There is no playbook for what the Central Banks are about to do: Unwind the Qualitative Easing or the bond purchasing that all of the major Central Banks have done over the past 10 years. Since the Central Banks don’t have a playbook, we don’t know what the ramifications for this unwind will be. That is one reason why volatility has increased considerably since February 1, 2018. Investors lack certainty as to how this is all going to work out. Volatility is the progeny of uncertainty.
Not Just the Fed
The US Fed added over $4 Trillion to its balance sheet through its QE bond-buying program. The Fed is not the only Central Bank to have done so. The European Central Bank (ECB) and the Bank of Japan (BOJ) have also been on a spending spree. Currently, the Fed is leading the reversal of course by saying it will stop the bond buying and then let some bonds fall off when they mature. The amount of fall off (about $80 million) is not significant relative to the $4 Trillion, but the change in direction is significant. Neither ECB nor BOJ has yet put a plan in place to reverse course, so they are still effectively feeding the markets with money. The real new territory will be charted when the ECB and/or the BOJ reverse course. If their relative economies continue to strengthen, this will occur within the next year or so.
Feeding the Stock Runup
By buying bonds, the Fed (and the other Central Banks) inject money into the financial system which is in turn used to buy additional financial and other assets. Banks whose bonds the Fed buy may use that money to buy additional bonds, thereby keeping interest rates low. They may lend it to companies who in turn use it to buy stocks. They may increase their employees’ wages, who may use their new money to increase their holdings in their retirement accounts. Directly or indirectly, the money that the Fed has injected through its QE program has found its way into the stock market and has thereby propped up stock prices. Some analysts say the Fed (and the other Central Banks) are the single most important reason why we have been in an almost uninterrupted bull market for the last 10 years. Now this Central Bank cash injection is about to end. This is a big change in direction that hasn’t played itself out before. That’s why I say there is no playbook for what is about to happen in the markets, and that’s why there is more market volatility.
In November 2007, prior to the financial crisis, the S&P 500 Index was at about 1,500. It dropped almost 50% to about the 760 range before heading back upward. It regained the 1,500 level in about February 2013 and kept going from there. Its highest was 2,853 in late January 2018 and now (as I write this) sits at 2,643. If the Fed and the other Centrals change course, how far could the S&P 500 Index fall?
If the entirety of the gain from 760 to 2,643 is due to Central Bank intervention, could we fall all the way back to 760 if the intervention is reversed? No, because the Central Banks will re-intervene if stocks fall too much. No, also because the economy has become much healthier since 2007. Profits are up and balance sheet debt is down. Could we fall back to 1,500? That is possible more than 760, but still unlikely in my opinion because 1,500 would represent a 47% correction from the all-time high, which is the same magnitude as the 2008 correction which caused the Central Bank intervention in the first place. What I am saying is that the reversal of QE may work if it is done slowly. Even investors need to be slowly weaned off of government assistance. The issue is that investors may freak out as the process plays out, and market movements may be disconnected from the fundamentals of the economy and the companies whose stocks investors may be selling. In this environment, it is probably best not to be all in on stocks and instead to have a diversified portfolio that will still profit if things pan out ok but will be relatively safe if things go sour.