Fed’s QE3 exit strategy: ECB’s negative rates will force European banks to buy our debt?

Today the markets popped with the announcement of the European Central Bank’s (ECB) new policy of ultra low and negative interest rates for excess bank reserves.  This was done in an effort to combat perceived deflation.

The S&P500 closed at a record high (slightly below average volume).  The NASDAQ was up a strong 1.05% (in average volume) signaling this rally’s first accumulation day (heavy buying by institutional investors).

On the negative side, this accumulation day came 36 days after April’s bottom.  That’s an extremely long time to show investor enthusiasm, but better late than never.

On the positive side, the indexes have not had any days of poor performance since the uptrend started 8 days ago.  That’s an indication that no knee jerk selling has occurred.  The indexes have unspectacularly crept up slowly but deliberately.

The ECB’s low rates may inspire more lending by the European bankers…but, maybe not.  Unlike the US loose money policies, the ECB is not offering any cover or protection to their banking system.  Remember back to the Housing Bubble shenanigans, banks were motivated to make bad loans primarily because they weren’t planning to hold the debt.  The mortgages were sold to Fannie Mae/Freddie Mac or bundled and sold off to unsuspecting income funds.  Even now, 6 years after housing prices started collapsing, US banks are still peddling their bad mortgages to the Federal Reserve (through QE3 mortgages purchases).

European banks are being given no such backdoor exit plan.  They’re simply being penalized for holding cash reserves.  So maybe there isn’t enough incentive for them to take on bad debt.  Let’s face it, if there were profitable loans to be make, those greedy German bankers would be exploiting borrowers without the prodding of the ECB.

The US dollar has been trading up on the rumor of the ECB’s actions but today was down on the news.  Ten year Treasuries are hovering around 2.58%.  I guess the new carry trade will be European banks buying US Treasuries…maybe that’s been the Fed’s QE3 exit strategy all along???

I should know better, but what still concerns me is that after all these years of “recovery”, the global markets still need to be propped up by central banks.   How is that a healthy economy?

Call me a contrarian, but I’m still risk averse.  How about you?  I’m interested to poll your opinion.  Are you in this rally or setting on the sidelines?  Let me know at:  [email protected]

Market in UPTREND…but I’m staying out, for now

Today Investor’s Business Daily (IBD) confirmed the market was in an uptrend.  They’ve had the market in correction for about 43 days…something we haven’t seen since the recovery got underway.  This has been a turbulent year, IBD has only had the market in “confirmed uptrend” for about 40 total days all year.

I’m not one to argue with or fight the market.  When it’s up, it’s up.  However, for now I am still mostly remaining on the sidelines.  That could all change tomorrow, if something spectacular occurs.  Otherwise,  I plan to patiently remain in cash for a little longer.  It’s been a turbulent five months, with more trading volume on Losing days than Gaining days.  At this point, I’m more concerned with risk management than growth.

Yes, the blue chip indexes are making new highs, and in recent days the NASDAQ and Russell2000 have performed well…BUT trading volume remains weak. Today the S&P500 hit a new high but trading volume was 12% below average.  The NASDAQ was up a substantial 1.22% today but volume was 9% below average.

I’m cautious because over my nearly 30 years of investing, I’ve learned that the best way to make money in stocks is to NOT LOSE IT.  If a solid uptrend is underway, there will be multiple entry points.  If this is just a “dead cat bounce,” I want to avoid the risk and preserve my capital for smoother sailing.

Maybe some GLOOM but not DOOM

I’ve received many inquiries as to my current stance on the market.  I see some potential gloom but certainly not long term doom.

Our current economic situation is characterized by Grisham’s law which states that “bad money drives out good.”  The corollary is: “money flows where it’s treated best.”

Artificially suppressed interest rates have driven money back into real estate and stocks [such was the intent of the Federal Reserve to re-capitalize their member banks].  So far the scheme has worked.  Stocks have re-inflated as corporate earnings continue to grow (growth has been driven primarily by historically low labor and borrowing costs- NOT sales growth).  Residential real estate pricing is mostly up but fragile as somewhere near 20% of mortgages are still underwater.  [see global headwinds below]

Now that large cap markets are stable and the banks have excess reserves…will interest rates rise and drawdown blue chip stock valuations?

The below chart shows the relationship of S&P500 performance (black line, left axis) with price-earnings ratios of both the S&P500 (blue line, right axis) and 10 year US Treasuries (green line, right axis).  [Treasury PE is calculated by taking the inverse of the bond yield, i.e.  a 2.50% Treasury has a PE of 40:  1/.025=40]

Since the Great Recession, the Treasury PE has spiked well above historic norms…paying a low interest rate and thus driving money into stock equities.  [money flows where it’s treated best]  Despite the near zero Fed interest rates, it’s important to remember that an escalating stock market was only possible because corporate earnings have been positive and growing.  Take away corporate earnings and the stock market will dive, regardless of interest rates or Fed policy.  Blue chip stocks are at reasonable valuations if future earnings estimates pan out.  2014 corporate profit growth below 5% would be worrisome.

Interest rates may or may not rise.  Japan has been easing rates and running unsustainable debt for a generation.  There are global headwinds holding back growth which could keep Fed monetary policy extremely loose.  Even if the Fed ends QE, it’s likely that they will continue to roll over their $4 trillion reserves into new debt for the foreseeable future.

Global headwinds holding back growth are:

  1. Aging population
  2. Extreme debt (both public and private)
  3. Government over reach (from crony capitalism in the US to China & Russia trying to expand their borders)

So do I think we’re on the road to economic meltdown?  No.  A 10-20% correction is likely, as part of any business cycle (if corporate profits decline there will be a correction).  A significant stock market drop could even be provoked by the Fed to help them mandate their monetary policies.

I’m optimistic over the long term.  Despite the headwinds, there are robust tailwinds sweeping the US economy.  Five secular megatrends are:

  1. Energy boom- fracking and horizontal drilling technology will be adopted globally and dramatically expand the world’s petroleum and gas reserves.  Low cost energy drives an economy and covers up innumerable inefficiencies.
  2. Automation- will continue to increase productivity and sustain innovation.
  3. Internet connectivity- from the cloud, to social media, to the internet-of-everything:  the information age is just coming out of its infancy and will continue to have a profound impact on efficiency and creative destruction.
  4. Immigration- into the US will provide skilled & unskilled labor to counteract the declining birth rate.  Unskilled labor will particularly benefit service industries that can’t gain efficiencies through automation.
  5. US manufacturing resurgence- small and large scale manufacturing will boom in the coming years due to the convergence of the above four megatrends.

My long term forecast is that the Fed will keep this stagnant economy on track until the above five megatrends kick in.  At which time the megatrends will drive the US economy for a generation.

NOTE: I’m not ruling out a normal 10-20% business cycle correction to the stock market, or multiple corrections for that matter.  I expect turbulence, and as stated in previous articles my current portfolio is mostly in cash.  But I don’t foresee an economic meltdown of the economy.

Treasury price earnings ratio 140522


S&P500 within 1% of all time high…BUT

Despite turbulent market conditions, the S&P500 has been clawing its way up and is within striking range of a new all-time high.  The broad index has fared much better than the NASDAQ or Russell 2000.  Problem is these latter indexes are where the growth and leadership originate, as opposed to the S&P500 and DOW which offer safe havens and defensive positions.

It’s probable that a bull market rally will be led with an advance in the tech heavy NASDAQ or small cap Russell 2000, not the stogy blue chip DOW.  Likewise, a downturn will originate with these momentum indexes and if there is truly a correction the safe havens will crumble too.

As previously noted, NASDAQ trading volume continues to be lighter on Up days, an ominous tell.

Concerns abound- Russia/Ukraine conflict, Fed tapering, weak Q1 earnings, deflation in Europe, soft growth in China…a 5 year bull market getting long in the tooth.

A prudent investor patiently waits and would rather miss a run up than suffer through a drawdown.

Volume matters…that’s why I’m still on the sidelines

No doubt the market has been up the past six trading sessions.  But in this volatile environment I prefer to remain cautious.  I have several concerns about this market, the most elementary being- low trading volume on Up days and high trading volume on Down days .

2014 has been characterized by the majority of above average trading volume occurring on days when the market is down.  That’s known as “distribution” i.e., institutional investors are selling while they tell you to “buy & hold”.  A healthy market would be characterized by down days having significantly lower trading volume…an indication that less people are running towards the fire exit.

That’s why trading volume is such an important indicator.  Think of Econ 101 and the relationship between Supply & Demand.  If everyone wants your product, you raise the price.  If nothing is selling, you lower the price.

The stock market works in a similar way.  If more stocks are being sold at lower prices that indicates an enticement is being offered to find buyers.

As growth investors, we want to sell at a premium, not a discount.

The recent rebound has been weak in terms of volume.  All but one of the past six trading sessions have been below average trading volume.  Monday’s volume was the lowest trading day of the year (on both the S&P500 & NASDAQ).  That’s my concern.

Everything could change tomorrow, but for now I remain cautious and my portfolio mostly in cash.