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Friday, March 29, 2024

Last Time This Happened, The Markets Dropped 18%

Courtesy of Doug Short.

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.


A major financial event looks likely to happen in the next 3-6 months. As investors, we need to be aware of what’s coming, so today let’s take a look ahead. Here we go:

By the end of 2014, most observers expect the Federal Reserve (the “Fed”) to end the 3rd round of its “large-scale asset purchases,” a.k.a., “Quantitative Easing,” or “QE.” So we’d all be wise to consider this:

How will markets react when the Fed’s “QE” program ends?

Background

In the last 6 years, the Fed has introduced the world to QE1, QE2, and QE3, which are essentially massive attempts to inject money (liquidity) into the economy, purportedly as a “stimulus.” (You can read more about it, if you want, at the end of this article).

The sheer magnitude of these 3 “QE” money-printing programs has been staggering; although unfortunately, all the money printing has led to anemic results in terms of stimulating real economic growth.

How much money printing are we talking? Before QE1, the Fed owned about $900 Billion in assets on its books – which was already an all-time record high. Here’s what happened next:

As the charts above show, the Fed has printed enough money in the last 6 years to increase its own assets from a record $900 Billion to a new record of about $4,400 Billion (a.k.a., $4.4 Trillion). And oh, by the way, this is separate from all the “bailout” & “stimulus” money spent by Congress, which amounts to another several hundred billion dollars above & beyond the Fed’s “QE” programs! (Are you gagging yet?).

When QE programs end, markets react

So how have markets behaved in the midst of all this unprecedented monetary meddling? For clues and a visual perspective, I’ve prepared 3 charts (inspired by one of my favorite charts from Doug Short).

This 1st chart shows a history of the stock market – along with the Fed’s “QE” programs – beginning in 2007.

Click to View

Sources: Yahoo! Finance, Doug Short (dshort.com), TakeTimeForThis.com. Chart inspired by Doug Short’s chart here. This chart uses a logarithmic scale so that any given 1% change will appear equal to any other 1% change.

The 1st thing you should notice is that after QE1 and QE2, the stock market suffered immediate declines! Will the same thing happen when QE3 ends in a few months?

Let’s think this through. The 1st two QE programs ended badly for stocks. The “logical explanation,” of course, is that without the Fed pumping money into the economy, stocks couldn’t stand on their own two feet. But in practice, is that what really happened? And will it happen again?

There are actually complex arguments on both sides of the debate. My take? The markets are influenced by way too many factors to definitively answer those questions either way – even though the chart makes the case look pretty cut-and-dried. Certainly, the Fed’s actions have heavily influenced the markets in recent years. HOWEVER, trying to predict the market’s corresponding reaction to a single, predetermined event has NEVER been a winning strategy. Bottom line: I believe the end of QE3 will probably play out somewhat differently than either QE1 or QE2.

The point, though, is that the end of a MAJOR Fed program like QE3 is on the near horizon, and since this has all been one big, long experiment since 2008, investors simply MUST be aware of what’s coming. The risk of a market decline at some point is very real, whether the timing coincides perfectly with the whims of Janet Yellen & Co. (the Fed), or not!

NOTE: Many people tend to forget, the end of QE3 does NOT mean the end of Fed “stimulus.” Not by a longshot! The Fed will still have interest rates near zero for probably several months after the end of QE3, and in fact, the Fed will still own well over $4 Trillion in assets on its books for several months as well (as shown in the blue chart above). Oh, and by the way, while the Fed is “tapering” its QE program, the European Central Bank (ECB) is busy ramping up theirs! To say nothing of Japan’s Central Bank, which already owns twice as much debt as either the Fed or the ECB, as a percentage of the economy. Oh, boy.

How does “QE” impact interest rates?

The “QE” experiments have also whipsawed interest rates – in fact, even more so than the stock market. This next chart shows interest rates for 10-year US Treasury bonds.

Click to View

Sources: Yahoo! Finance, Doug Short (dshort.com), TakeTimeForThis.com. Chart inspired by Doug Short’s chart here. This chart uses a logarithmic scale so that any given 1% change will appear equal to any other 1% change.

Notice a few things:

  • Interest rates have been even more volatile than the stock market.
  • Rates crashed with the stock market before QE1, then skyrocketed during QE1… then plummeted again as soon as QE1 ended! And that was just the beginning….
  • Rates hit an all-time record low of 1.4% in July 2012 (in the midst of “Operation Twist,” about 2 months before the start of QE3). Over the next 17 months, rates shot higher, hitting an interim high of 3.03% on 12/31/2013, before dropping slightly in 2014.

Gold

Finally, the Fed’s QE programs have also played havoc with gold… but in a very different way. See chart below, which uses the price of an exchange-traded fund (symbol: IAU) to represent gold prices.

Click to View

Sources: Yahoo! Finance, Doug Short (dshort.com), TakeTimeForThis.com. Chart inspired by Doug Short’s chart here. This chart uses a logarithmic scale so that any given 1% change will appear equal to any other 1% change.

One would expect “QE” programs to de-value the dollar while driving up gold prices (because as the Fed prints more & more dollars, each dollar, in theory, loses some value… which in turn means each dollar would therefore buy fewer ounces of gold; the same principle often holds true for other commodities, like oil, as well).

Instead, though, gold continued its multi-year uptrend (yellow trendline) right on through QE1 & QE2, but then hit a ceiling in August 2011, right before the Fed announced “Operation Twist.” Gold prices fell significantly from that point forward (red trendline), hitting a low in December 2013 – despite the massive QE3 program! Gold remains about 30% below its all-time highs.

Why have gold prices behaved this way, when logic would have dictated otherwise? Part of the answer is that “QE” is not the only factor influencing gold prices (just as “QE” is not the only factor influencing stocks or interest rates). With gold, one of those “other” factors is simply supply & demand. Perhaps at the beginning of Operation Twist & QE3, investors simply threw in the towel on investing in gold (which had already had a huge run-up), opting instead for stocks (which the Fed seemed determined to continue propping up). After all, many investors may have reasoned, why fight the Fed’s dogged determination to inflate the stock market into a bubble?

Summary

I hope you find these charts informative & helpful. The takeaway is that we’re living in times of unprecedented central planning and intervention into our “free markets.” In response, markets are certainly behaving differently than they otherwise would (i.e., if left to operate freely).

Which way will the stock market go as QE3 winds down? What will interest rates do? Or gold prices?

No one knows; but change is in the air, as always, because well, the only constant is change. The trend is only the trend until it’s no longer the trend (to borrow a rather obvious investing adage).

Again, Fed actions are certainly not the only factors influencing these markets. Other factors come into play as well. On balance, the Fed can’t totally control markets as much as they seem to think they can… at least, not indefinitely.

Note: I wrote about interest rates and whether they’ll go higher or stay lower on June 3rd. (link). I wrote about gold & silver on June 24th. And I’ve written about the stock market regularly, of course.

As for stocks, returns are likely to be low over the next 7-10 years, if not longer. Not to say there won’t be big swings, both up & down. Big downswings will even create opportunities for us to profit during the volatility… as long as we’ve protected the bulk of your assets using the “Retirement War Chest” strategies I espouse to avoid losses during market collapses.

What to do

Fortunately for my subscribers, the Take Time for This monthly guidebook shows you exact investment recommendations to help you build & manage your portfolio every month, starting with a solid foundation of “Retirement War Chest” assets, and using a small portion of those RWC assets – on occasion – to invest in “Aggressive Growth Opportunities.”


APPENDIX – A very brief history of the Global Financial Crisis

On March 9, 2009, the stock market hit bottom after dropping nearly 57% over the 17-month period starting 10/9/2007. During those dreadful months – known as the Global Financial Crisis (GFC) – the US & other governments paraded out a litany of extreme, historic actions in their efforts to “save” the global financial system from total meltdown. Whether or not government actions actually helped or exacerbated the situation over the ensuing years is open to debate. I know what I believe. The sad truth, though, is that the world will never know how things would have played out had markets been allowed to operate freely. Nevertheless…

Among other things, the government during the GFC gave us an alphabet soup of bailouts and programs including TARP, TALF, PDCF, ZIRP, and so on. Government spent hundreds of billions of dollars. And last but not least, the Federal Reserve Bank (the “Fed”) – our nation’s “central bank” – gave us a series of “Quantitative Easing” (QE) programs.

What is “QE”?

Normally, the Fed’s main tool is the Fed funds rate, which is essentially an interest rate that the Fed controls rather than allowing pricing to occur in the free markets like bond rates, for example. In fact, the aforementioned “ZIRP” program refers to the Fed’s extraordinarily unusual “zero-interest-rate policy” that has been in effect continuously since late 2008 (nearly 6 years now), in an attempt to “stimulate the economy.” (An aside: Most Fed watchers and officials project ZIRP will end sometime in 2015. Until then, the Fed apparently hasn’t had/doesn’t have enough faith in the economy to raise rates at all).

In addition to using interest rates to manipulate the economy – the Fed’s usual tool – the Fed since November 25, 2008, has rolled out its “QE” experiment, in which the Fed makes outright purchases of government bonds and mortgage-related securities.

“QE” means that in addition to tinkering with its own Fed funds interest rate, the Fed intervenes in the markets in a ploy to manipulate bond and mortgage interest rates that are normally market-driven.

In the process, the sheer quantity of assets owned by the Fed has ballooned, as shown in the blue graph earlier in this article. This is all unprecedented, and is essentially a massive experiment. One unfortunate side effect has been that retirees who have saved throughout their lives have been unable to earn a normal interest rate on their investments for several years now. Meanwhile, the low interest rates encourage borrowing (a.k.a., indebtedness), which is not necessarily the wisest financial approach for individuals or businesses. In other words, “QE” has facilitated a massive wealth transfer from retirees & savers to borrowers.


© Adam Feik
Take Time for This

This article is for informational purposes and does not constitute individualized investment, financial, tax, or legal advice. See additional disclosures here.

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