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Market Oracle FREE Newsletter

Why 95% of Traders Fail

Fed Shift Is Major Stock Market Risk

Stock-Markets / Stock Markets 2015 Jun 19, 2015 - 05:43 PM GMT

By: Zeal_LLC

Stock-Markets

The US stock markets were quick to rally after the Federal Reserve did nothing at its policy meeting this week.  Traders love the endless dovishness gushing forth from this Yellen Fed.  But their complacency is very misplaced.  It was epic Fed easing that fueled the stock-market levitation of recent years.  So the Fed shifting away from these extraordinary policies is a major downside risk for these Fed-inflated stock markets.


The Federal Reserve has utterly dominated stock-market sentiment in recent years, to a truly shocking degree.  From the Fed’s Federal Open Market Committee policy meetings every 6 weeks or so, to the subsequent Janet Yellen press conferences and FOMC members’ economic projections, to the endless speeches by Fed officials, the great majority of important stock-market moves have been driven by the Fed.

These include plenty of sharp rallies out of pullback lows.  This Fed has shown an uncanny ability to spin up the dovish rhetoric at critical times to short-circuit in-progress selloffs.  Many of the larger stock-market rallies to new highs in recent years were also a direct consequence of Fed actions or jawboning.  Unfortunately this tight cause-and-effect relationship is only apparent when watching markets in real-time.

As a full-time speculator and student of the markets, I’ve long been blessed with the opportunity to observe all day every day.  Every morning I get up at 5am to catch up on Asian and European action, and don’t stop watching until well after the US stock markets close.  And since early 2013, it’s just been flabbergasting how many key intraday rallies were directly driven by dovish talk or actions from the Fed.

For over a dozen years now, I’ve documented every trading day’s action in much detail in our popular weekly newsletter for speculators.  I’m tempted to wade through the 127 of these newsletters I’ve penned since early 2013 and quantify exactly how many trading days, and how many index points on the benchmark S&P 500 stock index (SPX), were a direct result of Fed actions or jawboning.  It would be shocking.

But you don’t have to take my word for it.  The research department at the St. Louis Federal Reserve bank publishes literally hundreds of thousands of data series.  Buried deep in this treasure trove of information is the size of the Fed’s balance sheet.  Comparing that to the remarkable progress the SPX has made in recent years is very telling.  It all but proves these lofty stock prices are a Fed-conjured aberration.

First some background is in order.  Back in October 2008, the SPX plummeted a gut-wrenching 25.9% in just two weeks!  This was the first full-blown stock panic the American markets had witnessed since 1907, a century earlier.  The Federal Reserve panicked too, fearing that the wealth effect that leads people to spend less when stock markets fall would drag down the entire US economy into a new great depression.

So the Bernanke Fed aggressively slashed the benchmark Federal Funds Rate it controls.  While this is a market for commercial banks to lend money to each other overnight, it is the core short-term interest rate from which most others are set.  Between October and December 2008, the Fed cut its FFR by 200 basis points to zero.  This marked the dawn of the Fed’s first-ever zero-interest-rate policy in its 95-year history.

But once the Fed had gone full ZIRP, it was zero-bound.  It could ease no more by conventional means of cutting rates.  So the Bernanke Fed decided to implement the extreme monetary policy known as quantitative easing.  That simply means creating brand-new money out of thin air to use to buy bonds.  Known throughout history as debt monetization, this highly-inflationary tactic turns bonds into new money.

This money is then injected into the economy as bond sellers, who obviously need the funds, quickly spend it.  When the Fed wishes up new money to buy US government bonds, Washington soon spends every last dollar on the usual transfer payments to American citizens, government salaries, and debt service.  So QE is direct monetary inflation.  And all those bonds the Fed monetizes go to its balance sheet.

Ominously for today’s lofty stock markets, the SPX’s progress has closely mirrored the ballooning Fed balance sheet since the dawn of the QE era in late 2008.  This first chart superimposes the SPX over the Fed’s balance sheet, and also notes when the Fed launched major new QE campaigns.  Discussing each QE ramping is beyond the scope of this essay, but I’ve written much on QE history in past essays.


For the legions of hyper-complacent American stock traders who think the Fed’s policy shifts away from QE and ZIRP are no big deal, this chart is a shocking wake-up call.  The entire massive bull run in the S&P 500 since early 2009 appears to have been largely driven by the Fed’s mushrooming balance sheet!  Many of the trillions of dollars created out of thin air to buy bonds found their way into stocks.

In the 6.3 years since the last cyclical bear bottomed in March 2009, the SPX has blasted an incredible 215.0% higher at best!  This was an anomalously outsized and long-lived bull.  The average size and duration of stock bulls at this stage in the great stock-market cycles is a mere doubling over just 2.9 years.  Something goosed this bull to enormous proportions, and it was the Fed’s extraordinary levels of easy money.

The stock markets only rallied when the Fed was aggressively monetizing debt and adding to its bond holdings.  Compare the blue SPX line with the orange and red Fed-balance-sheet lines.  The former shows the Fed’s total bond-bloated balance sheet, while the latter shows its Treasuries QE specifically.  The stock markets only powered higher when the Fed was rapidly adding to its massive bond holdings!

And their growth since late 2008 has been nothing short of mind-boggling.  In the first 8 months of 2008 before that stock panic and the first-ever large-scale quantitative easing in the Fed’s century-long history, its balance sheet averaged $875b.  As of mid-February 2015, it had exploded to $4474b.  That’s incredible 411% growth in just 6.5 years, literally a quintupling!  This $3598b wished into existence had to go somewhere.

And some major fraction sloshed into the stock markets.  How is that possible since the Fed was buying bonds, not stocks?  Just as the Fed used ZIRP to force short rates artificially low near zero, it used QE to bludgeon long rates to artificial lows.  The Fed has always been very forthright and open about QE’s goal of actively manipulating interest rates.  For years, every FOMC statement actually acknowledged this mission!

The Fed’s QE Treasury buying battered long rates so low that US corporations were unable to resist the cheap debt costs.  So they rushed to borrow literally trillions of dollars to take advantage of the epically-low rates, and then plowed the vast majority of that into gargantuan stock buybacks.  That was the major source of stock demand in recent years, and pushed the SPX inexorably higher.  It was ultimately Fed-fueled.

QE’s indirect impact on stock prices through this debt-fueled stock-buyback binge is readily apparent in this damning chart.  Not only did the SPX only rally considerably when the Fed’s money-printing machinery was spinning the fastest, the only major selloffs in recent years happened during lulls in QE debt monetization between specific QE campaigns.  As soon as that money printing abated, stocks fell.

This led to a 16.0% SPX correction in mid-2010 as QE1’s new buying ended, and another 19.4% one in mid-2011 as QE2’s bond purchases wound down.  This stock bull was looking tired and toppy, with many major technical and sentiment indicators pointing to its imminent failure, back in late 2012.  But then the Fed launched QE3, which proved wildly different from QE1 and QE2 in that it was totally open-ended.

While QE1 and QE2 had set sizes and end dates determined at launch, QE3 was a monthly campaign with no predetermined size or end date.  And the uber-dovish Fed used the resulting uncertainty that surrounded QE3 to actively manipulate stock traders’ psychology.  Whenever stocks started to sell off since early 2013 when QE3 shifted into full swing, the Fed would soon step up and jawbone about easing.

Fed officials often implied, and sometimes outright said, that they were ready to ramp up QE3’s size if the US economy weakened.  Stock traders interpreted this just as the Fed intended, that this central bank would ramp QE3 if necessary to arrest any material stock-market selloff.  So they figured the Fed was effectively backstopping the stock markets, thus they threw all caution to the wind to buy with reckless abandon.

And the result is readily evident above, an extraordinary Fed-driven levitation in the US stock markets since early 2013.  It perfectly mirrored the Fed’s ballooning balance sheet under QE3.  And since the FOMC announced it was ending QE3’s new buying back in late October, that balance-sheet growth has stalled out.  The Fed’s balance sheet has actually been modestly shrinking since mid-February, which is ominous!

If the epic record Fed easing is indeed responsible for the extraordinary stock-market rally of recent years, then the ongoing and upcoming major Fed policy shifts are almost certainly going to slaughter this artificial stock bull.  After ending new QE bond monetizations late last year, the Fed is on track to end ZIRP later this year.  And the ramifications for these lofty and very overvalued stock markets are super-bearish.

Without QE and ZIRP, the stock markets are long overdue for a serious reckoning.  They are extremely overextended and hyper-complacent, which this next chart reveals.  This means once stock traders start to realize the remarkable Fed tailwinds of recent years are abating, the selling pressure is likely to be fierce.  That realization will mount in intensity as we get closer to the Fed’s first rate hike in a whopping 9 years.

Before the dawn of the extraordinarily-manipulative QE3 in early 2013, this cyclical stock bull was on a normal trajectory.  Bulls surge dramatically initially out of deeply oversold and undervalued conditions at the end of the preceding bear.  Then as they march higher in the subsequent years, the pace of those gains moderates.  This stock bull was topping in late 2012 before the Fed pulled out all the stops with QE3.

That led to a dramatic Fed-driven decoupling of the stock markets from normal bull-market behavior.  And the subsequent Fed-fueled stock-market levitation was wildly unprecedented on multiple fronts.  In normal healthy bull markets, corrections arise about once a year or so to bleed away excessive greed that builds within uplegs.  These periodic 10%+ selloffs in the S&P 500 are essential to keep sentiment balanced.

Incredibly the last full-blown correction ended in early October 2011, fully 3.6 years ago!  All kinds of major technical and sentiment indicators showed the SPX was ready to correct again on schedule in late 2012, but the open-ended QE3’s impact on stock traders’ sentiment short circuited it.  And the stock markets have been magically levitating ever since, basking in a Fed-conjured fiction where stock prices never fall.

This dangerous span since the last correction-magnitude selloff has been one of the longest ever on record for the US stock markets.  Since such big selloffs are inevitable and essential, artificially delaying the next one is like stretching a rubber band.  Just as its odds of snapping grow the farther it is pulled apart, so do the odds for the next 10%+ stock-market selloff the longer it has been since the previous one.

And since this incredibly anomalous stock-market levitation of recent years was the direct result of the Fed’s radically-unprecedented easy money, the end of that era is likely to shatter it.  Fed officials are making it more and more clear that they are itching to end ZIRP.  They realize it has created tremendous economic distortions, and holding rates at zero leaves the Fed no rate-cutting ammunition for future crises.

Make no mistake, despite the dovish FOMC meeting and rate projections this week the Fed is going to have to start hiking rates soon.  If it doesn’t, the bond markets will force its hand.  And whether that first rate hike comes at the FOMC’s September, December, or even March 2016 meeting, stock traders will start worrying about it long before it becomes reality.  And that means a serious stock-market selloff is looming.

Thanks to the Fed’s gross market distortions, it’s been an incredible 4 years since the last correction-grade selloff in the US stock markets.  And stock traders as a herd are rightfully notorious for their short-term memories.  The SPX has been levitating for so long that they’ve forgotten how bad real selloffs feel.  So as the Fed’s next rate-hike cycle nears and stocks fall, complacent traders’ fear will surge faster than usual.

This second chart above replaces the S&P 500 with its flagship SPDR S&P 500 ETF, SPY.  That’s the most-widely-used vehicle to gain direct exposure to this elite flagship index.  And since it’s been so long since the stock markets experienced a normal healthy selloff thanks to the Fed, I suspect most traders don’t realize how serious today’s downside risk is.  Selloff levels in 10% increments are noted on this chart.

A mere 10% SPX selloff, the minimum to qualify as a correction, would take the US stock markets back to mid-2014 levels.  That would wipe out nearly an entire year’s progress!  Can you imagine that not seriously scaring complacent traders?  At a full-blown 20% correction, which is all but certain, the SPX would be dragged all the way back down to mid-2013 levels.  The last two years of the SPX’s progress would vanish.

But since the aberrant stock-market rally in recent years was fueled by extreme Fed easing that is going away, since this resulting bull is so abnormally large and old, since these stock markets are so seriously overvalued, since complacency is off-the-charts high as the super-low VIX fear gauge reveals, and since it has been so incredibly long since the last correction, I doubt any selloff would conveniently stop at 20%.

Before the Fed brazenly attempted to eradicate stock-market cycles, traders understood that bear markets inevitably follow bull markets.  The stock markets are forever cyclical, an endless series of bulls followed by bears.  And there are very high odds the next bear looms as the Fed starts tightening.  A 30% selloff would drag the SPX all the way back to early-2013 levels, erasing the entirety of the Fed’s QE3 levitation.

At 40%, which is nothing special as far as bear markets go, the stock markets would retreat all the way back to early-2011 levels.  And at 50%, which is the average size of bear markets at this stage in the great stock-market cycles, the SPX and SPY would plunge all the way back down to late-2009 levels!  Even though such 50% full bear markets take a couple years to unfold, the devastation would be breathtaking.

So don’t drink the Kool-Aid with the euphoric stock traders and blind yourself to the dangerous realities of today’s lofty and overextended markets!  QE’s new buying is done and the Fed’s balance sheet has already started to shrink.  And the end of ZIRP is rapidly approaching.  The most extreme easing in the history of the Federal Reserve that so buoyed and goosed US stock markets is rapidly coming to an end.

With the Fed’s late-2014 shift in QE policy already underway and its upcoming late-2015 shift away from ZIRP looming, this central bank is becoming a major downside risk for these stock markets.  Only fools would willingly buy high in such a hazardous environment fraught with peril.  Rather than piling into stocks high, smart contrarian investors are looking elsewhere to deploy capital in deeply-out-of-favor assets.

Their destination of choice is the despised precious metals, trading near major lows.  Not only are the gold seasonals bottoming, but gold actually thrives in rising-rate and higher-rate environments since they are so damaging to stocks.  That rekindles demand for alternative investments, which are led by gold.  During the Fed’s last rate-hike cycle between June 2004 to June 2006, gold blasted 50% higher!

That was despite the Fed more than quintupling the Federal Funds Rate to 5.25% over that span!  And in the 1970s when the Fed had to reverse course from an earlier less-extreme easing, it was forced to hike its FFR from 3.5% in 1971 to an astounding 20.0% by early 1980!  And gold skyrocketed 24.3x higher over that span.  Gold, silver, and the best of their miners’ stocks are fantastic investments in Fed tightenings!

But incredibly today, gold is so far out of favor almost no one is talking about it.  That’s why it’s essential to cultivate great contrarian sources of market intelligence.  That’s what we specialize in at Zeal.  We’ve long published acclaimed weekly and monthly newsletters for contrarians.  They draw on our decades of market experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  Since 2001, all 700 stock trades recommended in our newsletters have averaged annualized realized gains of +21.3%!  Subscribe today and enjoy 33% off!

The bottom line is the Fed’s massive policy shift from record easing to tightening is a huge downside risk for today’s lofty, overvalued, and overextended stock markets.  The Fed has already stopped its new QE bond buying, and its balance sheet that the stock markets closely mirrored in this bull has started to shrink.  And despite the dovish FOMC this week, the first rate hikes near that will pound the nails in ZIRP’s coffin.

These Fed-levitated stock markets that have almost magically avoided significant selloffs thanks to QE, ZIRP, and the associated Fed jawboning are in serious trouble when this next tightening cycle arrives.  It will prove an extraordinarily-risky time for extraordinarily-anomalous markets.  So sell high while you still can, and redeploy some of that capital by buying low in the precious metals which are set to soar.

Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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