The U.S. stock markets have suffered their worst early-year losses in history in young 2016, an ominous proof that a major trend change is underway. The Fed's new tightening cycle is already slaying recent years' extraordinary easy-Fed-fueled stock-market levitation. Unfortunately the only possible reckoning after such a record artificial stock boost is a long-overdue major bear market that is finally awakening.
Just a month ago, the stock markets looked radically different. The Federal Reserve's Federal Open Market Committee that sets monetary policy mustered the courage to hike rates, ending exactly 7 years of a record zero-interest-rate policy. Stock traders rejoiced, interpreting the first rate hike in 9.5 years as a sign the Fed had great confidence that the U.S. economy was improving. So they bid stocks higher that day.
The benchmark S&P 500 stock index (SPX) surged 1.5% to 2073 the afternoon of the Fed's first-ever ZIRP-ending rate hike. That was merely 2.7% under the SPX's all-time record high seen just 7 months earlier in late May. Euphoric Wall Street strategists spent the next couple weeks calling for that powerful bull market in stocks to continue in 2016, with plenty of predictions for the SPX climbing another 10%+ this year.
But something snapped as this new year dawned, unleashing waves of selling. Enough stock traders worried that an anomalous stock bull fueled by the Fed's ZIRP and quantitative-easing money printing might not fare so well without ZIRP and QE. Since that first rate hike since June 2006 was so close to the new year, they waited to 2016 to realize their big gains which delayed their taxation for an entire year.
So instead of rallying in recent weeks in line with early years' strong upside bias on new capital inflows from pension funds and year-end bonuses, the stock markets have plunged. The SPX has lost a truly breathtaking 7.5% in 2016's mere 8 trading days as of the middle of this week! The massive selling that is necessary to drive such a drop has been relentless yet orderly, with insufficient fear to mark a durable bottom.
As I warned last June just weeks after the SPX's record high as euphoria reigned supreme, the Fed shift is a major stock-market risk. The U.S. stock markets had perfectly mirrored the Fed's increasingly-bloated balance sheet since the dawn of the wildly-unprecedented QE and ZIRP era in late 2008 in response to that year's stock panic. Whenever the Fed was actively monetizing bonds with QE, stock markets rallied.
But when both QE1 and QE2 ended, the stock markets corrected hard. Popular greed had grown so epic that the end of the final QE3 bond-buying campaign in October 2014 was shrugged off. Yet the SPX's QE-fueled momentum soon stalled out anyway, with this flagship index peaking less than 7 months later. While the new bond monetizations ended with QE3, the Fed hadn't started selling its gargantuan holdings.
As recent weeks are proving, the final nail in the Fed stock levitation's coffin was the end of ZIRP less than 14 months later in December 2015. But the Fed-boosted stock bull was already in topping mode. During that long span between the Fed ending QE's new buying and executing its initial rate hike, the SPX only edged 3.1% higher. The end of ZIRP is even more ominous for stock markets than the end of QE.
The 7 years of ZIRP and QE had openly manipulated short and long interest rates to record lows. Corporations took advantage of the deluges of cheap money to borrow with a vengeance. But instead of using these vast amounts to actually grow their businesses and hire people, the great majority of it went into pure financial engineering. It was used to buy back stocks, boosting share prices and apparent profitability.
According to the Fed, U.S. non-financial corporations spent a staggering $2.24t buying back their stocks since 2009. And the Fed reports they borrowed $1.9t to do this, so over 5/6ths of all the stock buybacks of the ZIRP era were debt-financed! Without record-low interest rates, the economics of such stock buybacks crumble. And they have been recent years' overwhelmingly-dominant source of stock demand.
The 2015 stock-market action reflected the dire implications of the end of QE and ZIRP, which euphoric traders foolishly chose to ignore. As this first chart shows, the U.S. stock markets stalled out before rolling over to form a giant rounded topping pattern in the past year or so. That gradually eroded all the bullish psychology enough to start breaking it in early 2016. But the flagship VIX fear gauge shows no bottom in sight.
Stock traders are notorious for their myopic shortsightedness. Their opinions on market outlook are just dominated by the latest action from recent days and weeks. But much-longer-term context is necessary to understand why a major stock bear is awakening. And to the great peril of everyone who refuses to study the bigger picture, the serious stock selling seen so far in 2016 is only the very tip of the iceberg.
Despite the vast distortions caused by QE and ZIRP, the stock markets behaved normally between 2009 and 2012. They had just plummeted in a once-in-a-century stock panic in late 2008, so a major cyclical bull market was due as I predicted in early 2009. By September 2012 just days before the Fed launched QE3, the SPX had powered 112.5% higher in 3.5 years. Its bull-market trajectory to that point was totally normal.
The stock markets would rally for a year or so, and then correct. These 10%+ declines in stock prices are normal and healthy in bull markets, as they rebalance sentiment before greed grows too excessive. It's provocative to note though that both major corrections in the SPX in that era ignited right after the Fed's massive QE1 and QE2 bond-monetization campaigns ended. So the Fed was already distorting stocks.
But in September 2012, the Fed birthed its wildly-unprecedented QE3 campaign. It was very different from QE1 and QE2 in that it was open-ended, with no predetermined size or end date. QE3 was soon more than doubled in December 2012 to an $85b-per-month pace of conjuring new money out of thin air to buy bonds. Fed officials deftly used QE3's undefined nature to actively manipulate stock traders' psychology.
Every time the stock markets threatened to sell off since early 2013, top Fed officials would rush to their microphones to declare they were ready and willing to expand QE3 if necessary. This was interpreted by stock traders exactly as the Fed intended. They started to believe an effective Fed Put was in place, that the Fed would quickly ramp its record easing if necessary to arrest any material stock-market selloff.
So the stock markets started levitating, decoupling from their normal bull trajectory. Not wanting to fight the Fed, traders began ignoring all conventional sentimental, technical, and fundamental indicators to aggressively buy every minor dip. This Fed-spawned psychology along with the extreme debt-financed corporate stock buybacks courtesy of ZIRP drove the most extraordinary stock-market levitation ever witnessed!
Nearly all the stock-market action since early 2013 is a Fed-conjured illusion that never represented the underlying real-world fundamentals as we'll discuss shortly. That indicators-be-damned buying without any normal selling to rebalance sentiment resulted in one of the longest correction-less spans in stock-market history, an incredible 3.6 years. That only ended with the SPX's brutal 10.2% 4-day plunge in late August.
That extreme selling was a big warning shot across traders' bows that the markets were topping and rolling over into bear mode, as I warned again just days after that plummet. While China's surprise devaluation of its yuan was credited as that plunge's cause, that revisionist history isn't true. That yuan devaluation came on August 11th, which was fully 7 trading days before that intense stock-market selling began.
The real catalyst for August's sharp correction was the release of minutes from the latest FOMC meeting the afternoon before that big selling hit. They were more hawkish than expected, with most of the FOMC members agreeing that conditions had almost been achieved for hiking rates at their next meeting in mid-September. So it really wasn't China that blasted U.S. stocks in late August, but Fed-rate-hike fears!
Of course that very global stock selloff the hawkish Fed spawned stayed its hand in September. But at the FOMC's next meeting in late October, the Yellen Fed hellbent on finally hiking warned that it would likely happen at the next mid-December meeting. And so it came to pass. Though the end of ZIRP that had enabled the debt-financed stock buybacks that levitated stock markets was wildly bearish, stocks held on.
The Fed's first rate hike in nearly a decade happened just a couple trading days before Christmas week which many traders take off entirely. But during the two trading days between the hike and that holiday week, the SPX plunged 3.3%. The writing was on the wall for anyone who cared to read it, as I warned again that very day. But with year-end so near, traders nervously sat on their hands to avoid realizing gains.
Then as 2016 dawned and all those capital-gains-tax bills would be pushed an entire year into the future, all hell broke loose. Again China was blamed, with its ongoing yuan devaluation and limit-down stock-market closes under brand-new circuit breakers apparently driving heavy American stock selling. But underneath it all was the super-bearish ramifications of the Fed's first tightening cycle in a decade underway.
Then just this Wednesday, the blame-China excuse for the horrendous early-year U.S. losses imploded. On a day with the best economic news out of China in some time, a big upside surprise in exports, the U.S. stock markets opened higher. But they soon started to sell off on no news whatsoever, collapsing to a huge 2.5% loss which made for the worst trading day of 2016. And this year, that's sure saying a lot!
Make no mistake, China is a peripheral issue to the dire implications of the new Fed tightening cycle on stock markets levitated for years by epic record Fed easing. And the selling isn't over even on a near-term basis. Check out the definitive VIX fear gauge above, which measures the implied volatility on 1-month S&P 500 index options. The higher the VIX, the greater general fear which is necessary for a bottoming.
Even during the Fed's levitation, durable bottoms after major selloffs never occurred unless the VIX shot above 40. During the SPX's 16.0% correction in mid-2010 following the end of QE1, the VIX rocketed as high as 45.8 on close. During the next 19.4% correction a year or so later after the end of QE2, the VIX soared as high as 47.5 on close. And in late August 2015's sharp correction, the VIX hit 40.1 on close.
The near-term selling in the stock markets is very unlikely to end in the magnitude of plunge we've seen so far in 2016 without a VIX read up above 40. As of Wednesday, the VIX's highest close of the year was merely 26.4 last Friday. Even Wednesday's sharp 2.5% SPX plunge saw the VIX merely hit 25.0. There is simply not yet enough fear to see a durable bottom, as the selling has been big and relentless but orderly.
And even when that 40+ VIX inevitably arrives and a major short-covering rally is unleashed, the stock markets aren't out of the woods by a longshot. They remain overdue for the major bear market that was artificially delayed by the Fed's record easy money spewing from QE and ZIRP. While extreme central-bank manipulations can temporarily distort market cycles, history has proven they can't be eliminated.
Before we get into the fundamental proof of why a major stock bear is awakening, consider the sheer damage it will wreak in the chart above. Bear markets start at a 20% SPX loss off of the preceding bull's peak, which would drag this benchmark index to 1705. That would erase all the stock-market gains since mid-2013, the majority of the Fed's stock-market levitation! Even 20% would devastate stock-trader sentiment.
But it's going to get far worse than that, as bear markets tend to cut stock prices in half! And that average comes after garden-variety bulls that haven't been artificially extended by central banks. A 50% overall drop is likely very conservative for this new bear underway. Yet even that would drag the SPX all the way back to 1065 within a couple years or so, blasting this index back to late-2009 levels just after the stock panic!
The bigger this long-overdue bear market grows, the more it's going to scare stock investors into selling and running for the exits. And the more they sell, the bigger this bear will grow. Bear markets, just like bulls, are self-feeding beasts. So selling is only going to intensify as 20%, 30%, 40%, and even 50% total declines in the S&P 500 are seen. Naive investors trapped unaware in this are going to lose fortunes.
While the end of 7 years of QE and ZIRP is exceedingly dangerous for Fed-levitated stock markets, this risk is compounded greatly by the resulting extreme stock-market valuations. This next chart looks at the average trailing-twelve-month price-to-earnings ratio of all 500 SPX component stocks. Weighted both simply and by companies' market capitalizations, this terrifying valuation data guarantees an outsized bear.
The stock markets move in great third-of-a-century cycles I call Long Valuation Waves. Their first halves see mighty secular bulls where stock prices are bid up far faster than underlying corporate earnings, so valuations soar. This necessitates second-half secular bears, which see stock markets grind sideways on balance for long enough for profits to catch up with lofty stock prices. We remain deep in a secular bear.
It started in early 2000 as the last secular bull peaked, and consisted of a series of shorter cyclical bears and bulls. The former indeed cut stock prices in half, while the latter doubled them back up to breakeven again. Thus for fully 13 years ending in late 2012, the SPX slowly meandered within a giant secular trading range between roughly 750 support to 1500 resistance. That typical pattern was very healthy for stocks.
As these blue SPX P/E lines reveal, stock-market valuations gradually mean reverted from bubble levels over 28x earnings as the last secular bull peaked down towards normal levels. The century-and-a-quarter fair-value level for U.S. stock markets is 14x earnings, and we were well on our way back there before the Fed's brazen open-ended QE3 campaign reached full steam in early 2013. Then stocks soared to a breakout.
The SPX blasted above its secular-bear 1500 resistance in January 2013 on the Fed's we'll-expand-QE-if-we-need-to jawboning and never looked back. But this sentiment-driven stock levitation truly had no fundamental foundation. Stock-market P/E ratios soared with stock markets, proving that earnings were not justifying recent years' big gains. By last month, the SPX's P/E of 26x was back near 28x bubble levels!
Such extreme valuations demand a stock bear to bring them back in line with norms, which is why one is guaranteed. And it's even more remarkable to see near-bubble stock prices considering recent years' epic ZIRP-fueled stock buybacks. Buying back stocks reduces outstanding share counts, which spreads overall profits across fewer shares. This boosts the earnings per share used to calculate P/E ratios.
So without the radical stock-buyback binge the Fed fomented, valuations would now be well into bubble territory at today's stock prices! And they're actually heading higher if stock prices don't drop sharply to bring them back in line. Overall U.S. corporate earnings are now projected to fall in the fourth quarter of 2015, up to 5%. Lower profits will force valuations even higher, further ensuring one heck of a bear.
Based on the latest trailing twelve months of earnings for all the elite S&P 500 component companies, and that's current to the third quarter, the SPX would have to fall all the way back down under 1100 merely to hit historic fair value at 14x earnings! The white line above shows where the SPX would be trading at 14x fair value. Just getting there would require a 48.5% bear market, right in line with historic averages.
But today's situation is much worse than that. We remain mired deep in the secular bear which started in early 2000, and tend to run for 17 years. While the SPX's nominal peak near 2125 last May was a lot higher than March 2000's near 1525, if you adjust the latter using CPI inflation it works out to about 2100 as well in early-2015 dollars. So ever since 2000, the stock markets really have ground sideways on balance.
Secular bears don't end at fair value of 14x earnings, but persist until stocks are trading at half that level or 7x before they finally yield to the next secular bull. In order to push valuations down that far based on today's corporate earnings, the SPX would have to see an astounding 74% bear market that would crush it under 550! Since bears take a couple years to unfold, stock prices won't have to go that low as profits rise.
But this still illustrates how scary-extreme these stock markets are in fundamental valuation terms due to the wild distortions the Fed unleashed through QE and ZIRP. Given the extraordinary stock-market levitation fed by epic record Fed easing leading into this awakening bear, I'd be shocked if it stops at a mere 50% loss. Traders are going to pay an awful price as these markets mean revert lower and overshoot.
All the Fed's record monetary inflation ballooning its balance sheet and record-low rates accomplished was artificially extending a long-in-the-tooth cyclical bull market within a secular bear. And with QE and ZIRP done and a new tightening cycle upon us, the gross stock-market excesses are only just starting to unwind. Investors and speculators alike trapped unaware in this resulting bear are going to get slaughtered.
But the prudent can still thrive during stock bears. The coming S&P 500 downside can be directly bet on with puts in the leading SPDR S&P 500 Trust ETF (NYSEARCA:SPY). Investors can also use SPY puts to hedge their long stock investments. But since the vast majority of stocks get sucked into bear markets, a far better option is selling investments and parking capital in cash. Cash is king in bears, going beyond preserving wealth.
Investors who wisely go fully in cash early in a bear can literally buy back twice as many shares in their investments after the bear runs its course and cuts stock prices in half. Then they can use this much-larger base to rapidly multiply their wealth in the next bull. And gold is even better, because unlike cash it rallies during stock bears as falling stock prices kindle gold investment demand for portfolio diversification.
Just like during the last two cyclical stock bears that cut the markets in half in the early 2000s and again in the late 2000s, Wall Street is going to deny this current selling is a new bear all the way down. Since it earns vast percent-of-assets management fees, Wall Street's mission is to keep people fully invested no matter what. In order to understand what's really going on, you have to cultivate contrarian intelligence sources.
The bottom line is a major stock bear is awakening. The new Fed tightening cycle marks the end of the most extraordinary record easing in history. Its combination of record-low interest rates and record-high money printing unleashed vast deluges of stock buying resulting in recent years' artificial levitation. But it was totally unjustified fundamentally, with stocks soaring far faster than profits leading to near-bubble valuations.
With those extreme Fed tailwinds suddenly shifting to headwinds, the Fed-fueled stock-market levitation is rapidly starting to unwind in this young new year. And this selling is just getting started, as nothing short of a full bear market will force extreme valuations back down to fair value. The chickens are finally coming home to roost for the Fed's radical stock-market distortions, and the reckoning ain't gonna be pretty!
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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. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own various SPY puts options, which have been recommended to our newsletter subscribers.