Quantitative Dis-Ease Is Slowing The Market

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Includes: BUNL, BWZ, EDV, EZU, IEUR, IGOV, ITLY, IWM, SPY, TLT, VGK, VTI
by: David Cretcher

Summary

Quantitative dis-ease is taking money out of the US markets.

This money shortage combined with a stronger dollar is slowing growth in US markets.

Euro easing and a strong dollar will have the opposite effect in Europe and stimulate growth.

For the last few years, I have been investing from the general thesis that quantitative easing was creating an artificial government bond shortage. That is, when the Federal Reserve buys $80 billion per month of bonds, it then creates an $80 billion shortage of bonds in the private market. This action makes US bonds more scarce. The shortage drives up the price of the bonds and the interest rate of the bonds downward.

It also creates a second dynamic. There is now $4.5 trillion in unallocated investment dollars that would have been invested in government bonds that is needed to find somewhere else to be invested. If the Fed hadn't first purchased the bonds, the bonds would have been sold on the private market.

Figure 1: Total Assets held by Federal Reserve Banks

Some of this extra money has found its way into the stock market, helping to drive the price earnings ratio of stocks higher.

Figure 2: Total Federal Reserve Assets (blue) vs. S&P Operation Price Earnings Ratio (orange)

More Bonds Available

Last year the Fed, slowed and eventually stopped its bond purchases. Now, $80 billion that was going into private markets is instead going into the government bond market.

The effects of the dis-ease are showing on the Fed's balance sheet as the quantity of bonds starts to slowly decline as they mature. Remember, the Fed hasn't yet sold any bonds back into the market and the Fed may never sell these bonds; they may simply allow them to mature out.

Figure 3: Treasury bonds owned by Fed and Mortgage Bonds held by Fed (green)

The extra supply of bonds into the private market is starting to put downward pressure on some segments of the markets. We are seeing weakness in treasury bonds.

Figure 4: iShares 20+ Bond Fund 10-week moving average flattening

And in large-cap stocks.

Figure 5: Dow Jones Industrial average 10-week moving average moving sideways

And in the transports.

Figure 6: Dow Jones Transportation 10-week moving average declining

And also the municipal market.

Figure 7: iShares Municipal Bond Fund 10-week moving average leveling

And the agency market also appears at the beginning of a reaction.

Figure 8: iShares 20+ Bond Fund 10-week moving average starting to roll

Time will tell if the flattening is a coincidence or a reaction to the dis-easing, but clearly we are seeing some weakness in major markets.

The Exceptions that Prove the Rule

There are still exceptions to the theory. In spite of a Fed reduction of close to $30 million per year in mortgage bond purchases, at this point the mortgage bond market seems unaffected. Of course, the mortgage bond market was also unfazed by the Taper Tantrum of 2013. It seems to have a mind of its own.

Figure 9: iShares Mortgage Bond ETF 10-week moving average steady going

And the smaller stocks are unaffected.

Figure 10: Vanguard Extended Market ETF 10-week moving average still climbing

As is the corporate market.

Figure 11: iShares Corporate Bond ETF 10-week moving average still positive

Time will tell if these markets are an exception or just slow to react.

EQE is finally here

Just as the Fed has wound down its Quantitative Easing Program, the Europeans have finally motivated and started their own QE program. The European Central Bank will purchase $80 billion in European Bonds monthly. This is a larger QE program than the US on a relative basis.

Just as US QE spilled into Europe and the emerging markets, some of the European easing will spill into the US market. This will create new upward pressure on US markets and mitigate the slowing.

And We Change Partners

The big international investment driver is an increase in the supply of US bonds from the end of US quantitative easing and an decrease in supply of euro bonds from the new European quantitative easing. The amount of global easing hasn't significantly changed, although the euro QE is relatively larger than US QE was.

This should on a relative basis, generate slower US growth and faster euro growth. It should slow the P/E increases of US stocks and increase the P/E growth of euro stocks. Just the opposite of what happened in the last five years.

At the same time that Europe is being stimulated, the US is tightening from the end of QE and the effects of the appreciation of the dollar. The soaring dollar has the same economic effect as a rise in interest rates.

Investment Considerations

Investors should consider moving some allocations from the struggling large-cap stocks (NYSEARCA:SPY) (NYSEARCA:VTI) to European stocks (NYSEARCA:VGK) (NYSEARCA:IEUR) (BATS:EZU). Particularly euro stocks of exporters that will benefit from the stronger US dollar.

A shortage of European Bonds will continue to put upward pressure on the European bond market (NYSEARCA:BUNL) (NYSEARCA:BUND) (NYSEARCA:ITLY). There is also high euro exposure in IGOV, BWZ.

The low rates in Europe make the interest rates of US Bonds more attractive and will put upward pressure on US bonds (NYSEARCA:TLT) (NYSEARCA:EDV).

US stocks will benefit some from EQE but suffer from the soaring dollar and the change in US QE. Time will tell, but plan on a flat US market for the next few months.

Low oil prices will help the US economy and mitigate the effects of the ending of US QE. This and strong dollar will mean low inflation in the near future. Focus on small and mid-cap US stocks that are less likely to rely on foreign revenue (NYSEARCA:IWM).

Figure 12: Vanguard European ETF 10-week moving average - is this the first market reaction to European easing?

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 (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment have risk please consult your financial and tax advisers before investing.