The stock market since early August has pulled back from record highs. If the market follows the trend of the past 8 years, the respite will be shallow and short in duration.
Like many investors, I tend to be skeptical when a financial asset goes perpetually upward, particularly stocks. Within reason, the US stock market does have an upward bias, rising with the growth of the economy throughout history. In fact, there is a very high correlation (R: .97) between the US nominal GDP and the S&P 500 (SPY) looking back to 1952.
The fact that the US economy has continuously grown over an extended period of time, albeit at a slow pace, has made investor expectations build that stocks will continually move higher. However, investing is not just about making momentum trades and getting out before the crash. Knowing when assets are overvalued is a key to successful portfolio management. And the issue that continues to haunt the market today is the suspicion that stocks have reached a pinnacle not supportable by ongoing economic growth.
As shown above, annual US GDP growth since 1952 has been 6.31%. The S&P 500 has grown through this time period (not including dividends) at a rate of 7.75%. The two measures in different time periods clearly diverge, such as the high interest rate period of the 70s and 80s, and the more recent spikes that include the DOT com boom and the 2008 Financial Crisis collapse. However, through time stock valuations tend to be tethered to reality as measured by the US GDP.
Most recently, the stock market has entered a new period of divergence that I believe will produce the next financial crisis, the magnitude of which is dependent upon how much longer the current distortion in the market is allowed to continue. In reviewing the last eight years of financial returns, stocks have “remarkably” outperformed the growth in the US economy. If you review the growth in GDP since early 2010, you will find nominal growth of 3.66%, well below the historical average. There is ample political dispute and economic analysis about the cause. I don’t expect Washington to create policies that will grow the economy anytime soon.
On the other hand, stocks have catapulted higher, growing at 11.34% (not including dividends). [Author note: I purposefully did not measure the growth rate from the market bottom in March 2009 to account for the early 2009 oversold condition.] The 8-year pattern in which stocks have perpetually grown much faster than the economy has now placed the market in an untenable position. To justify the current valuation level over the long term, real economic growth must take off. Otherwise, the current stock market speculative bubble will pop.
How Did the Stock Bubble Get Created?
What has caused stocks to race upward in value well beyond economic reality? The answer currently is not DOT com mania (QQQ) (FDN) or an excessive home-buying spree by American consumers financed by hot money. Rather, a concerted policy by Central Banks around the world, led by the Fed, to chase money into riskier investments to spur economic growth is the clear cause.
I am not saying anything new here that has not been voiced by many other market investors and analysts. What I do provide is mathematical evidence that excessive Central Bank plan accommodation has worked wonderfully to drive up the stock market, but not the economy.
In the graph above, I illustrate how the Fed balance sheet, net of all excess reserves, has changed relative to the value of the US stock market since 1952. It should not be a big surprise that the size of the Fed balance sheet is highly correlated to size of the S&P 500. In fact, the correlation, like the relationship of nominal US GDP, is very high (R: .93). The Fed balance sheet has grown 7.57% since 1952, and correspondingly the S&P 500 has grown 7.75% (not including dividends).
But, just like the relationship of stocks to GDP, stock valuations have many times diverged over the short term from the fundamental relationship with the size of the Federal Reserve Bank. The two most recent examples were the DOT com bubble and the 2008 Housing bubble (XHB) (ITB) (REZ). In these two cases, the Fed in my review of the data leaned against the market trend by steadily raising interest rates and tightening financial reserve requirements until the trend broke and the market corrected.
One very noticeable aspect of the graph is the change in the Fed balance sheet size net of excess reserves (red line) pre-September 2008 and after. [Author note: I call the balance sheet net of excess reserves the Fed Effective Balance Sheet, as it reflects the level of financial assets being leveraged in the US banking system, not those sitting idle]
You can visually see how the Federal Reserve constrained liquidity in the U.S. financial system leading up to the 2008 Financial Crisis as the slope of the red line became visibly flatter. With the advent of extraordinary financial measures initiated by Ben Bernanke post the Lehman Brothers bankruptcy, the slope in the Fed Effective Balance Sheet line changed to become dramatically more upward sloping.
The effective size of the Fed balance sheet on a weekly basis also became much more volatile. Meanwhile the stock market has tracked the increasing size of the Fed Effective Balance Sheet on an almost one for one basis, and in direct opposite fashion, has become much less volatile as measured by the VIX.
However, the unprecedented actions of the Fed since September of 2008 have not instigated faster economic growth. To the contrary, the Fed actions have been isolated in effect, promoting primarily asset value growth through increasing leverage with the S&P 500 growing 11.34% since 2010 as the Fed Effective Balance Sheet grew 9.81% annually.
A data point supporting the excess leverage observation can be found in many lending areas, but particularly margin debt. For example, margin debt on the NYSE in July 2017 reached an all-time high of $549B, which is 2.87% of GDP, also a record high. By comparison, leading up to 2008, NYSE margin debt as a percent of GDP peaked at 2.6% as the market peaked. In the year 2000, the margin debt peaked at 2.78% of GDP. The current margin debt level indicates that much of the excess liquidity the Fed is creating is simply being lent to continually leverage existing assets, not economic growth.
Stock market, Fed balance sheet and margin debt growth rates are all seriously out of alignment with reality as measured by GDP at the present time.
The current stock market trading level, by historical standards dating back to 1952, meets the definition of an asset bubble. The source of the bubble in this case, as opposed to the year 2000 and year 2008 time frames, is directly attributable to the policies of the Federal Reserve, not private, free market forces.
Will the Fed now reverse its current over-extended policy of accommodation and bring stocks back in alignment with economic growth trends? Or will the Fed continue to accommodate the now well formed market expectations that they will provide a liquidity put to prop up the stock market when and if it experiences any future downturn?
Market Disrupting Event Can Be Triggered By Balance Sheet Reduction
The Federal Reserve is currently telecasting to the market that it is going to reverse course on its balance sheet expansion experiment, subject to what happens as it begins to unwind a large portion of its $4.24T Treasury and MBS portfolio. The run-off in assets held on its balance sheet is expected to begin sometime in the 4th quarter of 2017, potentially as early as September. The exact time has not been stated by the Fed as of the writing of this article.
The planned reduction in assets will be accomplished by letting Treasury (TLT) (SHY) and MBS securities (MBB) (VMBS) mature, not re-investing the proceeds as has been the policy since the QE policy began. Although not a direct sale of securities, the effect will be the same as the U.S. Treasury will have to create an auction to sell Treasuries in order to fill the National Debt funding gap since the US government is running a deficit, not surplus operation.
The Fed’s decision to become a net seller of assets may be happening at a very inopportune time for the U.S. Treasury, as the National debt ceiling must be raised by the end of September or the Federal government is out of cash and in default. The Treasury, beginning in the 4th quarter, may need to enter the financial market to fund expanding government operations as well as to buy-out the portion of the position held by the Fed which it will chose not to re-invest. The Fed currently projects that it will reduce its asset positions for the next 4 years.
My opinion, based on the data gathered and presented in this article, is that stock values will stagnate and eventually crash as the current Fed plan is executed. The key to how severe the downward market pressure will become is how much the growth rate in the Effective size of Fed Balance Sheet slows down. Currently, there is $2.2T in excess reserves in the U.S. financial system created by the last eight years of Fed, ECB and BOJ asset-buying activities.
Selling assets by the Fed need not cause an immediate collapse if the transition is orderly – although I would say that it has rarely been done without a corresponding market downturn, and never to the extent envisioned. If the Excess Reserves held at the Fed reduce at a pace to fill the U.S. Treasury financing void in the system as the Fed reduces its portfolio size, the Fed’s effective balance sheet may continue to expand in the near term in support of riskier asset market valuations. This is the hope of the FOMC policy makers.
However, if the Fed actions in unwinding its balance sheet cause a contraction in the amount of liquidity in the financial system available for riskier assets, then the QE house of cards will fall quicker than DOT com start-ups disappeared after the year 2000.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.