I want to share a point of view about what's moving the markets that pushes back on a point of view reflected in a post Thursday after the close by a Seeking Alpha editor. The point made was that:
A drop in bond yields today offered some relief for stock traders, who have been cautious since yields shot to multi-year highs last week...
I disagree, and think that a brief missive to present an alternative point of view that may explain the trends in force lately may interest some readers.
A "quantity of excess reserves" theory of financial markets
Rather, I continue to see the quantity of excess reserves diminishing, and traders working with ever smaller amounts of cash jumping around from one asset class to another. Translated to Thursday's market action, it happened to be a day where liquidity moved to bonds. Given diminishing liquidity, that meant less for equities. Most days this year, as the Fed has taken the liquidity punch bowl away, the still copious liquidity has been directed toward stocks and away from bonds. Whereas, with QE, there was plenty of money for both assets, so both stocks and bonds were in structural bull markets.
The adverse liquidity trend is global. This is shown by an ECRI graphic:
You can track diminishing base money characteristics at the Fed's H.4.1 release, which is updated weekly. Securities owned by the Fed dropped to $3.98 T at the latest count, down a hefty $0.26 T yoy. Remember, the Fed obtained those securities by creating money (credit) out of thin air (aka "printing" money). The Fed is destroying the same money (excess bank reserves) by letting securities mature and no longer replacing them. This process reverses QE and is often called quantitative tightening or QT. I prefer reverse QE because QT also implies the Fed's interest rate hikes, which are a separate way the Fed is tightening. It's a double-barreled, unprecedented tightening program; it's no wonder a president whose program is domestic growth is angry.
At the current pace of $50 B per month balance sheet shrinkage, in one year, the Fed's balance sheet is scheduled to drop by about $600 B. Thus the pace of liquidity withdrawal has been accelerating yoy.
Worse for the hot money that excess reserves (courtesy of multiple QEs) represent; their quantity is accelerating in the wrong direction for us bulls even if the $50 B/month level of reverse QE continues at the same level. The math is simple. Say the Fed is at $2 T of excess reserves and lowers them to $1.4 T over the course of one year. That's a 30% decline. Then it lowers them to $0.8 B over the next year. That's a larger 43% decline.
In every country or region where QE has been deployed, the excess reserves have acted as hot money pumping up prices of financial assets. These have ranged from bonds to stocks to gold and to assets paid for with leverage such as real estate.
The rise in excess reserves to crazy levels by the end of 2014 correlates with high valuations for both stocks and bonds in 2015-6 that drove bears in both asset classes crazy. My research shows the only time of comparably high stock-bond valuations was in 1936-7 before the Fed's tightening campaign that helped cause the depression of 1937-8.
The Dow (DIA) had approximately quadrupled from its 1932 low to its pre-depression peak. From that post-1929 peak into to its crash 1938 low, then into its Q2 1942 wartime gloom lower low from a valuation standpoint, it took about 5 years for stocks to go from expensive to cheap. For bonds, soon after their 1937-8 rally, they soon hit all-time lows in yields and spent most of the rest of the next 40 years getting destroyed first by war-time inflation, then by both inflation and decline in asset value of the bonds as rates rose inexorably.
Moving to today, it is obvious that this process is going on in the US markets.
This does not mean doom for the stock market (SPY), nor need it have much effect on the real economy. But let me explain why it matters so much.
Reverse QE may have inexorable effects on asset prices, even if the economy is OK
Remember, importantly, that I'm only focusing on reverse QE, aka QT.
Since my point relates to valuations, any effects that the Fed increasing short-term interest rates from their still low levels are additional to the points I'm making and are clearly relevant.
Every day I look at gold (GLD) and crude oil prices. Over and over, they move in opposite directions. This is completely different from the reflationary period, 2009-11, when all commodities moved together.
Similarly, on Thursday, the remaining liquidity bid up bond prices (TLT), causing rates to decline, and fled equities. But Friday morning as I submit this, stocks are bid up, but bonds are bid down in price. Crude oil is bid up, but GLD is bid down. To my eyes, the times such as 2014 where both stocks and bonds are bid up strongly in the same time period, and GLD and oil move together, have vanished.
I do not think that gradual 1/4 point interest rate increases could account for crude and gold moving in opposite directions. A confusing pattern of shrinking, allegedly excess liquidity does explain it. Even stocks and bonds could both trade higher if liquidity were increasing - but they no longer do so.
The recent sell-off in high-yield bonds (HYG) recently is also consistent with my thesis.
It's a return towards financial normalcy.
QE relentlessly pushed up valuations of asset prices across the board, with first equities surging and then bonds surging in price (declining in yield), and metals surging and then retrenching. The net effect was that surges in one asset class were associated with the other asset classes holding most of their gains. Hot money courtesy of QE was bidding up the universe of financial assets.
Something like the reverse of that is now being seen. An uptrend in long rates is visible, but the Fed could reverse that by tightening too much and causing a recession, but that would crash stocks.
For stocks, if there is no recession, I think that the frustrating "low" P/Es we now see on most financial stocks, homebuilders, Microns (MU) and Applied Materials (AMAT) of the world, etc. are a harbinger of things to come if the Fed continues its reverse QE program as well as rate hikes. The S&P 500 (SPY) has enjoyed a 5-year total return of 13.8%. Its 10-year CAGR total return has been 11.8%. Both of these are far in excess of actual sales growth. Thus these returns have come from a combination of P/E expansion and margin expansion. I believe that the Fed is threatening P/Es both via reverse QE and rate hikes. I also suspect that while rate hikes are understood by traders, reverse QE's effects may not be. Meanwhile, profit margins may be reverting down from elevated levels as labor regains bargaining power, commodities prices rise from depressed levels, and politically-driven factors. So I wonder if double-digit returns from SPY are unlikely going forward. If the economy continues to perform well, rate hikes and reverse QE will continue. If the economy falters, then profits and investor confidence will sag.
To summarize, I believe that the Fed's two-pronged approach to tightening is something new that is affecting financial asset prices more strongly than some think. This continues to lead me to believe that while unexciting, the optionality and rising returns on cash and cash equivalents provide a reasonable alternative to equities, bonds and commodities. It also leads me to prepare for a world in which stocks see declining valuations of their financial results while the secular bull market in bonds has given way to something very different. If the economy holds up, positive returns from both asset classes in excess of cash may well be achieved. But going forward, as long as the Fed persists in its tightening program, valuation gains in one asset class are in my view likely to come at the expense of another asset class. Thus a rise in bond prices Thursday (lower rates) does not cheer stock bulls, just as a rise in stock prices Friday morning does not cheer bond bulls. A period such as November 1998-March 2000, where stock prices soared and bond prices plunged, or the June 1998 period where bond prices soared and stock prices plunged (and similar periods when QE waxed and waned between 2009 and 2014) are more my model now.
But I believe that the big picture trend now, courtesy of the Fed's current policies, is for much more restrained total returns from a blended stock-bond portfolio than in the QE period.
Thanks for reading and sharing any comments you wish to provide.
Submitted Friday pre-market, S&P 500 futures 2,775, 10-year T-note 3.16%.
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: Not investment advice. I am not an investment adviser.