"Sleep with one eye open
Gripping your pillow tight
Take my hand
We're off to Never Never Land"
- Enter Sandman, Metallica, 1991
Our long global market dream is almost over. After nine years of relentlessly aggressive monetary policy from major global central banks, the flow of stimulus is heading toward its end. Exit: night. Enter: light. Awake with both eyes wide open, for investors may soon find themselves off to a whole new Never Never Land.
Global stock markets have a deeply seeded addiction to the euphoria of monetary stimulus. This more than anything else explains how stocks have managed to perform so well during the post-crisis period, despite the fact that the global economy has struggled to get back on its feet.
Nowhere in the world has the reliance on monetary stimulus for rising asset prices been more pronounced than in the United States. For while the warming effects of central bank liquidity began wearing off for emerging stock markets (NYSEARCA:EEM) back in 2011 and developed international markets (NYSEARCA:EFA) in 2014, it continues to elicit a dreamlike joy for the U.S. stock market (NYSEARCA:SPY) through today.
The fact that global stocks (NASDAQ:ACWX) in general and U.S. stocks (NYSEARCA:DIA) in particular are still hooked on monetary stimulus after so many years raises an important question. What ultimately happens to the U.S. stock market once it is finally forced to exit from its policy drug induced trance and go through the withdrawal process of waking up to the fundamental economic reality?
Gripping Your Pillow Tight
But "wait a second!" you might say for several reasons.
First, some might proclaim that the U.S. Federal Reserve effectively quit the liquidity dealing business more than two years ago now, and the U.S. stock market has held up just fine. For it was back in October 2014 that the U.S. Federal Reserve initiated their last asset purchases as part of their QE3 stimulus program. And they have held their balance sheet steady ever since. If the Fed is no longer injecting stimulus, how exactly can it be that the U.S. stock market is still addicted to central bank liquidity?
Indeed, it is true that the Fed is no longer a dealer and has instead made a painfully slow turn to trying to get some of the policy drugs off of the street through raising interest rates twice from the zero bound. But the U.S. Federal Reserve is not the only stimulus dealer in town. Instead, it has been two other major global central banks that have more than stepped in to fill the void left behind by the Fed.
For just as the Fed got out of the stimulus game, the European Central Bank and the Bank of Japan took the hands of the market addicts and ushered them off to a whole new dream state. Granted, it was not one that was potent enough to send stocks floating skyward. But it has been enough to keep stocks steady across the globe and recently pushing to new heights in the U.S.
What is often overlooked when it comes to the flow of central bank liquidity is the following. Despite the fact that the U.S. Federal Reserve has essentially kept their balance sheet steady and the People's Bank of China has been incrementally shrinking their balance sheet, the high octane stimulus programs from both the Bank of Japan and the European Central Bank resulted in the most dramatic calendar year increase in history in total assets on aggregate major central bank balance sheets in 2016. Overall, the major global central banks added roughly $3 trillion in total assets to their balance sheets last year, which marked a 20% increase versus where this asset total was at the start of the year.
In short, not only has monetary stimulus still been flowing into the global financial system, it was flowing at a record pace last year. And despite this record pace, the returns on global stocks that at one time would have euphorically rejoiced under the influence of such stimulus is now managing to just feel relatively fine under their effects.
An Overwhelming Gap To Fill
Second, others might contend that we are now at a juncture where fiscal policy is set to take the reins from monetary policy in supporting the stock market to reach new heights.
Maybe. But these hopes around fiscal policy were built around the unrealistic notion that the new administration along with Congress would be hitting the ground running with tax reform, profit repatriation, a $1-trillion stimulus plan chock full of shovel-ready projects, the repeal of Dodd-Frank and the Affordable Care Act all taking place seamlessly and at the same exact time. I have always had far more reasonable and measured expectations about what the new administration and Congress would actually be able to get accomplished once in place, so what I am about to say is not a knock whatsoever, but we are now on our third week of the new administration being in place and not only is the fiscal policy hydra that was supposed to be storming out of the gates on day one effectively nowhere to be found, but the new leadership in Washington is still struggling to get its cabinet appointees confirmed and in place at this point. Once again, not a knock, but instead a recognition that executing on fiscal policy is much easier said than done, can take months if not years to carry out, and often turns out in the end to look vastly different than what anyone might have been expecting along the way.
But let's still suppose for the sake of argument that all of these fiscal policy measures are carried out relatively quickly. Let's even go the next step and also suppose that they all prove as effective in supporting sustained economic growth as hoped.
Even if everything goes absolutely swimmingly on the fiscal policy front, the U.S. stock market in particular is confronted with the dilemma surrounding current valuations. For thanks to the endless liquidity induced dream provided by monetary policy over so many years, stock valuations have been inflated to the point that even if fiscal policy became supercharged and blew the doors off of current expectations that it may still not be enough to fill the gap between the fantasy of current valuations and the underlying reality of economic fundamentals.
To this point, consider the following. According to S&P Global, the current forecast for 2018 Q4 GAAP earnings that will be revealed as part of earnings season exactly two years from now in early 2019 is currently projected to be $131.63 per share on the S&P 500 Index. This represents a nearly 50% increase over the most recent final quarterly reading from 2016 Q3 at $89.09 per share. It is worth noting that such projections for two years out are notorious for being wildly optimistic and the final number is almost always nowhere close to these estimates once forecast becomes reality two years from now. For example, the forecast for 2017 Q4 GAAP earnings was essentially the same number in the $130 per share range this time a year ago, and it has already been reduced to $120.57 in the year since with further downward revisions almost certain in the months and quarters ahead.
But let's still assume for the sake of a generous argument that fiscal policy measures work like wildfire and we somehow actually hit this $131.63 per share projection two years from now. Not in late 2017 or early 2018, mind you, but two years from now in early 2019. Even if corporations managed to hit this optimistic GAAP earnings target AND the current price on the S&P 500 Index remained completely unchanged at around 2300 over the next two years, the S&P 500 Index would still be trading at 17.5 times trailing earnings, which would still be a 10% premium to its historical long-term average.
So even if the economy begins growing beyond our wildest expectations in the quarters ahead, the U.S. market has long ago already priced it in and then some. In other words, it likely doesn't matter how well the economy does at this point, as the markets are so far ahead of it that the waking up process once the effects of monetary stimulus finally wear off are likely to be a jarring one.
So why does all of this matter today to global stock investors in general and U.S. stock investors in particular? Because the global central bank stimulus game is soon coming to an end. Put differently, the time is soon coming where the U.S. stock market will finally be forced to emerge from its dream state and fully open its eyes into consciousness for the first time in the post-crisis period.
Why is this the case? As mentioned, the Fed and the PBOC have been out of the central bank stimulus game for some time. But where these two left off, the ECB and the BOJ filled the void and then some. But as we continue into 2017, the last two dealers are working their own way out of the liquidity stimulus game.
In the case of the Bank of Japan, we have already seen the total assets on their balance sheet abruptly shrink by $400 billion after nearly tripling almost uninterruptedly since Shinzo Abe and Haruhiko Kuroda became the Prime Minister of Japan and the Governor of the Bank of Japan, respectively, in 2013. And given the recent rhetoric from Mr. Kuroda over the past many months, it seems increasingly likely that the Bank of Japan has decided enough is enough in terms of continuing its unbelievably aggressive monetary stimulus program over the past few years much further.
As for the ECB, it announced in December that it would begin tapering its quantitative easing program from 80 billion euros to 60 billion euros starting in March. The latest plan is to end the stimulus program at the end of 2017, but given that the program was originally supposed to end in September 2016 when it was first launched in early 2015 and the ECB has already indicated it will extend the program further if needed, suggests that such end points should be taken with major qualifications. But the fact that they are already scaling it back indicates the direction in which the program is headed in the coming months.
Putting all of this together, the tag team duo that not only picked up the liquidity pumping slack from the Fed and the PBOC but also doubled down on it are now also getting out of the stimulus game themselves. The BOJ and the ECB will not be injecting another $3 trillion in stimulus into the global financial system this year like they did in 2016. In fact, neither central bank may be injecting anything at all on net by the end of this year.
Without central bank stimulus from any source and with fiscal policy likely to be too little, too late to fill the void and ease in the detoxification process, risks are rising that global stocks in general and U.S. stocks in particular may be in for some potentially unsettling shocks of uncharacteristically higher volatility as we continue through 2017.
Stone Cold Crazy
"I run right outta juice
They're gonna put me in a cell,
If I can't go to heaven
Will they let me go to hell?"
--Stone Cold Crazy, Metallica, 1990
(Enter Sandman B-Side, Original by Queen, 1974)
Let's flip the record and look ahead to the coming year. The central bank liquidity injection game is almost out of juice, and global stock markets may be waking up with both eyes wide open for the first time in nearly a decade. With valuations at historical highs, what this looks like once stocks finally enter back into light is anyone's guess.
But suppose stocks awaken with heightened bouts of volatility. The next important question is the following - will global central banks honestly allow their stock markets to go to hell? If recent history is any guide, almost certainly not. The U.S. Federal Reserve, for example, has demonstrated a pain tolerance of -7% on the S&P 500 Index over the course of two to four weeks before they feel compelled to take action either verbally or with policy. And given that they have had trouble to bring themselves to actually raise interest rates for several years now despite ample opportunities suggests that they would likely act no differently next time around.
Of course, if any garden variety correction is likely to get global central banks to back off, this remains bullish for stocks, which supports the stay long, buy any and all dips thesis that has worked so well during the post-crisis period. Such a scenario is even more so supportive of bonds (NYSEARCA:BND) and precious metals, including gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV).
But here is the wrinkle that has not existed in the past, but is likely to play an increasing role going forward. It cannot be ignored that a nationalist wave is taking hold across the developed world. This includes the new administration in the United States and the potential for similar transformational leadership changes across Europe in 2017. Even if we do not see the likes of Geert Wilders (NYSEARCA:EWN), Marine Le Pen (NYSEARCA:EWQ), Beppe Grillo (NYSEARCA:EWI) and the Alternative for Germany (NYSEARCA:EWG) rise into power in the months ahead, they are gaining prominence and their supporters are becoming increasingly vocal and restless. And nowhere to be found at the top of their respective agendas for change is going to great lengths and expending their national treasure in trying to prop up their stock markets. In fact, in some cases it is the exact opposite. Thus, even if those in power are able remain in control, they may feel increasingly compelled to redirect their priorities in an effort to maintain support and quell any potential social unrest.
As for the United States, we have a new administration with its own nationalist priorities and includes a team of advising monetary policy experts who have vocally slammed the ultra supportive path taken by the Federal Reserve during the post-crisis period under Bernanke, then Yellen. With as many as three Board of Governor seats to fill in 2017 and the opportunity to appoint a new Chair and Vice Chair in February 2018 and June 2018, respectively, we may have a Fed over the coming year that increasingly does not care the next time the stock market falls by -7% over a two-to-four-week period. In fact, they may even point to it as a good and healthy thing.
Still, will policy makers even under these new priorities let the stock market go to hell? Very likely not. But they are no longer likely to go out of their way to lift it back up to heaven either once the juice finally runs out. While such an outcome could prove difficult and painful in the short term but refreshingly healthy for stocks in the long term, it is likely to be decidedly more supportive of Treasuries (NYSEARCA:TLT) and gold along the way.
Does this mean get out of stocks? No, but it also doesn't mean that you should be all in on stocks or want to be a complacent market cheerleader either. Risks will almost certainly be rising as we continue through 2017. As a result, it is important to have a risk management plan in place and to keep both eyes wide open to the events that are unfolding not only here in the U.S. but also in markets across the globe including Europe (NYSEARCA:IEV) and China (NYSEARCA:GXC). This includes not only watching for downside corrections but also upside opportunities along the way. For the trip to whatever the new Never Never Land looks like without the crutch of monetary stimulus remains to be seen. But if nothing else, it is almost certainly going to be more volatile trip going forward versus what we have seen over the past few years.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: I am/we are long TLT,PHYS.
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.
Additional disclosure: I am long selected individual stocks as part of a broadly diversified asset allocation strategy.