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Fed’s Stock Market Distortions Unwind

Stock-Markets / Stock Markets 2016 Jan 08, 2016 - 05:53 PM GMT

By: Zeal_LLC

Stock-Markets

The world’s financial markets changed dramatically entering this young new year, led by sharp stock selloffs and a mounting gold rally.  These are major reversals from recent years’ action.  The immediate catalysts were China’s plummeting stocks and ongoing yuan devaluation.  But the far larger underlying driver is the Fed’s first tightening cycle in a decade, which is just starting to unwind years of gross distortions.

Just a few weeks ago on December 16th, the Fed’s Federal Open Market Committee chose to hike the benchmark federal-funds rate for the first time since June 2006.  This was widely hailed as bullish for stocks, since it implied the US economy had improved enough to weather a new tightening cycle.  The flagship S&P 500 stock index (SPX) surged 1.5% that day, as traders rejoiced at the Fed’s gradualist approach.


But as I argued a couple days later, that stock euphoria was terribly misplaced.  The Fed had originally implemented its zero-interest-rate policy during 2008’s stock panic, and promised ZIRP would only be a temporary emergency measure.  But the Fed reneged and kept ZIRP in place for an astounding 7 years.  This along with the Fed’s quantitative-easing debt monetizations unleashed a vast deluge of liquidity into markets.

Much of this flowed into stocks, through the mechanism of corporate stock buybacks.  Companies took advantage of the Fed forcing rates to artificial lows by borrowing incredible amounts of money.  Instead of investing it in actually growing their businesses, they used it to buy back their own stocks.  Enormous debt-fueled stock demand from corporations at a mind-boggling scale directly levitated the stock markets.

The Fed’s own data late last year reported that US non-financial companies spent a staggering $2.24t on stock buybacks since 2009.  This was 1.8x higher than the $1.24t of stocks purchased by the entire mutual-fund and exchange-traded-fund industry over the same span!  Meanwhile pension funds sold $1.05t of stocks, while households and hedge funds collectively liquidated another $0.56t.  Think about that.

Since 2009, stocks saw net selling from normal investors of $0.37t.  So the only reason the SPX blasted 215.0% higher between March 2009 and May 2015 was the trillions of dollars of stock buybacks.  And of that $2.24t, the Fed reports that a shocking $1.9t was debt-financed.  That’s over 5/6ths of all the stock buybacks since the panic!  ZIRP unleashed the biggest debt-fueled stock-buyback binge ever witnessed.

Corporations love buying back their own stocks not only because that extra demand boosts their share prices, but because of its impact on apparent profitability.  Buybacks leave fewer outstanding shares over which total income is spread, raising the critical earnings-per-share metric that feeds into price-to-earnings ratios.  Buybacks financially engineered the illusion of business growth despite stagnant sales.

While stock buybacks always happen, the record-low borrowing rates forced by ZIRP and QE ballooned them to radically-outsized levels.  This is why the end of ZIRP a few weeks ago was such a momentous event for stock markets.  Higher rates quickly erode the economics of borrowing vast amounts of money to buy back stocks.  And frenzied corporate stock buybacks have been this stock bull’s wildly-dominant driver.

Smart stock traders realized the first rate hike spelled doom for this Fed-conjured long-in-the-tooth bull market.  So the SPX plunged 3.3% in the couple trading days after December’s rate hike.  But with year-end looming, most investors didn’t want to sell because they had massive capital gains courtesy of the Fed’s stock-market levitation.  If they sold in 2015, they’d have to pay big taxes on those by April 2016.

By waiting just 2 weeks until the new year to harvest their gains, they pushed back the due date on their taxes by an entire year.  The dire implications of a new Fed tightening cycle on these extraordinary Fed-levitated stock markets is why so much selling has emerged in early 2016.  China’s plunging stocks and yuan devaluation are certainly sparking fear, but they remain a peripheral concern to a tightening Fed.

The potential stock-market losses to be endured from rate hikes slicing deeply into corporations’ debt-financed stock buybacks are breathtaking.  Recent years’ gross market distortions thanks to the Fed are going to reverse hard and are very likely to fully unwind before the dust settles.  Zooming out to a secular time frame is necessary to understand the terrible implications of all this for investors’ hard-earned wealth.

This first chart looks at the benchmark S&P 500 superimposed over the monthly average trailing-twelve-month price-to-earnings ratio of all 500 of its elite component stocks.  The light-blue line shows all these P/Es simply averaged, while the dark-blue line weights them by market capitalizations.  Stocks’ extreme valuations in recent years prove that the Fed’s stock-market levitation was never fundamentally righteous.

Normal stock markets not actively manipulated by interventionist central banks move in great third-of-a-century cycles I call Long Valuation Waves.  Their first halves are mighty secular bulls seeing stocks bid up far faster than underlying corporate earnings justify, which catapults valuations to extremes.  That’s followed by second-half secular bears where stock prices drift sideways for long enough for profits to catch up.

The last secular bull ended in early 2000 at extreme valuations far into bubble territory which starts at 28x earnings.  So stocks entered a new secular bear, which are an alternating series of shorter cyclical bears and bulls.  The former cut stock prices in half, while the latter double them again to simply bring them back to breakeven.  The net effect is sideways-grinding stock prices that earnings can grow into.

This totally normal and healthy secular-bear behavior persisted for fully 13 years, with the SPX slowly meandering in a mammoth trading range between 750 support and 1500 resistance.  Cyclical bears would drag the stock markets to support, then cyclical bulls would power them back up to resistance again.  All the while valuations were gradually falling on balance as profits rose faster than stock prices.

When the Fed launched its radically-unprecedented ZIRP and QE campaigns in late 2008, they didn’t upset these great bull-bear cycles.  After a cyclical bear climaxing in an ultra-rare once-in-a-century stock panic, a new cyclical bull was overdue in early 2009 as I called right at those lows.  And despite a sharp rebound in the SPX, stock-market valuations continued grinding lower between 2010 and 2012.

But in late 2012 just 8 weeks before the crucial presidential election, the Fed chose to launch QE3.  It’s certain that decision was political, as the Fed was under heavy attack by Republicans for its ZIRP and QE leading into that.  A new QE would boost the stock markets, and since 1900 their performance in the Septembers and Octobers leading into November presidential elections has predicted the winner 26 of 29 times!

If stock markets rally in those final 2 months, the incumbent party wins 94% of the time.  And in 2012 that happened to be the Keynesian easy-Fed-loving Democrats.  And QE3 proved far more potent for distorting the markets than its predecessors since it was the Fed’s first open-ended bond monetization.  Unlike QE1 and QE2, QE3 had no predetermined size or end date.  This turned out to be hugely important.

After QE3’s money printing to buy bonds ramped up to full steam in early 2013, Fed officials constantly used that campaign’s undefined nature to actively manipulate stock-trader psychology.  Every time the stock markets started selling off, elite Fed officials would rush to the microphones to declare that they were ready to expand QE3 anytime if necessary.  Traders interpreted this exactly as the Fed intended.

They started to believe there was a Fed Put in place on the stock markets, that this interventionist central bank would quickly step in to arrest any material stock-market selloff.  So soon after the debut of full-size QE3, the S&P 500 broke out above its secular-bear resistance at 1500.  And then it kept powering higher in 2013 and 2014 without any normal corrections.  The Fed succeeded in suppressing normal sentiment swings.

But just because the Fed convinced traders never to sell, and corporations trashed their balance sheets to boost earnings per share, it doesn’t mean those stock prices were fundamentally justified.  And the SPX valuation data proves that.  Thanks to QE3’s amplification of ZIRP’s stock-market impact, starting in early 2013 general valuations climbed from an already-expensive 20x earnings to a frightening 26x by late 2015.

The century-and-a-quarter average trailing-twelve-month price-to-earnings ratio of the US stock markets is 14x earnings.  Double that at 28x is officially bubble territory, and the stock markets weren’t far from that as the Fed hiked last month to slay ZIRP.  There is literally zero chance general-stock valuations can remain this high without the roaring stock-market tailwinds provided by the easiest Fed policy ever witnessed.

The white line above shows where the S&P 500 would be trading at historical fair value of 14x earnings.  And as of the final trading day of 2015, that number was down at a shocking 1096.  With the SPX exiting last year at 2044, the stock markets would have to fall 46% merely to hit fair-value price levels based on current corporate earnings!  That’s right in line with typical mid-secular-bear cyclical bears that cut stocks in half.

And despite the Fed’s herculean attempts to artificially truncate a secular bear, we remain in one.  Between 2000 and 2012 the SPX meandered sideways in that giant trading range, which is textbook secular-bear behavior.  The Fed-fueled breakout since early 2013 was totally fake, with even its May 2015 apex that saw the SPX hit 2131 a sideways grind.  This is evident when the SPX is adjusted for CPI inflation.

In constant early-2015 dollars, the SPX’s nominal 1527 peak in March 2000 works out to 2100 which is right where the SPX crested last year!  So the secular bear is very much alive and well despite the best efforts of the Fed to thwart it.  As evidenced again in China this week, central bankers have such puffed-up egos that they think they can succeed in bending markets to their will despite all of history proving otherwise.

And being 16 years into a 17-year secular bear, the stock-market downside as the Fed’s gross distortions unwind is far worse than fair value.  Secular bears exist solely to force market P/E ratios from extreme overvalued levels as secular bulls end to half fair value or 7x earnings.  This valuation downtrend was in progress before the Fed brazenly attempted to short circuit it, as the fat-blue dotted line above reveals.

Stock prices are likely to fall until current corporate earnings support valuations of 7x to 10x.  And those yield terrifying SPX targets of 553 at 7x and 790 at 10x.  So we are staring down the barrel of total SPX selloffs since the end of 2015 of 62% to 73%!  That sounds crazy, but all the Fed accomplished was a temporary delay of an already-in-force secular bear.  Without ZIRP, it’ll come roaring back with a vengeance.

And amazingly, the SPX’s market-capitalization weighted-average trailing-twelve-month P/E ratio of all its component stocks at 26.1x as 2015 ended is actually understated!  Real valuations are even worse for two reasons.  Without the epic debt-fueled corporate stock buybacks courtesy of ZIRP, earnings per share would be much lower driving P/Es much higher.  We are still at near-bubble 26x after $2.24t of buybacks!

And our SPX valuation data in this chart caps all individual stocks’ P/E ratios at 100x.  I implemented this practice back in early 2000 to keep tiny companies with crazy-high P/Es from unduly skewing the overall weighted average.  But today key mega-cap market darlings have insane P/Es.  The SPX’s 2 best-performing stocks last year were Netflix and Amazon, which exited 2015 at TTM P/Es of 304.3x and 968.6x!

So if this dataset’s P/E ratios weren’t capped at 100x on the individual-stock level, we’d be looking at a much more ominous broad-market valuation read.  So don’t let Wall Street deceive you, valuations are exceedingly dangerous today thanks to the Fed’s stock-market levitation.  Wall Street’s motivation has always been to keep people fully invested so it can “earn” its hefty percent-of-assets management fees.

Smart contrarian investors who do their homework realize the grave danger the stock markets are in with the Fed tightening again which will unwind its gross market distortions of recent years.  A new cyclical bear which will at least cut stocks in half likely began last May, as I warned last summer.  It will accelerate as the Fed hikes rates this year, which it plans to do 4 more times.  That’s why 2016 is seeing heavy selling.

While the Fed-delayed stock bear comes roaring back to maul stocks into a drastic mean reversion, all hope is not lost for investors.  The Fed’s gross market distortions didn’t levitate everything, they sucked all available capital into stocks.  That decimated other asset classes led by gold.  This forced gold down to deep secular lows every bit as artificial and unsustainable as the Fed-conjured stock-market highs.

As the stock markets levitated in the Fed’s wild orgy of ZIRP-fueled stock buybacks and QE3-jawboning-driven euphoria, investors rushed to stocks like moths to a flame.  Professional money managers have to chase performance to keep their customers, so they sold everything else including gold to migrate all their capital into red-hot stocks.  So in early 2013 they dumped GLD gold-ETF shares at an epic record pace.

This forced GLD’s managers to spew vast amounts of gold bullion into the markets, collapsing the gold price in the first half of 2013.  This extreme event caused by the Fed seducing everyone into stocks just wrecked gold-market psychology.  And with stock markets continuing to levitate since, gold’s traditional role as an essential portfolio diversifier that moves counter to stock markets was forgotten by nearly all.

So gold continued to grind lower in recent years as the Fed-conjured stock-market levitation blinded the world to the fact markets are forever cyclical, rising and falling.  Gold started to recover along the way, but was soon crushed back down by extreme record gold-futures short selling by American speculators that left it at major secular lows.  But these lows were totally artificial due to the very nature of short selling.

Short selling requires traders to sell something they don’t actually own to sell in the first place, so they first have to effectively borrow it before selling.  And those effective debts must soon be repaid.  So all gold-futures short selling is guaranteed proportional near-future buying.  The higher speculators’ gold-futures shorting level, the more bullish gold looks.  And these positions hit extreme record highs in late 2015.

As the Fed tightens and starts its long road to normalization, capital is going to return to gold.  It will start with speculators covering gold-futures shorts, followed by speculators adding new gold-futures longs.  This will give gold enough upside momentum over a half-year or so to convince investors with their vastly-larger pools of capital to return.  And this week, we are already seeing this new gold buying accelerate.

On December 31st when gold languished at $1060 and everyone still wrongly believed it was doomed to spiral lower indefinitely, I laid out the case for a powerful 2016 gold upleg in an essay.  And the modest gold buying this week is only the beginning.  It will take many months for futures speculators’ overall gold-futures positions to return to normal years’ levels, and years more for investors’ gold exposure to normalize.

With stock markets selling off without the Fed’s fierce tailwinds to levitate them, gold’s centuries-old role of diversifying portfolios will become very attractive again.  This will lead to surging investment demand as professional money managers flock to gold to own something actually rallying as stocks fall.  And contrary to all the extreme bearish hype late last year, Fed rate hikes are actually exceedingly bullish for gold!

In mid-December I published my latest comprehensive study on gold’s behavior in past Fed-rate-hike cycles.  Before this one, there have been 11 since 1971.  Gold’s average gain through the exact spans of all of them was 26.9%, an order of magnitude higher than the stock markets’!  Gold’s average gain in the majority 6 cycles where it rallied was 61.0%, and it only saw average losses of 13.9% in the other 5 cycles.

During the last Fed-rate-hike cycle running from June 2004 to June 2006, gold powered 49.6% higher.  That was despite the Fed more than quintupling the federal-funds rate to 5.25% through 17 consecutive rate hikes totaling 425 basis points.  Gold thrives the most in Fed-rate-hike cycles when it enters them near secular lows and they are gradual.  And both these conditions happen to be true in spades today.

So for the love of all that is good and holy, if you want to protect and multiply your wealth in 2016 you have to exit stocks and buy gold.  Both markets are going to mean revert away from recent years’ gross Fed-conjured extremes as this central bank tightens.  Stocks are going to fall as corporate buybacks wane and investors exit, while gold will surge as radically-underinvested investors start to prudently return.

Investors need to pare general-stock positions, especially market-darling ones with high P/E ratios.  The more expensive any stock is, the greater its downside in a cyclical bear market.  Puts on the flagship SPY SPDR S&P 500 ETF can be used to hedge investments or bet on more stock-market weakness.  And aggressively buy gold, either physical bullion itself or shares in the leading GLD SPDR Gold Shares ETF.

I’ve been pounding the table on this coming mean reversion after the Fed shift since summer, and the time to make these critical portfolio changes was late last year.  The longer you drag your feet, the greater your stock losses will grow and the more gold gains you will forgo.  And if you really want to multiply your wealth, augment your gold holdings with shares in the left-for-dead stocks of the gold miners.

The Fed-driven gold sentiment was so rotten that these stocks recently traded near fundamentally-absurd 13-year secular lows.  Even though this industry is mining gold at average cash and all-in-sustaining costs near $618 and $866 per ounce, and selling it for over $1050, their stocks were priced as if gold was trading around $305.  I’ve never seen a more ridiculously-undervalued sector in all my decades of trading.

As gold mean reverts higher as the Fed-levitated stock markets roll over into their long-overdue bear, the beaten-down gold stocks will greatly amplify its gains.  Merely to mean revert to normal levels relative to today’s gold price, let alone where gold is heading much higher, the leading gold stocks will have to see their stock prices at least quadruple in the next couple years.  This sector will dominate 2016’s wealth creation.

If you want to thrive in this dangerous new post-ZIRP era, Wall Street isn’t going to help you.  You need to cultivate excellent sources of contrarian market research and analysis, which is the realm that we’ve long specialized in at Zeal.  We are rare contrarians who actually walk the walk, buying low when few others will to later sell high when few others can.  We aggressively bought hated gold stocks in recent months.

They are soaring this week while the rest of the markets burn, but it’s not too late to deploy.  We’ve long published acclaimed weekly and monthly contrarian newsletters for speculators and investors.  They draw on our decades of exceptional experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks.  It’s never been more important to subscribe now with a new rate-hike cycle upon us!  We’re also running a 20%-off sale.

The bottom line is the massive market distortions fomented by the Fed in recent years are finally starting to unwind.  Without the howling tailwinds of epic Fed easing, the Fed-levitated stock markets are rolling over and mean reverting into a long-overdue cyclical bear that will at least cut stock prices in half.  The levitation wasn’t supported by earnings fundamentals, and stock valuations are near bubble territory.

And as stock markets fall, investors will remember the great wisdom of diversifying their portfolios with gold.  This unique asset class tends to move counter to stock markets, rallying during stock bears which makes it far more attractive than cash.  Massive new gold investment buying will be necessary to mean revert speculators’ gold-futures positions and investors’ gold stakes to normal-year levels, which is wildly bullish.

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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