In my previous post, I alluded that the US stock market may be climbing on the assumption that 2020 being an election year should be a good year for stocks. But how could I forget the elephant in the room which pretty much explains the unexpected and inexplicable rally that has been divorced from earnings (see previous post). Its the Fed's balance sheet expansion - they have pumped and expanded their balance sheet to the tune of $400B in the past 4 months (that is $1.2Trillion annualised). :
The outcome as you can see is the S&P500 shooting the lights in tandem with the Fed's QE4.
The Fed's balance sheet expansion had nothing to do with responding to a threat to economic expansion. Quite the contrary, the Fed acknowledged the economy in the US is chugging along quite nicely.
This flooding of cash is literally handing out almost free money to the financial /market participants in Wall St and has exacerbated extreme risk taking behaviour we have no understanding of. Who would be stupid not to borrow cheap to leverage up for substantial profits when the going is so strong?
So Why does the Fed do this, you may ask? Its not by choice that they do this, it is because the gambling has gone so high that if the market is devoid of excess liquidity, it may well freeze up creating a chain of counterparty default that could bring the house down. And that would be disastrous. But is the Fed now going to continue with QE4ever - and will this even perpetuate greater risk taking behaviour? Sadly, the Fed is in a rock and a hard place - if it doesn't, the market will throw a large tantrum , if it does it imperils the market to a greater and more dangerous plunge when the party stops.
And to add to this, this from Greg Canavan
US corporate earnings have been in a bear market all year. According to Factset, companies in the S&P 500 are expected to report a fourth quarter earnings decline of 2.4% compared to the same period last year.
This will mark the fourth consecutive quarterly earnings decline!
So just to be clear: While corporate earnings have declined this year, the S&P 500 index jumped around 30%.
In other words, the market is not moving higher based on ‘fundamentals’. It is moving higher based on the view that the Fed will prevent a bear market from taking hold.
This is an extremely powerful belief.
You can see just how powerful it is by looking at the performance of Apple Inc. [NASDAQ:AAPL] in 2019. Net income in the year to 30 September increased just 3%. Yet its share price jumped more than 90%.
The stock market is forward looking. So we should take into account earnings expectations for FY2020. Here it looks slightly better. Net income is expected to increase 8.25% year on year.
But as of yesterday’s close, the stock price is up 105% year on year!
To a rational observer this makes no sense.
Until you break it down, that is.
If you think back to this time last year, the market had just experienced a terrible fourth quarter of 2018. Stocks plunged heading into Christmas as it became apparent the Fed had tightened too fast.
As a reminder, during 2018 the Fed increased the official rate at the same time it shrank its balance sheet. Both of these actions removed cash (liquidity) from the market.
The Fed quickly realised that market forces were in the process of imposing some long absent discipline on the financial system. This being their greatest fear, they stepped in and did what they do best: Pump stocks up with an about face on monetary policy.
They started by reducing the Fed Funds rate, which is the official cash rate in the US. Then, as I explained yesterday, they turned to balance sheet expansion in September. This was after the ‘repo’ market blew a gasket.
Four months later, the Fed’s balance sheet is now US$400 billion larger.
Now, according to an article in TheWall Street Journal, the Fed is considering a new tool to allow smaller banks and hedge funds to borrow from it directly.
This relates to the stresses in the repo market that I discussed yesterday. Right now, only the big banks, known as ‘Primary Dealers’ can access repo funds from the Fed.
But the Fed appears to be exploring the idea of expanding this access.
The socialisation of our financial markets continues…
The thing is, having access to cash is the lifeblood of any business. A soundly functioning financial system should be the judge of whether a company or financial entity is worthy of borrowing cash.
When Bear Stearns and Lehman went bust, it was because the market realised they were bankrupt (liabilities were higher than assets). So they stopped lending. When the flow of cash stopped, it exposed the bankruptcy.
The socialists at the Fed obviously believe there are problems in the financial system. They think some players are having trouble getting access to cash. This is how the markets impose discipline.
But the Fed is having none of it. They want to remove discipline. Everyone’s a winner these days.
This feeds into the current market narrative that the Fed won’t let prices fall. No wonder prices are melting up. There is no longer even a dip to buy.
History tells you that this is a dangerous time for investors. We know it will end in tears, we just don’t know when.
and this from Jim Rickards
The same handful of FAAANG stocks that hauled markets up on an incoming tide can drag time rapidly down on an outgoing tide.
Panic selling begins. And panic selling begets panic selling — which begets panic selling.
Explains Jim Rickards: In a bull market, the effect is to amplify the upside as indexers pile into hot stocks like Google and Apple. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock... The technical name for this kind of spontaneous crowd behavior is hypersynchronicity, but it’s just as helpful to think of it as a herd of wildebeest that suddenly stampede as one at the first scent of an approaching lion. The last one to run is mostly likely to be eaten alive.
