Dangerous Stock Markets

These record US stock-market levels are very dangerous, riddled with extreme levels of euphoria and complacency. Largely thanks to the Fed, traders are convinced stocks can rally indefinitely. But stock prices are very expensive relative to underlying corporate earnings, with valuations back up near bubble levels. These are classic topping signs, with profits growth stalling and the Fed out of easy dovish ammunition.

Stock markets are forever cyclical, meandering in an endless series of bulls and bears. The latter phase of these cycles is inevitable, like winter following summer. Traders grow too excited in bull markets and bid up stock prices far higher than their fundamentals support. Subsequent bear markets are necessary to eradicate unsustainable valuation excesses, forcing stock prices sideways to lower until profits catch up.

This latest bull market grew into a raging monster largely fueled by extreme Fed easing. At its latest all-time record peak hit just this week, the flagship US S&P 500 broad-market stock index (SPX) has soared 335.4% higher over 10.1 years! That makes for the second-biggest and first-longest bull in US history, only possible because it gorged on $3625b of quantitative-easing money printing by the Fed over 6.7 years.

That epic 5.3x mushrooming of the Fed’s balance sheet peaked in February 2015, when the SPX was just clawing over 2100. It soon coasted to a 2130.8 topping in May 2015, before trading sideways to lower for 13.7 months without Fed QE. Modest new highs weren’t seen until July 2016, after the UK’s Brexit-vote surprise kindled hopes for more central-bank easing. Another surprising event drove the final third of this bull.

The November 2016 elections were a Republican sweep, with Trump winning the presidency while his party controlled both chambers of Congress. So the SPX started surging to new record highs, initially on hopes for big tax cuts soon and later on record corporate tax cuts becoming law. That ultimately propelled the SPX to 2872.9 in late January 2018 and 2930.8 in late September 2018, lofty new all-time record highs.

But paraphrasing an ancient Biblical passage from Job, the Fed gave then the Fed took away. Right after the SPX peaked, the Fed ramped its year-old quantitative-tightening campaign to full speed in Q4’18. QT was supposed to unwind a large fraction of that $3625b of QE-conjured money, shrinking the Fed’s crazy-bloated balance sheet. $50b per month of QT monetary destruction had to be this QE-fueled bull’s death knell!

Indeed the stock markets crumbled under that Fed-tightening onslaught, plunging 19.8% over the next 3.1 months into late December 2018. That severe correction was right on the verge of crossing the -20% threshold into new-bear territory. Over a third of those serious losses happened in just 4 trading days after the Fed chairman declared full-speed QT was “on automatic pilot”. By that time the SPX was very oversold.

Stock-market extremes never last long, with big and sharp mean-reversion bounces following major selloffs. The SPX reversed hard and soared into early 2019, already 12.3% higher by late January. Then the Fed’s first policy decision after that stock-crushing QT-autopilot one saw this central bank completely cave to the stock markets. It removed references to further rate hikes and declared it was ready to adjust QT.

That dovishness unleashed more waves of momentum buying. By the eve of the Fed’s next meeting in mid-March, the SPX had rocketed 20.5% above its severe-correction near-bear low. But that wasn’t good enough for the Fed, which slashed its future-rate-hike outlook while declaring it would essentially stop QT by September 2019. That is very premature, implying less than 23% of the Fed’s total QE will be unwound!

That goosed the stock markets again, helping push the SPX to an enormous 25.3% rebound-rally gain by this week. At 2945.8, it had edged 0.5% above late September’s then-record peak. With stock markets more than regaining their big losses, euphoria and complacency exploded again. These herd emotions have proven dangerous in market history, marking major toppings including terminal bulls rolling over to bears.

Euphoria is simply “a strong feeling of happiness, confidence, or well-being”. It is always accompanied by complacency, which is “a feeling of contentment or self-satisfaction, especially when coupled with an unawareness of danger or trouble”. This perfectly describes the stock markets’ sentiment-scape in recent months. Speculators and investors just love these lofty stock prices, with virtually no fear of material selloffs.

While euphoria and complacency are ethereal and unmeasurable, they can be inferred. The classic VIX fear gauge is the most popular way. It quantifies the implied volatility options traders expect in the SPX over the next month, as expressed through their collective trades. While a high VIX reveals fear, a low one shows the direct opposite which is complacency. In mid-April, the VIX revisited ominous bull-slaying levels.

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Gary Anderson 3 months ago Contributor's comment

The Fed is obsessed with wage inflation even when there is no real inflation. The obsession hurts consumers. There is no euphoria on mainstreet, only in the stock market.