Election, Fed And Stocks

Americans spoke loudly and clearly at the polls this week, repudiating Obama’s and the Democrats’ failed big-government policies.  This huge Republican victory has serious implications for the Fed and US stock markets.  Republican lawmakers have long opposed this easy Fed, and they will put great pressure on it to normalize its balance sheet and interest rates.  This is an ominous omen for these Fed-inflated stock markets.

Prior to Tuesday, the mainstream media dominated by Democratic sycophants did its best to downplay the American anger at Obama and the Democrats.  There were endless reports about how awesome the US economy is, despite the fact most Americans aren’t feeling it in their pocketbooks.  Recent Republican polling gains were ignored.  Without honest coverage leading into the elections, the results seemed shocking.

In the critical Senate, the Republicans picked up at least 7 seats for a solid 52-seat majority.  And 3 more are yet to be decided.  And in the House, the Republicans won at least 16 seats for a strong majority of at least 243.  And it could go as high as 249 when the recounts are done for the close races.  This would give Republicans their largest majority in the House since 1928!  Americans kicked out Democrats in droves.

Since Republicans are business-friendly and anti-regulation, traders saw their sweep as a major positive for the US stock markets.  And there are all kinds of historic stats about how stock markets almost always rise after midterm elections.  But the stock-market situation today is far from normal, with the major indexes at nominal record highs thanks to the big boost from the Fed’s unprecedented third quantitative-easing campaign.

Republican lawmakers have long opposed Fed inflation and easy money for several reasons.  Interest rates are effectively the price of money.  That should be neutral, not favoring savers or debtors.  Interest rates should be set by free markets, not government decree, at a fair level that is mutually beneficial for both savers and debtors.  The Fed’s zero-interest-rate policy has robbed savers blind to subsidize debtors’ binge.

The Bernanke Fed launched ZIRP in December 2008, and it was promised to be a temporary measure for the stock-panic crisis.  But here we are, nearly 6 years later with stock markets at record highs, and the Fed has kept rates at zero.  The Fed has aggressively discouraged saving, even though that is what builds wealth and makes economies grow.  Republican lawmakers want to end this asinine attack on savers.

The Fed’s easy money is also essential to “finance” Obama’s and the Democrats’ big government.  The artificially-low interest rates ZIRP fostered have dramatically lowered the borrowing costs for the federal government.  This has enabled the Obama Administration to go on the biggest debt-fueled spending spree in the history of the world.  The government debt growth under Obama has been staggering, very scary.

Republican lawmakers want to bring back accountability and restraint to government spending.  And the quickest way to force it is to normalize interest rates.  If Treasury yields were back up near normal levels, the government’s interest expense would be far higher.  That would make it far more difficult for debt growth to continue, imposing market discipline.  Normalizing interest rates would dramatically slow Democrats’ overspending.

Finally, Republican lawmakers recognize the Fed is overtly political and pro-Democrat.  Janet Yellen is a hardcore Democrat, all for big government.  And back before the November 2012 elections that gave a second term to Obama, the Fed manipulated the markets into his favor.  Just before those elections in September 2012, the Fed launched QE3.  This goosed the stock markets in the critical final pre-election months.

The stock markets were topping and starting to roll over before the Fed birthed QE3.  And the stock-market performance in September and October before presidential elections almost always decides them.  In the 28 presidential elections since 1900 before that 2012 one, the stock markets rallied in September and October 16 times.  The incumbent party won 15 of those 16 presidential elections, a stellar correlation.

And during the 12 times when stock markets fell in September and October before a presidential election, the incumbent party lost 10 times.  This may sound surprising, but it makes perfect sense.  The fortunes of the US stock markets dominate American sentiment, leading voters to feel better or worse about their political leaders.  The Fed launching QE3 right before the 2012 election almost certainly gave Obama his victory.

So Republican lawmakers are openly hostile to this easy-money Fed that has robbed American savers, enabled the Democrats’ big-government spending binge, and even got Obama reelected despite him presiding over the worst US economy since the Great Depression.  A Republican-dominated Congress is the worst nightmare for the Federal Reserve, and vastly limits the Fed’s ability to continue printing money.

Republican legislators are ready to make life a living hell for the Yellen Fed.  They can drag Yellen before endless hearings, putting intense political pressure on her to normalize the Fed’s balance sheet and interest rates.  They can vote for more Fed oversight, or even force the Fed to tie its interest-rate targets to hard mathematical metrics rather than the FOMC’s discretion.  They could even threaten to revoke the Fed’s charter!

The Federal Reserve was created by an act of Congress 101 years ago, and it serves at the Congress’s pleasure.  The Congress can kill it anytime, or impose any restrictions it wants.  Sure, Obama can and will veto any aggressive anti-Fed legislation since he needs the Fed’s inflation to “pay for” the big-government spending that bribes Americans to vote Democrat.  But Yellen will still be forced to tread very softly now.

Shackling this easy-money Fed has massive implications for the Fed-levitated US stock markets.  For all kinds of fundamental, technical, and sentimental reasons based on over a century of market history, this cyclical stock bull was topping in late 2012.  The bull was overvalued, overextended, at its secular-bear resistance, and euphoria was rampant.  It was starting to roll over on schedule before the Fed hatched QE3.

Its third quantitative-easing campaign, which means creating new money out of thin air to buy bonds, was unprecedented on multiple fronts.  Unlike QE1 and QE2, it was open-ended.  The Fed didn’t announce an end date up front, and kept promising it could ramp up the QE3 debt monetizations if the stock markets started to flag.  This created a Fed Put, a psychological backstop that kept traders aggressively buying stocks.

QE3 was also unprecedented in its direct monetization of US Treasuries, inflating away the Democrats’ excessive spending.  QE1 had $300b of Treasury buying, QE2 had $600b of new Treasury buying, and QE3 weighed in at $790b by its recent end.  The whole QE experiment since late 2008 has ballooned the Fed’s Treasury holdings by $1982b!  That’s $2t of government spending that wouldn’t have otherwise happened.

Without this brazen Fed effort to artificially manipulate interest rates lower, the stock markets would look very different today.  If bond yields weren’t so anomalously low, stock markets wouldn’t have soared on bond investors grudgingly giving up on that manipulated market to move capital into stocks to seek out some returns.  And without that QE-fueled government spending, overall corporate profits would’ve been lower.

And with Republicans now running Congress, the QE era is definitely over.  The Fed can’t risk launching QE4 to support stock markets when they inevitably start to swoon.  The political backlash would be too great, threatening the Fed’s coveted independence or maybe even its very existence.  Yellen’s hands are tied, she can’t further alienate a hostile Congress.  So the Fed’s balance sheet is done growing through QE.

Curiously the euphoric stock bulls think these extraordinarily anomalous stock markets are normal and righteous.  But nothing could be farther from the truth.  As of this week, this latest cyclical stock bull in benchmark S&P 500 (SPX) terms was up 199.1% over 68 months.  This is far beyond the average size and duration of mid-secular-bear cyclical bulls of a doubling over merely 35 months.  Talk about overextended!

And healthy stock bulls see periodic corrections, selloffs greater than 10%, to rebalance sentiment and bleed off excess greed.  These generally happen about once per year or so.  But today’s stock markets have gone an astounding, and near-record, 37 months without a single correction-magnitude selloff!  Without sentiment being rebalanced, greed has blossomed into extremely dangerous full-blown euphoria.

How did such a wildly-unprecedented market extreme come to pass?  The Fed.  QE3 convinced stock traders the Fed would quickly jump in and print money to arrest any stock-market selloff.  So they quickly forgot about market history and cycles to buy, buy, buy no matter what.  The Fed had their backs, so why bother selling ever?  With the Fed printing money, couldn’t the stock markets only rise to the end of time?

While the cyclical bull between early 2009 and late 2012 was normal, everything since was an illusion that was conjured by the Fed’s QE3 inflation.  This chart shows the SPX superimposed over the Fed’s balance sheet, and is incredibly damning.  Even before late 2012’s QE3 launch, the stock markets only rose when the Fed’s balance sheet was ramping up through debt monetization.  Whenever it stalled, stocks sold off hard.

For more background on this chart, check out an essay I wrote a couple months ago.  But basically it shows the Fed’s total balance sheet in orange, its Treasury holdings in red, and its mortgage-backed-securities holdings in yellow.  Also shown are key dates in QE, when the Fed’s campaigns began, were expanded, and ended.  The message of this chart is crystal-clear, without QE4 the stock markets are doomed.

This mighty cyclical bull, one of the largest in history, has had two full-blown corrections.  They happened in mid-2010 and mid-2011, and weighed in at 16.0% and 19.4% SPX declines in a matter of months.  Note that the catalyst both times was the Fed’s balance-sheet growth stalling out when QE1 and QE2 ended!  In both cases the stock markets didn’t start rallying again until the Fed announced more debt monetizations.

QE2’s birth ended the post-QE1 correction, and the so-called Operation Twist campaign of migrating the Fed’s Treasury holdings from short-term to long-term to manipulate long rates lower ended the post-QE2 correction.  If the Fed hadn’t continued its radically unprecedented balance-sheet expansions, would either of those corrections ended where they did?  No one knows, but we are about to find out I suspect.

Since late 2012 when the Fed goosed the stock markets with QE3 and gave the election to Obama, the growth rate in the Fed’s balance sheet has been unprecedented.  Look at how steeply that orange line in this chart rises!  And the correlation between it and the US stock markets is nearly perfect.  As long as the Fed was aggressively printing new money to buy bonds, the stock markets soared on all this inflation.

The FOMC just ended QE3 in late October, and it ultimately weighed in at total monetizing of $1590b.  This dwarfs QE2’s $600b of new buying, and challenges QE1’s staggering $1750b right after 2008’s big stock panic.  In the first 8 months of 2008 before Bernanke launched ZIRP and QE, the Fed’s balance sheet averaged $875b.  Today it is a jaw-dropping $4451b!  QE has totaled nearly $3.6t, a staggering sum.

With QE3 over, the Fed’s balance sheet has stalled out and will soon start to shrink.  This is happening at a time when stocks are near nominal record highs after an outsized bull market and trading at extremely high valuations.  The simple average of the individual trailing-twelve-month price-to-earnings ratios of all 500 SPX stocks is now 25.3x.  This is far above 14x historical fair value and nearing the 28x bubble level!

If everything beyond 1500 in the S&P 500 was the result of the Fed’s QE3 manipulations, what is going to happen to the stock markets with QE3 over and QE4 impossible politically?  It isn’t going to be pretty.  Absolute best case we are looking at a full-blown correction approaching 20%, which would drag the SPX back under 1625.  And far more likely the overdue cyclical bear will arrive, ultimately cutting stocks in half.

The new Republican Congress won’t only pressure the Fed to normalize its balance sheet, but its interest rates too.  In the quarter century between the early 1980s rate spike and 2008’s stock panic, the federal-funds rate the Fed directly controls averaged 5.3%.  That’s far higher than today’s zero!  Stock markets abhor rising rates, as bonds look relatively more attractive and therefore suck increasing capital out of the stock markets.

Coupling rising interest rates with the Fed’s soon-to-be-shrinking balance sheet greatly compounds risk for today’s stock markets.  This would be a recipe for serious selling no matter when it happened.  But at a time when the euphoric stock markets are at record highs after an overextended bull, haven’t experienced a single correction in several years, and are dangerously overvalued, the implications couldn’t be more ominous.

And almost certainly the Republican lawmakers’ righteous disdain for this easy-money Fed will not lapse merely because the stock markets sell off.  America needs to get back on an even keel financially, to stop the Obama Administration’s debt binge and restore normal interest rates.  Republicans aren’t going to betray their fiscally-conservative convictions to encourage QE4 no matter how low the stock markets go.

And they may not even care due to political calculus!  Obama is still in charge for the next two years, and if the stock markets suffer a new cyclical bear between now and the 2016 elections the voters will put the blame squarely on his shoulders.  Weaker stock markets actually increase the odds a Republican will win the presidency in 2016!  And there’s nothing Republicans want more than one of our own in that high office.

So contrary to euphoric stock traders’ belief that the massive Republican victory this week will prove great for stock markets, just the opposite is likely true.  The artificial Fed-spawned levitation of stocks over the past couple years or so is doomed without more QE.  And the Republican Congress makes it far too risky for the Fed to push its luck with QE4.  This will make for tough sledding for the SPX and all its derivatives.

And it’s not just SPX ETFs like SPY at risk, but the entire stock markets.  As the general stock markets sell off on the Fed’s QE backstop vanishing, nearly all stocks will be dragged lower in the carnage.  The one sector that thrives when stock markets are selling off is gold, as demand for alternative investments surges when conventional ones are struggling.  Gold is a proven stock-bear-market performer, with great upside.

With more QE politically impossible, investors and speculators alike need to prepare for a much different stock-market environment going forward.  It’s absolutely essential to cultivate contrarian thought and trading philosophies when the stock markets are overdue for a major selloff.  Contrarianism is all about fighting the crowd, buying low when few others will then later selling high when everyone gets excited.

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The bottom line is the massive Republican Congressional victory is not bullish for these overextended and overvalued Fed-levitated stock markets.  The Republican lawmakers are going to put tremendous pressure on the Fed to normalize its bloated balance sheet and horrible zero-interest-rate policy.  The Fed serves at the pleasure of Congress, and can’t risk infuriating it to launch a QE4 to rescue stock markets.

Thus the overdue major selloff is still imminent.  At very best it will be a full-blown 20% correction, but far more likely is a 50% cyclical bear market unfolding over a couple years.  The markets are forever cyclical, and bears always follow bulls.  With the Yellen easy-money Fed’s hands now tied, the implied backstop that temporarily delayed that down cycle has vanished.  It’s time for these Fed-inflated stock markets to pay the piper.

Adam Hamilton, CPA

November 7, 2014

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