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IQ Trend's Primer on Quantitative Easing

10/05/2017 6:00 am EST


Kelley Wright

Managing Editor, Investment Quality Trends

Three-quarters of the year is in the books. If the trading year were to end now I doubt seriously that investors would mind given that most of the major indices are sporting double-digit gains, observes value investing expert Kelley Wright, editor of Investment Quality Trends.

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Of course, annual gains in the stock markets have become de riguer since the market bottomed in March 2009, which is pretty astounding given that the economy hasn’t grown more than 2.0%, on average, in any year since 2009.

Now, it’s been a long time since I’ve been in school, so I’m not sure what they’re teaching these days, if anything. To the best of my ever-fading recollection, however, the stock market rises in line with economic growth.


So, forgive me if I’m missing something here, but somehow the S&P 500 has increased about 270% in the 8.7 years since March 2009. For those of you scoring at home, that’s over 30% per year calculated on a simple basis.

Keeping with simplicity, this makes absolutely no economic sense, until you take one very important thing into consideration—the Fed’s balance sheet has basically quintupled over the same period.

The reason this is important to understand is that by ballooning their balance sheet the Fed provided the ammunition for the market that the economy could not.

Without getting too wonky, the Fed "created" money out of thin air, which allowed them to purchase Treasury and mortgage-backed bonds by the billions month after month.

This resulted in very low interest rates, and an enormous amount of liquidity, which subsequently made its way into the equity markets. Before 2008/2009 this was known as debt monetization. Today we know it as Quantitative Easing (QE). QE impacted the stock market in two ways.

One, with interest rates near zero, fixed-income investors were literally forced into buying stocks for the higher yield. Two, corporations took advantage of the lower rates to refinance their debt, which allowed them to buy back huge amounts of stock. These buybacks, in fact, are directly responsible for much of the gain since 2009.

With fewer shares outstanding, the appearance was that earnings were growing, which Wall Street analysts and pundits alike trumpeted ad nauseum as evidence of a glowing and growing economy.

On the other hand, the Fed seemed to understand that too much QE was a risky proposition, and they tried to rein it in on a couple of occasions, only to see the stock market throw a tantrum, which the Fed caved into by expanding QE several times in several different ways.

Although the Fed was finally able to taper back QE, the reality that the salad days were over didn’t really begin to take hold until the summer of 2016.

At that point the market seemed resigned that without further QE, the next four years, based on the then conventional wisdom of the presupposed outcome of the presidential election, would be a period of low economic growth, and subsequently paltry market returns.

Then Trump happened, and for the first time since Ronald Reagan, the markets priced in the possibilities of a pro-growth agenda, replete with tax reform and tax cuts, an overhaul of the health care system, and an infrastructure spending binge.

You can't really blame the conventional wisdom for their optimism, given that the federal government would be run primarily by folks with an "R" after their name.

Clearly, getting Mr. Trump's agenda through the system would be a walk in the park. The only flaw in this thinking was that Congress would be a willing partner to bring the pro-growth agenda into fruition.

While hope springs eternal that some portion of the pro-growth agenda will still get passed, it may be moot because Quantitative Tightening (QT) is coming down the pike.

Quantitative Tightening, as the name suggests, is a reversal, or removal, of Quantitative Easing. In simple terms it means the  Fed will be taking the money it put into the system out of the system. Based on the Fed’s timeline at $50 billion a month by the end of 2018, it would take about six years to remove the entire accommodation.

From what I have read from the Wall Street elite, the consensus seems to be the Fed won’t actually remove all $4 trillion, but will stop half way at "only" $2 trillion. Yes folks, that’s trillion with a T.

Theoretically, removal of this amount of accommodation will eventually have consequences in the economy without an offsetting amount of growth. The most obvious consequence would be higher interest rates, which at some point will make the return on fixed-income more attractive, and therefore competitive, with the return in the stock market.

This is to suggest investors that are more comfortable with fixed-income than stocks may exit the latter to purchase the former. Higher interest rates also result in a higher cost of capital for corporations, which ultimately will affect earnings unless there is an offsetting amount of growth for earnings to keep pace with a higher cost of capital.

If a rising interest rate environment proves to be a drag on economic growth, generating ever-higher earnings may prove to be problematic. How all this plays out remains to be seen, but my thought is the days of growth outperforming value will be coming to an end.

While this may appear a bleak forecast to some investors, for the enlightened investor it is welcome news. The simple fact is that speculative stocks do well when the monetary wind is at their back because there is little risk.

When that accommodation is removed it is no longer a case of just being in, you must be able to identify great companies with long-term track records of excellence and performance, as those are the companies that perform on their merits rather than on accommodation. I believe it is Warren Buffet who said that, "When the tide goes out we’ll see who is swimming naked."

What this October brings is anyone’s guess, so we’ll have to suit up, show up, and look alert. Personally, I would welcome a good old-fashioned correction, which is at least a 5% decline.

That would provide an excellent opportunity to acquire high-quality shares that represent good value. Mr. Market has his own agenda, however, which he’ll get to in his own sweet time.

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