stock selling this year.

The euphoric bulls won't even entertain that possibility, another topping indicator. They claim QE was a wild success and now the US stock markets can keep on powering higher indefinitely without the Fed. But there's a fatal flaw in this argument, QE and the associated zero-interest-rate policy remain far from over. No one knows the true impact of QE until the Fed has fully normalized its balance sheet and interest rates!

Until QE is totally unwound, which means the Fed's balance sheet returns to that $875b level where it was before 2008's stock panic, QE isn't over. And even though uber-dove Janet Yellen has promised never to return to those levels, the Fed's balance sheet still has to shrink dramatically from today's crazy extremes. And the normalization on the interest-rate front is every bit as extreme and dangerous for stock markets.

In the quarter-century between the early 1980s rate spike and 2008's stock panic, the federal-funds rate averaged 5.3%! So interest rates aren't normalized in the post-ZIRP era until they return to such high levels by recent standards. Traders have no idea if these Fed-inflated stock markets can stand on their own feet until the Fed's balance sheet shrinks back to $875b and the Fed's key federal-funds rate soars over 5%!

So prudent investors and speculators need to be exceedingly careful in 2015. The extreme stock-market rally of the last couple years was the product of Fed manipulation, and those gale-force tailwinds are now reversing into howling headwinds for the stock markets. Without the Fed's implied backstop that was such a powerful psychological motivator for traders in recent years, 2015 is going to prove a far-different ballgame.

The bottom line is the Fed has abandoned the stock markets. The powerful rallies of 2013 and 2014 were driven by extreme Fed money printing to buy up bonds. But with QE3's new buying terminated and any QE4 a political impossibility with the new Republican Congress, 2015 is going to look vastly different. A shrinking Fed balance sheet sparked major corrections even from far lower and cheaper stock levels.

With the Fed's balance sheet and zeroed interest rates finally starting to normalize in 2015, the lofty and overvalued Fed-levitated stock markets are in for some tough sledding. The implied backstop that enticed and forced so many traders to over-deploy in the stock markets in recent years has vanished. And the serious gravity of the Fed's absence will become readily apparent once the next selloff starts cascading.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.