Some investors will get the timing right and short the stock market. We think there is the potential for a 60% decline in the broad stock market…in the range of the declines we saw after the bubble collapses of 2002 and 2009. In a collapse, we expect gold stocks will once again rise considerably more than the stock market falls.
The stock market bulls do not agree with us, of course. If they argue valuation at all, they contend that historic low interest rates justify historic high valuations. They do not, in our opinion. In the long run, equity valuations reflect the discounted value of future earnings. Although low interest rates suggest a low discount rate which boosts valuations, they also coincide with periods of poor growth in the economy and lower earnings, facts which the bulls ignore. Can you keep the discount rate advantage while projecting rates of growth and earnings that never revert to the mean? Having your cake and eating it too? We don’t think so.
The stock market gains of 1996-1999 came when quarterly GDP growth averaged 4.6% and the gains of 2003-2007 came when quarterly GDP growth averaged 2.96%. In contrast, between 2010 and 2017, GDP growth has averaged only 2.1%. Central banks have replaced growth as the primary driver for stocks with their creation of $15 trillion in fresh liquidity since 2008. And now, they want to take it back.
Can the bond and stock market bubbles outlive the reversal of the monetary stimulus that created them? We are about to find out.
The Federal Reserve and the European Central Bank have been two of the biggest liquidity creators and both have stated they intend to reverse their policies in the short term, transitioning from “Peak Quantitative Easing” to Quantitative Tightening. Francesco Filia of Fasanara Capital calculates that these policy changes will force a liquidity withdrawal of over $1 trillion in 2018 alone. Deutsche Bank has issued a similar estimate that central bank liquidity injections will collapse from this year’s annual rate of $2 trillion to zero in 12 months.
This is not a distant future scenario. The Fed has already announced that its balance sheet “normalization” will begin next month and reach a level of $50 billion monthly in a year. Until this month, the Fed has been replacing maturing securities with new purchases, thus maintaining a significant bid in the market despite QE ending in late 2014.
Meanwhile, the ECB program begins to take on reality as soon as this Thursday, October 26, when the ECB is expected to announce a significant reduction in its asset buying. Bloomberg has reported that ECB policymakers see room for little more than €200 billion of purchases under the institution’s bond-buying program in 2018, down sharply from €720 billion this year. The calculation is not difficult: the established limit to bond buying is €2.5 trillion under the current rules and purchases are expected to reach €2.28 trillion by the end of 2017. Germany is unlikely to allow for an increase to the limit.
The ECB bond-buying program has immensely distorted world debt markets. Since it began in March 2015 (and later expanded to include corporate debt in June 2016), the ECB has created enough money out of thin air to purchase €1.89 trillion in bonds with no consideration for price.
ECB holdings of Euro-denominated bonds with monthly change
Meanwhile, over the entire QE period, net European bond new issuance amounted to only €394 billion…one-fifth of what the ECB bought. In fact, through much of 2016 there was hardly any net issuance at all according to Citi data.
Net issuance of Euro-denominated bonds
Any private investor who sold to the ECB and wanted to continue to hold debt would have to bid into a declining supply against a dominant price-insensitive buyer or move money out of Europe. How could this unprecedented crowding out of private investors not create a bubble? Here is the proof. Bond purchases by the ECB have forced the yield on EU junk bonds down to the same level as 10-year U.S. Treasuries.
10-yr Treasury yield vs Euro high yield index
Is it any surprise that EU investors have markedly increased their purchases of equities this year?
In short: the ECB purchased €1.5 trillion in bonds in excess of new issuance with no regard for prices, thereby virtually assuring booked profits for the sellers who then turned around and purchased overpriced domestic debt and equities and foreign investments.
And so, with the ECB set to taper its purchases, what will happen to yields? And where will the liquidity come from to hold bond and equity prices aloft? Are central banks about to pop the bubbles they have created?