By Adam Hamilton – Re-Blogged From http://www.Gold-Eagle.com
The US stock markets just suffered an extraordinary plunge, shocking traders out of their complacency psychosis. This cast the foundational premise behind recent years’ incredible stock-market levitation into serious doubt. Traders are finally starting to question whether central banks can indeed manipulate stock markets higher indefinitely. Any wavering in this faith has very bearish implications for stock prices.
Less than two weeks ago, the US’s flagship S&P 500 stock index (SPX) was up above 2100. It finished August’s middle trading day just 1.3% below the latest record highs from late May. At the time, the Wall Street analysts were overwhelmingly bullish and saw nothing but clear sailing ahead. Predictions for the SPX ending this year above 2250 were ubiquitous, and retail investors were urged to aggressively buy stocks.
But warning signs abounded on fundamental, technical, and sentimental fronts as I’ve discussed in our newsletters extensively. The US stock markets were radically overvalued relative to historical norms in trailing-twelve-month price-to-earnings-ratio terms. As the SPX left July, its 500 elite components had a simple-average trailing P/E of 25.6x! That was nearing 28x bubble territory, far above the 14x historical average.
Stock-market technicals were incredibly overextended too. By the SPX’s peak in late May, this massive broad-market index had powered higher for 3.6 years without any correction-magnitude selloffs. In normal bull markets, these 10%+ selloffs happen about once a year on average. They are healthy and necessary to rebalance sentiment. The longer since the last major selloff, the greater the odds for the next one.
And without normal corrections to bleed away excessive greed periodically, it was really getting extreme. The VIX S&P 500 implied-volatility index has long been the definitive fear gauge. And it had spent the month between mid-July and mid-August averaging just 12.9 on close. That showed American stock traders feared nothing, they were exceptionally complacent and full of hubris. Mounting selloff risks were ignored.
Yet these very conditions were perfect for spawning a selloff, as all students of the markets know. The only reason it took so long to arrive was traders’ fanatical faith in central banks to keep acting to boost stock prices. Traders believe central-bank easing has the power to eradicate normal stock-market cycles. While market history shatters this myth of central-bank omnipotency, it is universally assumed today.
The US Federal Reserve birthed and then carefully nurtured this notion. Back in December 2008 the Fed implemented its zero-interest-rate policy in response to that year’s once-in-a-century stock panic. It was promised to be a temporary measure. After that the Fed started conjuring new dollars out of thin air to buy trillions of dollars of bonds, outright debt monetization pleasantly euphemized as quantitative easing.
While the first and second QE campaigns had preset sizes and end dates determined at launch, the Fed radically shifted its modus operandi for the third campaign. Spun up to full speed in early 2013, QE3 was open-ended. The Fed deftly used this ambiguity to entice and badger capital into stocks. Whenever the stock markets threatened to fall, Fed officials rushed to hint that they could ramp QE3 to arrest the selling.
The result was the extraordinary stock-market levitation since early 2013. With the Federal Reserve’s implicit promises to backstop stocks, traders flooded in with reckless abandon. Every minor selloff was quickly met with aggressive buy-the-dip purchases, usually on some strategically-timed comment by a top Fed official. Near every major SPX low, Fed officials goosed stocks by arguing QE3 could be expanded.
So traders ignored the entire highly-cyclical history of the stock markets to keep on bidding them higher in recent years. Without any material selloffs thanks to Fed jawboning, complacency and greed quickly ballooned to dangerous extremes. Leading the way were countless hundreds of billions of dollars in corporate stock buybacks, largely financed through cheap borrowing courtesy of the Fed’s zero-bound rates.
But something had to give, as the stock markets are forever cyclical. Not even the central banks’ printing presses can eradicate the greed and fear in traders’ hearts, and those emotions are what ultimately drive market cycles. Traders wax too greedy and bid stock prices way above fundamentally-righteous levels, leading to subsequent major selloffs. Then traders fearfully run for the exits, leaving stocks too cheap.
Earlier this summer, the failure of China’s popular speculative mania should have irreparably damaged the omnipotent-central-bank myth. China’s central bank had engineered an extreme stock-market rally through exquisitely-timed rate cuts. China’s flagship Shanghai Composite stock index had soared an astounding 110.8% higher in less than 7 months by early June! Most traders thought that rally was unassailable.
There is no government in the whole world with more power over its local economy than China’s. So its government-nurtured stock-market bubble was the ultimate test of the all-powerful-central-bank thesis. And despite extreme and unprecedented efforts to manipulate stocks higher, the Shanghai Composite still plummeted by 32.1% in less than a month as greed turned to fear when that stock bubble popped.
Since history has proven countless times that central banks can only temporarily delay stock-market cycles, never eliminate them, we bet against that Chinese stock bubble before it popped. We bought and recommended puts trades on the leading Chinese-stock ETF, and our subscribers soon realized profits averaging +137% in just several months. Central banks can’t manipulate stock prices for long.
Yet amazingly, the Fed-deluded American traders ignored the sobering example of China’s gross failure of central-planned stock markets. They still clung to their zealous faith in the American central bank’s magical ability to levitate stock markets indefinitely. This was foolish, as I’ve argued many times in the past couple years. Artificially delaying selloffs makes markets feel less risky, but greatly amplifies risks in reality.
My favorite analogy of the risks of central-bank stock-market manipulation is wildfires. However noble governments’ intentions, when they send firefighters to quickly extinguish small wildfires that just lets underbrush flourish unchecked. Sooner or later there is so much dry fuel laying around that some small wildfire quickly mushrooms into a hellfire conflagration. Suppressing small fires guarantees far bigger ones later!
The same is true of suppressing normal and healthy stock-market selloffs. Those firefighting efforts by the central banks enable dangerous levels of sentimental and technical underbrush to choke off the stock markets. Then it’s only a matter of time until the right spark arrives, and the whole fuel-rich mess flashes into intense and uncontrollable flames. These dwarf central-bank printing presses’ ability to help.
The Fed’s extreme selloff-suppression efforts fueled one of the most extraordinary stock-market runs in history in recent years. While no one could know in advance when the catalyst would arrive to ignite all that epic complacency, it emerged out of the blue with no warning just a week ago. And even the initial resulting devastation is incredible, as this Fed-levitation-era chart of the VIX and leading SPY S&P 500 ETF shows.
While the Fed formally launched QE3 in September 2012 just in time to sway the national elections in Democrats’ favor, it didn’t ramp to full steam to include direct monetizations of US Treasuries until a few months later in December. That’s when the surreal QE3-stock-market era started. Between late December 2012 and May 2015, that dominant SPY SPDR S&P 500 ETF tracking that index soared 52.5%!
But that extreme straight-up stock-market advance was always unnatural. It improbably began late in a maturing cyclical bull when stock prices were already high and overvalued. And it continued powering higher with nothing approaching a correction. Every time the stock markets started to dip, Fed officials would quickly step up to the microphones to assure traders they were ready to ease more if necessary.