MorningWord 1/13/16: Runs & Ammo

by Dan January 13, 2016 9:48 am • Commentary

Every correction in U.S. stocks since the end of QE1 in early 2010 has been a fantastic buying opportunity.  Yesterday, Ed Yardeni posted a series of charts detailing numerous factors that have been impacted by the Fed’s expansion of its balance sheet since the depths of the financial crisis. Few make the case for buying the dip as much as the chart of the S&P 500 (SPX) vs the lapses and re-starts of QE:

From Dr.Ed'sBlog
From Dr.Ed’s Blog

The chart above shows the Fed balance sheet expanding from under a half a trillion dollars to over $4 trillion since the financial crisis. But in the last 15 or months since the end of QE4, the upward momentum is U.S. stocks has waned. It was preceded by a sharp rally in the U.S. dollar and the drop in industrial commodities. This is what an unwind, or merely the tightening of unprecedented easy monetary policy looks like.

The bouts of equity volatility have accelerated in the last six months as it became clear the Fed would attempt to normalize monetary policy, and foreign countries and regions like China and Europe would continue on divergent monetary policy to ours and in some instances do their best to continue to weaken their currencies, specifically vs the U.S. dollar. And unfortunately, global currency, credit and commodity markets are driving the train for us equity passengers, and like you, I have no idea how this is all gonna shake out.  Do the risks to our fragile economic recovery seem to be mounting? No doubt about it. But think hard, does it feel that much worse than at any point in the yellow shaded periods above? Not really. Investor sentiment got really bad at every other 5 to 10% correction of the last few years.

But I want to stress what is different this time. Unlike those other instances, QE5 ain’t coming to the rescue. If the Fed were to reverse their recent rate increase to a more accomodative stance that looks like QE5, then they will signal that they drastically miscalculated their move, and under-estimated the health of the global economy and the potential adverse affects on ours.  This would not be good for U.S. stocks given the weak breadth, and mounting technical cracks. We are coming off a surprisingly long period of side-ways to downward price action in U.S. stocks, and despite what should be obvious benefits of lower input costs from commodities, the global economy seems closer to a deflationary spiral than garnering upward momentum from the benefits of said lower costs. Again, I have no idea, I can only opine on the price action, and data in front of me.

Lastly, for those considering worst case scenarios for U.S. stocks, and considering recent history with the collapse that started in 2000, and the financial crisis that got real in 2008. There are big differences between those two periods that saw the SPX decline at least 50% from both peaks.  The March 2000 high to the October 2002 low was excruciating.  For three straight years the most profitable trade in U.S. stocks was to sell rallies:

SPX 1999 to 2004 from Bloomberg
SPX 1999 to 2004 from Bloomberg

While the 57% decline from the 2007 peak in the SPX to the March 2009 low was deeper than the prior crash, it developed far quicker, had far greater implications to the global economy and was met with unprecedented coordinated central bank action. That resulted in only one down year for the SPX in 2008, its first since 2002, and including last year’s (excluding dividends) 73 basis point decline, only the second since 2002:

SPX Jan 2007 through Jan 2010 from Bloomberg
SPX Jan 2007 through Jan 2010 from Bloomberg

If this correction in large cap stocks (many smaller caps are in a full on bear market already) turns into something more, I suspect it will more closely resemble the post crash 2000-2003 bear market period than the financial crisis crash. The touch points will emanate from overseas, therefore U.S. stocks will be a sort of second derivative trade.

That’s good for the Fed because they don’t really have the tools left for an economic crisis centered in the U.S.  As the WSJ’s favorite Fed whisperer John Hilsenrath warned on August 17th, 2015:


The lack of policy options for our powers that be, in the face of some sort of emerging market debt deleveraging hangover that drags down our tepid recovery will manifest itself in a sub-optimal equity investment environment much like the post crash period. U.S. domestic (non-dollar exposed) defensive sectors like Utilities, Telcos and even some large cap Pharma are decent places to park cash, take in some yield while providing a mild downside cushion.