The ducks are lining up for an absolute disaster in the stock market over the months ahead. The Fed clearly see risks on the horizon, and the stock market does not. That will change very soon. How do we know this?
The equation for calculating real stimulus involves consideration to the funding operations of the U.S. Treasury department. The U.S. Treasury is issuing bonds every month, increasing the debt levels of the United States accordingly, and the Federal Reserve is essentially funding the operations of the U.S. Treasury, and then some. It is this excess that equates real stimulus.
When we offset the drain on liquidity that exists when the U.S. Treasury issues bonds to fund the government from the operations of the Federal Reserve in 2013, the real stimulus offered by the $85B bond buying program is only about $11.5 billion, far less than the face value, but still a net positive.
This is not unusual. This was true during past quantitative-easing programs, too, but because the U.S. Treasury department expects to need substantially less money to operate in 2014, the amount of funding needed on a monthly basis has come down substantially. The net effect of the offset increases the real stimulus of the current $85B bond buying program from $11.5 billion to $35B.
The decision to not taper was a decision to increase stimulus, and although the face value of the program is exactly what it was before, the net effect of this decision not to act is to increase the net real stimulus offered by the Federal Reserve to the U.S. economy by $23.5 billion, or 204%.
I am writing this knowing full well that the proactive strategies we use at Stock Traders Daily do not depend on market direction, and none of us should forget that, but there are major concerns, and now more traditional metrics are supporting the idea that the stock-market rally will soon end.
First, companies have been selling into this rally aggressively. They do this by issuing secondarys, IPOs and debt. They did this through all of 2013, but corporate America has been selling in a more-pronounced fashion recently, and individual investors have been buying. This is significantly different than years past.
Looking back at the earnings-per-share (EPS) growth rate for the Dow Jones Industrial Average in the second quarter of 2013, it was clear from the disastrous results that the share-repurchase programs have been restrained. We have calculated the influence share-repurchase programs had on the earnings of the Dow before, and some conclude that share-repurchase programs have accounted for as much as 80% of the EPS growth for the Dow, but during this most-recent quarter, the positive influence on EPS from these share-repurchase programs did not exist at nearly the same rate.
Therefore, companies are not only selling into this rally, but they are not buying back stock aggressively either, even though share-repurchase programs are still authorized by most companies. There is a material difference here, and authorizing a share-repurchase program and actually buying stock are two completely different things. A couple of years ago, companies were buying aggressively, but today, especially recently, companies are selling into the rally.
Next, although one might expect interest rates to fall back down to where they were before the market became concerned with tapering, the reaction of the bond market to the no-tapering announcement on Wednesday was little more than a knee-jerk reaction.
Bonds are essentially where they were a week or so before the Federal Open Market Committee (FOMC) meeting, and the impact of that no decision has been muted in that smart-money category.
In my opinion, bond investors are almost always smarter than stock-market investors because bond-market investors rarely look for a quick trade, they study more carefully, and they make educated decisions when stock-market investors might make decisions based on a news event or something similar.
With focus on the ProShares UltraShort Lehman 20+ Year Treasury ETF (NAR:TBT) , the double-short long-term Treasury ETF, this instrument tested the defined midterm support level in our real-time trading report twice since the FOMC decision, and thus far, that support level has held. Investors do not seem to be clamoring to buy bonds, and interest rates have remained higher than the FOMC probably would like.
In my opinion, the Federal Reserve did not act on Wednesday for one of a few reasons, or a combination of them all. Either they were concerned that interest rates moved higher so fast that they would impede economic growth and tapering might exacerbate that situation, or the Federal Reserve was concerned about a government shutdown.
I understand the debate about employment. I understand the underlying economy, as well, but if the rationale for no tapering was based on weak economic data, and the prospects for weaker economic data if interest rates remain high, the corresponding move in the stock market is not warranted.
In no uncertain terms, the decision not to taper by the FOMC told us that there are problems that exist and additional problems that can surface; these can be due to higher interest rates, problems in Congress, and quite reasonably, the state of our current economy once the top layers are peeled back.
My initial indication a few weeks ago was that the FOMC would not taper their bond-buying program due to these factors, but I succumbed to the general-market pressures and began to expect the FOMC to begin this tapering process because it had an open-door opportunity to do it.
But apparently they are seeing a far worse economy than I thought, which is more in line with my observations as well, and now they have essentially increased stimulus by doing this.
The result of not tapering is actually to increase the amount of stimulus because the Treasury does not need as much money in 2014 as it needed in 2013, so the offsets that existed before are no longer there at the same rate. That means the decision not to taper was actually a decision to increase stimulus, and that as well is a red flag.
When the FOMC makes a conscious decision to stimulate the economy, it does it because the economy is too weak and likely to get weaker, and that is exactly where we are today. Corporate America recognizes this, is selling into the rally, and they are doing it before third-quarter earnings results.
In my opinion, based on my overall analysis, I believe the third-quarter earnings results will come in much lower than current expectations, and I am prepared for earnings warnings. I am also prepared for significantly lower market levels, with 1425 in the S&P 500 still as a downside target.