US stock market propelled by QE, buybacks and margin debt since 2009

The US stock market has enjoyed a spectacular rally from its lows of 666 on the S&P 500 in March, 2009.  Since then the market has surged higher, surpassing 2,100 on that same index.  Stocks are credited with the ability to forecast the economic future of their respective country.  This is a pattern that explains why rallies may occur before substantive economic improvements are realized.

This time is different

Instead of fundamental economic improvement, the stock market has rallied largely because of cost cutting, earnings improvements, quantitative easing (QE) and share buybacks.  The latter two phenomenon are of particular concern because they offer a glimpse in to catalysts that are a complete departure from normal stock market rallies.  The economy itself has largely languished since the 2008 collapse.  As an indicator of that the workforce participation rate is at multi-decade lows while US debt is at an all time high.

Enter QE 1 through 3

During QE the stock market experienced the majority of its gains.  As you can see in the chart below QE 1 through 3 bolstered the US stock market from its lows to new highs.

qeThis unprecedented accommodative monetary policy, combined with a backdrop of enormous share buyback programs (see chart below), seems to account for the majority of gains that US equities have experienced since 2009.

Share buybacks surge to 2007 levels (from 2010 until now)

buybacks1Share buybacks engender an atmosphere where corporate earnings seem to be better than they really are delivering.  This is because with each share purchased the earnings per share reported increases.  That is to say, a corporate stock buyback takes the shares out of public circulation and by virtue of doing so makes price-to-earnings multiples appear to be healthier than they really are.

Margin speculation exceeds 2007 highs

nyse_margin_debtAs seen in the chart above, margin debt is now exceeding that of the previous bull market.  This is a disconcerting trend as all three indicators (QE, buybacks and margin debt) seem to illustrate a stock market that is thrusted higher more by debt than fundamental macroeconomic improvement or by improvements in company financials.   That isn’t to say that this is a universally applicable rule to every individual stock, but by and large it is having an enormous effect on US equity indices.

Where do we go from here?

Every investor would love a crystal ball that shows them tomorrow’s prices today.  If such a device existed there would be no uncertainty in investments.  Indeed, everyone would be a winner — and there would be no losing trades.

My personal take on these charts and the facts they bring to light is that we are currently in the midst of a bull market that has been driven more by debt than structural improvement.  A market where more of the gains eked out have been contingent on monetary stimulus, share buybacks and margin-based speculation than what this country truly needs: a stable, growing economy.

Burst bubbles lead to bigger and bigger bubbles

With that in mind I feel as though the lessons of bubbles past have been largely missed.  Each time there is a bubble (NASDAQ 1999, real estate and finance in 2007 and with just about every debt-based asset class now) the bubble itself becomes more dangerous due to the underlying amount of debt and leverage necessary to inflate it. This trend is made possible by ever increasing amounts of monetary stimulus, market intervention and debt-driven speculation being used as the remedy for each previous bubble bursting.

I do not believe we have ever been in a more dangerous bubble than we are now.  Real estate, stocks and bonds are largely at inflated values that rely on debt-based expansion rather than economic expansion.  As a result, it may be worth considering exiting from those asset classes that have benefited from outsized gains due to, at least in part, an incredibly unsustainable combination of supporting factors.

Once this current bubble pops, the very same one that financial media, talking heads and central bankers claim does not exist, we may see a return to 2008-like volatility — or worse — a total seize up of the financial system.  But one truth is certain: the rally we have experienced to date across multiple asset classes has been built on nothing more than a house of cards.  And when it tumbles, so too shall confidence in the financial system at large.

US dollar index rally stalling, long term trend still down

With all of the fervor over the US dollar index rallying close to 100, a reality check is in order.  According to financial media reports the Euro is collapsing, gold is a barbarous relic that’s lust its luster, oil is falling and the commodity complex itself is imploding.  Readers of this blog may remember that on November 1st of 2014 I wrote about the possibility that such a situation may play out in 2015.

Opportunities may exist in battered markets

Sentiment for other major currencies, energy, precious and non-precious metals could not be much worse than it is now.  Cautious contrarian investors may find opportunities in the extreme negative sentiment. Certainly many natural resources companies have much more attractive valuations now than they did several years ago.  Commodities themselves may also offer more value at these price levels than they did in previous years.  Both as a hedge against inflation and a bet that resource consumption will increase in years to come.

Meanwhile US dollar trend followers may pile on to what appears to be a massive multi-year rally in the US dollar index or short other currencies, commodities and similar assets.  There already exists an enormous amount of speculative betting on the dollar surging higher and other dollar priced commodities and foreign currencies tumbling.  This positioning leads me to believe that we may be closer to a high in the US dollar rally than a base to move higher from.

united-states-currencyThus far the US dollar index on a long term technical basis appears to have made a series of lower highs and lower lows stretching back to the rally in the mid-1980s (see above chart) which began as a result of massive interest rate increases by the US Federal Reserve.  In order to break this downtrend the index would have to rally beyond 120 and sustain itself there.  Only then would I feel that the US dollar has decisively entered an uptrend. That has not happened yet.

The range bound US dollar index

As of the last 10 years we find the US dollar index trading within a range between 72 and 100 (see chart below) which may continue for some time if there isn’t an outside catalyst.  Ultimately I believe the US dollar index is headed for a lower low when the current rally stalls further and then reverses lower.


One must remember that the US dollar index is a trade weighted currency basket that measures the dollar vs. the Euro, Yen, Pound Sterling and does not necessarily directly reflect the purchasing power of the US dollar other than when buying these currencies.  In addition, the US dollar index has enjoyed its current rally largely on expectations of a widening interest rate differential between the US Federal Reserve and other central banks.

Will the September hike come to fruition? Is it meaningful?

The Federal Reserve has repeatedly delayed its much anticipated interest rate hike, setting expectations that such an event may occur this September — and only if economic data fits their ever moving target.  Given the mix of economic data (both good and bad), combined with the backdrop of a significantly weaker Euro and the US dollar beginning to impact multinational companies earnings, I would be surprised if the Federal Reserve set its sights on a heightening cycle.  Perhaps a few increases to placate the financial media.  But a significant normalization of interest rates would likely have catastrophic effects on multiple asset markets, including mortgages, bonds, stocks and interbank financing.

Fed and interest rates thru 2009Up until 2008 the Federal Reserve largely followed the US Treasury 3 month bill rate — rather than vice versa. This meant that interest policy was apparently largely set by the 90-day Treasury Bill market.  See the chart above for a visualization of this trend.

Where there was once rate guidance there exists only volatility

Below you will find a chart of the 3 month Treasury bill rate graphed from 2000 to present.  In that chart one can see that the same dynamic may no longer exist. That is to say that the 3 month Treasury bill rate is extremely volatile and has been since 2008.  Is this an unintended consequence of quantitative easing and zero interest rate policy?  Is the Federal Reserve now without guidance from this critical interest rate setting market?  Or is the paradigm shift one where the Federal Reserve will now lead where the markets once did?

IRX-2000Much as the rate heightening cycle in 2004-2007 set off a powder keg of insolvencies related to highly leveraged speculative bets imploding, I believe any similar rate heightening cycle this time around will have equally disruptivbe, if not worse, consequences. But it’s anyone’s guess at this point.  As you can see we are largely in uncharted territory.

The crude contagion could cause chaos, crash

On the heels of another massive sell off in crude oil, the US stock market woke up from its slumber.  Instead of the discount in crude oil being priced in as a stimulus, it was seen (perhaps more accurately) as a risk. Crude touched prices that had not been seen since April, 2009.

US equities sold off on higher than average volume, with bonds, gold and silver catching a bid.  The VIX showed fear entering the market and spiked higher, but the rally faded as the day went on.  The US dollar strengthened modestly on the back of a weaker Euro and Yen.

Interest rates on the 10 year bond tested 2.00%, while gold has climbed above $1,200 and stabilized.  Tonight the Nikkei is selling off significantly in Tokyo.

crude oil

Greed may pause to give room for fear to take the reigns.

Markets are decidedly in a risk off mindset.  I suspect that this fear of risk will prevail over the leveraged and crowded long side bullishness that has pushed the US stock market up to record highs with few downdrafts over the last few years.

The fundamental improvements in the US economy have been sluggish, with many corporations buying back their own shares to boost EPS.  There is a dislocation between current perceived valuations and the global economy’s condition.

The crash in crude oil has brought about a serious challenge to many economies of energy producing nations, including the US.  Since 2008 many of the high paying new jobs have been in the energy sector.  Now that oil is down over 50% from its highs, many of these projects are no longer viable and drill rig operations are now at 10 month lows.

us oil and gas rigs jan 5 2015

Energy markets are an indication of economic health.

There is a certain amount of feedback from energy market prices that can be indicative of manufacturing activity, shipping and transportation.  To the extent that supply exceeds demand, prices should diminish until demand returns.  But even with a 50% cut in prices, there still seems to be room for more of a decline.  That is because while demand is diminishing, some oil producers are keeping or increasing supply rather than removing production.  This includes OPEC, Russia and Iraq, who stubbornly churn out more oil as prices lose support.

The perception becomes that a flood of oil is oversupplying the markets, but the reality is that demand has declined to such an extent that softening Chinese manufacturing demand has caused a ripple effect.  Most of the softening demand comes from Europe, China’s largest customer, coming to grips with a wave of economic headwinds.

This new normal, if we are to give it a name, is likely an indication of future global macroecnomic trends.

Global GDP 2015

Deflation strikes Japan and the EU.  Is the US next?

Persistent deflation is becoming a persistent theme.  Bond yields in Germany on 5 year notes hit negative yields.  Japanese bonds have fractional yields.  The US bonds seem to be ebbing lower and lower in interest rates in sympathy of the global deflationary pressures coming home to roost.

Are we going to experience a lost quarter century like Japan?  It seems ever more likely as the similarities are increasingly problematic.  A prescription of debt to solve debt-related problems.  Liquidity injections for structural economic problems show a lack of understanding from central authorities about what is wrong with our economy.

Nikkei stock index

Too much leverage, too many derivatives, too little transparency.

What the world needs now is more clarity about how far stretched the current system has become.  With over 700 trillion dollars of global derivatives, there is such an enormous amount of risk in opaque markets that a significant dislocation could cause another financial collapse.

None of the problems of 2008-2009’s Great Recession have been resolved at home or globally.  Instead the financial players that created the problem have now been given the reigns of the global economy and are leading us down a destructive path towards crisis.

The problems of the world will most likely come home to the US in 2015 and cause a profound impact on our economy and financial markets.  While it may not be apparent yet, I believe that the risks now are much greater than back in 2008-2009 and the ability of monetary authorities to mitigate those risks is impaired by the current and recent aggressive measures.


Stay tuned in to the flow of news.  Interesting things may happen sooner than we expect.

Caution! Market crash could be imminent

With growing uncertainty surrounding the European debt crisis, and the contagion spreading to much larger sovereigns, such as Italy, we now see risk aversion back on the table.  US markets are down over 3%, the headlines seem to be getting progressively worse and many fear that the situation could deteriorate much further — giving up much of the gains achieved in October.

Growing concern as market whipsaws

This kind of volatility, both up and down, is historically an indicator of very large market moves.  With the bias largely negative, it seems that a market crash could be coming if no resolution is found for the EU debt implosion.  Alternatively, should a large scale bailout ($2T+) occur, we could see a significant rally, especially within precious metals spot prices and miners.

For investors and traders, this type of price action is stressful.  Seeing fluctuations of multiple percentage points in indices and nearly 10% in stocks can cause forced position liquidation because of stop loss orders being triggered.  For traders, who generally capitalize on multi-day moves rather than moves within a single day, this type of action can cause significant losses should one be caught on the wrong side of the market action.  High frequency trading machines may capture gains, but are not providing liquidity or improving market efficiency, especially during periods of intense market moves.  Instead, evidence seems to be growing that the machine-based traders are making the market less stable and more prone to large price swings.

World view deteriorates

Global markets plunged as well, with Italy down over 9%, Poland down nearly 9%, Germany down over 7% and other European markets leading weakness as stock prices bleed, especially within the financial sector.  The lackadaisical response out of the EU, ECB and IMF leadership seems to be draining confidence and sparking fear in the markets.

US banks have hundreds of billions of dollars worth of exposure to European sovereign debt, banks and other related instruments.  Many have written credit default swaps, a form of insurance that has no capital reserve (see AIG implosion circa 2008) against European debt, exposing them to significant risks should the EU situation worsen.

Broken bonds from backwards economies

Many Western countries now face the prospect of sovereign debt problems, as their economies continue to slow, while investors fear that they will not be able to pay back the debt.  The United States is no exception, as its official debt reaches 100% of GDP, and by some estimates, their total outstanding unfunded liabilities have reached $75 trillion.

Japan has a 200% debt-to-GDP ratio, which is only made possible by the fact that most of their debt is held by Japanese banks and pensioners, but the situation there is deteriorating with growing political and economic instability.  Even China is no exception, as their economy is slowing down and the yield curve on Chinese debt has inverted for the first time — causing serious concern for those that felt China would lead the world out of recession.

The coming crisis

What happens next is not clear, but what is evident is that the world is changing.  Slowing economic growth, the bursting of the largest credit bubble in history, significant deterioration in debt-driven consumption and resource depletion all leads to a potential crisis.  All of the new debt that has been created to attempt to stem the last debt crisis has only exacerbated the underlying structural economic problems we are facing.  Papering over large amounts of fraud within the financial system and ignoring the peril of main street has divided the Western world.  Growing civil unrest and lack of available employment, especially for the young, has created the potential for large scale disruptions (think of the “Occupy” movement, but on a global scale with a significant percentage of the population participating).

I feel that unless we start seeing accountability within the financial sector and governments of the world, prosecution of the enormous fraud, transparency within the political and electoral process and erosion of corporate personhood in so far as money is considered free speech, as well as more regulation of over the counter derivatives, we will look back at the 2008 crisis and think of it as a relatively calm and orderly time within the financial markets compared to what could happen next.

News recap for Monday, Oct 3rd

Today was an exciting day for global markets.  Below you’ll find a recap of today’s most important news.  We are not anywhere near out of the woods, yet.  In fact I think equity markets are bound to get much worse.

Global equity markets are tumbling:

Banks are getting hit the hardest:\

Many EU banks have serious liquidity problems:

The yield curve is flattening, which usually happens before it inverts, signaling a potentially deep recession:

Protests in NYC are spreading:

And more protests are being planned:

I’ll have more posted as I digest and research the events that are transpiring in global markets.

Twist, but don’t shout

(Updated at 4:25 p.m.) The Federal Reserve announced that it will begin selling shorter term US Treasury securities and use the funds raised to buy in to the 6 to 30 year space.  They also indicated more easing in the mortgage-backed security market.  Stock and commodity markets had a knee jerk reaction lower, selling off on the statement’s release.  The total size of the program is expected to be about $400 billion — but there is no balance sheet expansion, just swapping of securities.   Notably the Fed did not reduce interest rates on bank reserves, thus there is no expectation that banks will lend more when they are poised to make even less because of the yield curve compression.

I believe that this is the beginning of more aggressive approach that the Federal Reserve will implement to lower borrowing rates for consumers on both fixed-rate mortgages and revolving lines of credit.  Whether this action has any material impact on the ailing economy remains to be seen, but I am highly skeptical as I don’t believe the Federal Reserve is capable of doing much more than delaying the deleveraging that must happen in all sectors of the economy.

Fed causes sell-off of equities with twist

Traders are apparently not enthused by Fed's maturity "twist."

Because of the renewed pressure on equities and the lackluster reaction to the policy release, I now expect the head and shoulders pattern to play out on major US indices.  These stock market indices have decisively broken down below the 10 day moving average, indicating a loss of upward momentum.

A sell-off down to the 10,000 area on the Dow could occur within the next week or two, and if that area does not provide technical support to markets, additional downside pressure could bring markets to the 9,750 to 9,500 area in relatively short order.  If frenzied selling occurs, perhaps as a result of news-driven events in Europe or more bombshells being revealed in the American banking sector we could see the 9,000 area give way to much lower stock prices.

Curiously silver is outperforming gold today, with gold weaker and silver spending much of the trading day in the green.  Even more interesting, however, was the difference in action in the paper and physical markets.  SLV and silver futures took a hit after the announcement and did not recover, but PSLV (the Sprott Asset Management physically-backed silver fund) saw selling and then filled the gap almost immediately, albeit temporarily.  Does this bifurcation in trading indicate that investors are more confident in the real thing or is it only a blip that will be arbitraged by the quants?  At this point it looks like an aberration as the gains have been given back, and then some.

Overall I think this monetary policy shift should be bullish in the long term for hard assets, especially gold and silver, as the maturity “twist” diminishes the interest rates on long-dated fixed-income securities and provides less “safe havens” for investors to seek returns in the paper markets.  In the short to intermediate term a longer period of consolidation and possibly a correction across the commodity spectrum is growing more likely.

Full Fed statement here: