As of last week, our assessment of the overall market return/risk profile remains dominated by three factors, the first being wickedly extreme valuations (which we associate with near-zero expected S&P 500 nominal total returns over the coming 12-year period, with the likelihood of interim losses on the order of 50-60%), the second being the most extreme syndromes of overvalued, overbought, overbullish conditions we define, and the third - and the most important in terms of near-term market risk - being divergent and deteriorating market internals on the measures we use to assess investor risk-preferences.
It’s important to emphasize that this full set of conditions has been present during only a fraction of the advancing half-cycle since 2009, and that on balance, the S&P 500 has lost value during these periods. Moreover, this is the same set of conditions that allowed us to anticipate the 2000-2002 and 2007-2009 collapses.
Investors would do well to understand the distinction between an overvalued market that retains uniformly favorable market internals, and an overvalued market that has lost that feature. I’ve openly detailed our challenges in this half cycle and how we adapted, primarily in 2014 (see Being Wrong In An Interesting Way for a detailed narrative). The central lesson of this half-cycle is not that quantitative easing or zero interest rates can be relied on to permanently support stocks, but rather, that the novel and deranged monetary policy of the Federal Reserve was able to encourage continued yield-seeking speculation long after the emergence of “overvalued, overbought, overbullish” extremes that had reliably heralded steep downside risk in prior market cycles across history. In the face of zero interest rates, one had to wait for market internals to deteriorate explicitly (indicating a shift in investor preferences from speculation to risk-aversion), before adopting a hard-negative market outlook.
Even here, an improvement in market internals would defer our immediate concerns about severe downside risk. Presently, however, investors who believe our current defensiveness is simply “more of the same” haven’t absorbed the central lessons of our challenges in the advancing portion of this market cycle, nor the distinctions that could potentially save them from extraordinary market losses over the completion of this cycle.
How to wind down a $4 trillion balance sheet
Last week, the Federal Reserve issued a set of Policy Normalization Principles and Plans, by which the size of its portfolio of government securities would “decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.” Essentially, as existing securities held by the Fed mature, the Fed would reinvest the proceeds into new government securities only to the extent that those proceeds exceed “caps” which begin at $10 billion monthly, expand by an additional $10 billion every 3 months, and top out at $50 billion monthly.
Recall how the Federal Reserve’s open market transactions operate. When the Fed buys Treasury securities or U.S. government agency securities from the public (it can’t buy them directly from the Treasury, because, see, that would make us look like a banana republic), it pays for those securities by creating bank reserves, which are deposited in the seller’s bank account. The bonds become assets on the Fed’s balance sheet, and the reserves are liabilities of the Fed (as is the currency in your pocket, which you can verify by looking at the top line just above the picture of a President). The sum of currency and bank reserves comprises the “monetary base,” which is the only version of the money supply that the Fed can directly control. In short, when the Fed buys bonds, the Fed creates base money. When the Fed sells bonds (or Fed holdings mature without the Fed reinvesting the proceeds in new bonds), the Fed retires base money.