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Market Lab Report - QE Debt for Dummies - A "Crash" Course: The Case for a Parabolic Stock Market

QE Debt for Dummies - A "Crash" Course:

The Case for a Parabolic Stock Market

by Dr. Chris Kacher, Managing Director

Today, the Federal Reserve minutes showed that Federal Reserve officials were in broad agreement at their meeting on May 2-3 to shrink the balance sheet instead of asset sales- in slow, ever-increasing, stages. Stocks will be the beneficiary whether the Fed shrinks the balance sheet slowly or not. 

Stocks have also shown great resilience in the face of negative news which has turned out to be a series of one-hit shocks, pushing the stock market down suddenly such as with Brexit in June 2016 or more recently, the Trump health-care/tax reform issue in March and the Trump impeachment issue in May. A shallow floor is then quickly found as the market resumes its uptrend. A serious bear market in stocks may thus be further off than thought.

Since 1945, there have been 14 interest rate tightening cycles. So far, the Federal Reserve has tightened twice but on either false or misunderstood premises.

The Federal Reserve is tightening into...

...the weakest economy since 1945 as measured by growth in nominal GDP.

...record levels of debt on business and government balance sheets spawned by QE which suggests even small changes in interest rates may have a much larger than normal impact.

...a monetary base reduction and increasingly restrictive regulatory laws such as Dodd-Frank, thus banks are required to hold more liquid reserves, thus increasing monetary restraint, thus lending has indeed slowed over the last few quarters. So while liquidity has increased as a % of total bank assets, liquidity less reserve requirements is actually near all-time lows. This is a good example of how regulation can stifle intended growth as Dodd-Frank works against QE. 

...deteriorating key monetary variables that are heavily influenced by Fed policy operations.

...the weakest population growth since the 1930s.


Any of the above could spur a serious correction while a combination could create a collapse of great magnitude. But such a situation could take time to unfold while in the meantime, the stock market would be the recipient of the Fed having to unwind their balance sheet which has become massive. But instead of making things go "supernova", the Fed said today they would be unwinding gradually... in stages.

Meanwhile, we are at the lowest annual economic growth rate of this "expansion" and in the second straight year of declining growth. Yet the Fed has the public believing that GDP is on solid footing. 

Let's look at the facts. When QE was launched at the end of 2008, allowing growth to recover by 2010, growth sharply slowed again to 1.6% in 2011. It then picked up slightly in 2012, then slowed again to 1.7% in 2013 prompting the launch of renewed rounds of QE. In 2016, growth slowed once again to 1.6%. 

So why isn't the Fed adding rather than subtracting fiscal stimulus by lowering rates?

The level of rates are still at near record low levels despite two rate hikes. Thus the Fed's hands are tied. It has no choice but to continue their pro-interest rate hike agenda even at potentially great cost to the stability of the economy, so it will have interest rate "fuel" to reduce rates when the next recession rears up. 

The Federal Reserve is already reducing their balance sheet- $426 billion due in 2018, and $350 billion due a year later. The Fed will not repurchase the debt. Instead, the US economy is absorbing the debt because US dollars are effectively the only real reserve currency in the world right now.

As renowned bond fund manager Bill Gross has written, when the European Central Bank (ECB) and the Bank of Japan exit their Quantitative Easing programs, they will find little demand for their paper debt. This will lead to a brutally sharp increase in yields in the bond markets, thus financing costs will rise far more rapidly than at any time in past history. This would naturally spill over into stock markets as the two are deeply connected. Thus neither central bank will be in a position to completely unwind their QE programs. Nevertheless,  it is likely to create a serious headwind for bond markets going forward as yields continue to rise while the US market being the tallest standing midget stands to gain the most.

Indeed, without reduced financial support of central banks, we may see capital flow from bonds into equities. This would push the aging US stock bull market, now in its ninth year, ever higher as the sovereign debt crisis bubble fuels a stock market bubble. Whenever a government tries to create a solution to any crisis, that solution often creates the next crisis.

Why did the Fed paint itself into a corner?

These are unprecedented times making policy outcome prediction a near impossibility. They reduced rates which normally works under most situations but applied it to an extreme situation. Consequently, they found themselves reducing rates to historically low levels. Global central banks mimicked the Fed  even going negative via NIRP (Negative Interest Rate Policy) as Germany and Japan did. But what works in certain contexts such as reducing interest rates to spur economic growth breaks down at the extremes. And since 2008, the situation has become more and more extreme.

At no time in history has there been a soft landing when debt levels have been this extreme. This sentiment has been echoed by Jim Rogers, Alan Greenspan, and Ed Seykota (read his book "Govopoly in the 39th Day"). 

In the current environment, stocks on our Focus List have done well overall with a number of them having continued higher or even gapped up at times, well after they were placed on the list. Nevertheless, our strategy of taking profits when a stock gets ahead of itself in price and buying a stock near support so your risk is typically less 2-3% as showcased in our VoSI VooDoo Report remains key.

But trying to time a stock market bubble or a serious correction is foolhardy. Rather than predict, keep a close eye on price/volume action. Stocks and major averages have historically shown material weakness days if not weeks before a major correction such as in 1929, 1987, and 2008. Even the flash crash of 2010 showed warning signs days before which is why the Market Direction Model went to a sell signal on April 28, 2010. By contrast, in October 1999, leading stocks were off to the races with great vigor. Thus began the sharpest acceleration ever seen in US stocks over the next 6 months due to the Federal Reserve's prior easy-money injections to prevent Y2K from turning into a fiasco.

In the end, price is all that matters. Coupled with volume clues, it has always been the best way to let your stocks and watch lists tell you what to do. You can then take profits and exit to safety or initiate short positions in stocks or ETFs as the drama unfolds.

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