The stock market (DIA) (QQQ) (SPY) reacted positively to a jobs report on Friday March 9th 2018 which showed over 300K jobs added to the US workforce in the month of February. For the day the S&P500 moved up 48 points or +1.75% to end the week at 2787. The index move up in the daily trade continued a volatile sideways pattern in the index since mid-February when the S&P500 reached the 50% retracement zone from the early February correction of -10.2%.
The question investors are faced with is whether this move upward in response to positive economic jobs data is a signal that the market will break higher, or it is a false positive signal that just allows more investors to sell the rally and batten down the hatches for the next move downward.
Personally I was not impressed by the jobs number from the standpoint of being a factor that would make me want to go out and buy stocks. As I have published in previous articles, the market is overpriced relative to GDP. The extremely high correlation of GDP to the stock market over the last two years, which reached an all-time high on January 31st (see graph green line), is now so high that a continuation of the recent breakdown is a virtual certainty. In other words, the market has now in my analytical opinion fully priced in very high GDP growth expectations, to the extent that actual growth expectations are very unlikely to match expectations. This happens repeatedly through history, and the data currently are at the breakdown pinnacle just awaiting a pin to burst the expectation bubble.
What is the pin that will burst the high flying stock expectations relative to the US economy? There are actually two pins presently, working in disjointed fashion to cause one, Tax Reform and Trump Trade Policy, to make the other, a Central Bank Asset Buying Policy reversal, to push stocks on a reverse course from their perpetual upward motion for the past 10 years.
Stock Market Volatility Continues to Be Treasury Market Driven
The primary source of stock market volatility continues to be driven from the Treasury bond pits. As the series of events leading up to the February correction indicated, Treasury bond market volatility picked up after Tax Reform passed in December of 2017. That was to be expected since the legislation passed puts the US on course for $1.2T plus additional borrowing needs for 2018, with the prospect of moving toward $2T within the next 4 years. In 2017 the new debt borrowing need was just $500B.
But the Treasury market volatility created by the additional borrowing needs created by the fiscal spending increases and the tax cut package is only half the story. Now that the Federal Reserve is allowing its balance sheet to run-off, returning debt supply to the financial market that had been sequestered on its balance sheet for years, and additional $600B in Treasury supply per year must be absorbed by the market for the next 4 years. It was the double whammy impact Tax Reform plus Fed balance sheet run-off that instigated the high bond market volatility in early February, as Treasury rates were quickly increasing on both the long and short end of the yield curve, decimating the short volatility trade with large losses as the stock market reacted to the systemic market movement in the rate structure. And embedded in the Federal Reserve balance sheet data released a week later was a $12B balance sheet reduction in its Treasury holdings on January 31st, which does not sound like much, but in the context of a market that was trying to digest the implications of the dramatically higher fiscal borrowing needs of the Tax Reform legislation, it was definitely the trigger point in my forensic assessment.
Since the stock market hit a temporary correction bottom on February 8th, the yield curve has remained locked in the 2.90% range on the 10 year (IEF), while the 2 Year (SHY) has continued upward to 2.27% as of 3/9/2018. The inability of the 10 Year to move upward is probably a function of lack of new supply. The Treasury supply calendar is much more loaded toward shorter term issuance going forward as it seeks to keep the interest rate budget impact from the new fiscal path at a minimum, and Treasury Secretary Mnunchin probably realizes how weak long duration demand is going to be going forward given the structural circumstances. But on the demand side, it also may be reflection of a Pavlovian response from financial markets, trained since the 1990s (Greenspan Conundrum) to buy the 10 year when stocks decline because any risk-off move in the stock market has almost always been inversely met with a move into Treasuries. Currently the upward rate movement on the short end is not as concerning to the stock market as long bond rate moves up. And, with a lower rate of upward change on the long end of the curve, stocks have attempted to move back upward toward the highs set on January 26th 2018.
Goldilocks likely to be undermined by the Shift in Global Monetary Policy this Year
But the Goldilocks stock market environment being portrayed by the business media, where stocks continue to rise in the face of upward rate moves by the Federal Reserve, faces a severe test this year, one which I do not believe will be passed.
And the prospective inflation problem, which many investors are worried about, is not really the issue in my review of the situation. I currently do not believe consumer price inflation will have much to do with what is likely to happen to stock values this year, although Fed rate hikes fighting the inflation phantom will indirectly force leverage landmines to be hit in the financial system. I also do not see the US economy on the verge of recession currently, as the sugar highs from the tax cuts and continued easy money are flowing freely in the economic system presently. However, a persistent, sharp sudden drop in stock prices could ignite a negative economic trend that would bring a recession forward sooner than presently expected.
What I do see is that the broad market valuation of stocks is systemically overvalued presently given economic growth reality and the certainty that interest rates are on a fast trajectory higher.
And the reason I am so certain about the rate structure re-set now in progress will force further moves lower in stock prices is the relationship of the global central bank asset buying measures over the past 10 years and the movement in stock market prices. The collusion between the FED, the ECB and the BOJ to synchronize monetary policy in the hope of substituting monetary policy for fiscal policy in the world economic sphere has been a failure in one important respect in my assessment - it has stimulated market valuations of stocks, and just about any other traded asset category, without actually stimulating corresponding relative real economic growth. The result has been the escalation of stock prices to levels which are unsupportable should the central banks choose to withdraw support. The dependency on the ongoing monetary stimulus to keep stock values elevated is just too high as the correlation data show dating back to 1998.
For the decade before the 2008 financial crisis, the combined balance sheets of the FED, ECB and BOJ bore little relationship to the movement of the US stock market. However, post crisis, the surge in asset buying across these three central banks, coordinated on purpose I might add, has served to drive the stock market to progressively higher and higher all-time peaks with very few interruptions. The correlation at .97 is almost a perfect 1:1 relationship. But near the end of 2017, the graph clearly shows a leveling off in the asset buying rate of growth. And, as we know, the jolt higher in US stocks in the month of January 2018 was met with an unpleasant surprise in early February.
It is interesting to analyze which central bank asset buying pattern most correlates with the S&P500 market changes over the last 10 years, and additionally how it compares to the period from 1998 to 2008.
Prior to 2008, the data shows that the Greenspan Fed asset buys on balance thru time did not explain much of the stock market movement. The more interesting part of the data is that the BOJ post 2006 sold assets heavily on a relative basis, and the actions most likely had a strong negative impact on stock, but in a delayed fashion, thus the negative correlation as stocks spiked higher in 2006 and 2007, only to eventually crash. The BOJ asset sales are likely due to trade policies being pushed by the Bush administration which were intended to be pro-US manufacturing by pushing Japan to weaken its currency relative to the USD. The ECB in the same time period showed a positive correlating affect with its policy during the time period 1998 to 2008 time frame. In total, however, the policies effects cancelled out and stocks eventually imploded in 2008 as the leverage in the financial system relative to liquidity forced a major deleveraging event, with the US housing crisis getting the majority of the market attention.
The last ten years have witnessed a strong positive correlation between all 3 Central Bank Balance Sheet expansions and the US stock market, with the BOJ asset buying behavior showing the strongest influence. The Federal Reserve over the past decade, contrary to the Greenspan Fed in the prior decade, did not counter balance the International Banks in this instance; so now face a situation in which the stock market that has been inflated by the monetary actions of all three central banks simultaneously over time.
What Happens as the Central Banks Withdraw?
The data provoke the question about what will potentially happen as the asset buying activity tapers and even turns negative, as the US Federal Reserve is currently underway in doing, while the ECB and BOJ continue to buy assets but have announced plans to taper in 2018 and early 2019.
The answer, although intuitively simple, may be contained in analyzing the data which corresponds to the limited time periods in which stocks have pulled back over the past 10 years. As you can see from the graph above, when the moving average of the correlation over a 6 month to 2 year time period hits the peak correlation zone as it was prior to the market drop in 2011, 2015 and again by late 2017 (see green line in the graphs), the market is poised for a sudden drop.
Adding the addition information which shows the yearly rate of growth in the Central Bank asset purchases (see blue line in the graph) provides insight into the possible implications when the cumulative effect of the Central Bank asset buying programs begin to decline. From the data it appears that the asset purchase influence on upward stock price movements by Central Banks has a limited shelf life (6-9 months) if it is not continuously maintained at a level of 15% or more on a year to year basis. The stock market declines in 2011 and then again in 2015 were met with a return by the Central bankers to push their asset buying rate back upward significantly. The decline in 2013 was the anomaly in the data set. The saving grace for the stock rally in this time period was that the Federal Reserve QE3 program continued unabated until the end of 2014, and the BOJ escalated its massive program to $700B during 2013 after being only $154B in the previous year. The data show the FED and BOJ are the strongest influencers on the US stock market price pattern.
As for the ECB in the 2013 time period, their asset buying program was in reverse. Although US stocks rose in this time period, Treasury bonds and fixed income assets fell in price as rates increased, only to reverse the pattern as the ECB program ramped up to drive European interest rates into negative territory in 2015. The Treasury interest rate pattern influence as the ECB launched its asset buying program bonanza is a warning to fixed income holders who are long duration as the ECB is expected to ramp down their asset buying program going into the end of 2018 - just when the US Treasury needs more and more new financing.
Given the noted systemic relationships between the Central Bank buying behavior on US asset prices, both stocks and bonds, the real issue now is how will this grand coordinated QE experiment end as the programs are wound down? The massive monetary stimulus programs are not only scheduled to taper throughout 2018, pushing the yearly change rate toward zero, the buying programs are expected to go negative by 2019.
Bottom Line - Central Bank Withdrawal Equals US Rates Up, Dollar Down, Stock Market Thrashing
Based on the time series data available on the effect the Central Bank asset buying stimulus programs have had on asset prices worldwide, I think you can bet the house that stock markets will implode if the asset buying programs are shelved assuming there is not a replacing financial force to replace the bid in stocks and bonds. In terms of stocks, Goldman Sachs sees the bid coming from a couple of areas primarily, ETF demand (institutional and retail investors) and huge amount of corporate buybacks, and continuation of foreign equity inflows.
I don't know about you, but given the sensitivity I see in the data of stock prices to even the slightest slowdown in Central Bank purchases, the corporate buy-back machine is a BB gun for defense in the face of a barrage of tanks moving downhill with overvalued stock prices squarely in the cross-hairs. (See article: Corporate Stock Buy-Backs Gone Wild)
And there are those in the audience that keep believing that corporate profitability will save the day and keep stock prices levitated due the US Tax Reform, thus Goldman's continued forecast for ETF based stock demand. I say keep on dreaming. There is no free lunch for suffering corporations who just received a Corporate Welfare Tax Bill windfall. The interest rate increases that are coming down the pipeline because of the Tax Reform Bill, plus the disappearance of a sizable portion of the Central Bank bid in the credit market, will pipe through corporate leveraged balance sheets over the next 2 years like a hot knife through butter destroying any of the gains the Corporate Tax Reform seemingly offered. According to an analysis by David Stockman, "With a rise to 3.75% on the benchmark 10 Year UST, after-tax interest expense for the S&P 500 companies as a group will rise from $16 per share (2016 actual) to $36 per share. That prospective $20 rise is surely the current unseen skunk in the Wall Street woodpile: It would wipe-out virtually the entire one-time gain from the new 21% corporate tax rate. "
In a nutshell, a stock market crash diet off of Central Bank asset purchases is going to be painful for all assets, and riskier assets will not be spared, but instead will be the main course. Until the pain is fully absorbed in asset prices, and you will know it is happening as rates continue higher and rates on corporate (LQD) and junk bond (JNK) (HYG) credit versus Treasury spreads widen significantly, I would leave the risk taking to the uneducated and tighten up your portfolio when rallies allow to be in a better position to weather the coming storm. I currently expect a major next leg down in stocks to happen between now and the November 2018 election. The February event was just the appetizer to prepare the market for the new more volatile regimen. The big event should begin in earnest as the ECB begins to exit, with stocks paying very close attention to the still vague BOJ plans.
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.
Additional disclosure: I own Treasury and Corporate bonds and stocks that may be contained in the ETFs mentioned in the article.