Fed Abandons Stock Markets

The seemingly-invincible US stock markets powered higher again last year, still directly fueled by the Fed’s epic quantitative-easing money printing. But 2015 is shaping up to be radically different from the past couple years. The Fed effectively abandoned the stock markets when it terminated its bond buying late last year. So this year we will finally see if these lofty stock markets can remain afloat without the Fed.

Mainstream stock investors and speculators are certainly loving life these days. The flagship S&P 500 stock index enjoyed an excellent 2014, climbing 11.4%. And that followed 2013’s massive and amazing 29.6% blast higher! The last couple years were truly extraordinary and record-breaking on many fronts, with the US stock markets essentially doing nothing but rally to an endless streak of new nominal record highs.

The Secret Club That R... Kate Kelly Best Price: $2.23 Buy New $16.87 (as of 09:55 EST - Details) Such anomalously-one-sided stock markets naturally bred the extreme euphoria universally evident today. Greedy traders have totally forgotten the endlessly-cyclical nature of stock-market history, where bear markets always follow bulls. They’ve convinced themselves that these stock markets can keep on magically levitating indefinitely, that major selloffs of any magnitude are no longer a threat worth considering.

But extrapolating that incredible upside action of 2013 and 2014 into the future is supremely irrational, because its driver has vanished. The past couple years’ mammoth stock-market rally was completely artificial, the product of central-bank market manipulation. The Federal Reserve not only created vast sums of new money out of thin air to monetize bonds, but it aggressively jawboned the stock markets higher.

Virtually every time the Fed made a decision, or its high officials opened their mouths, the implication was being made that it wouldn’t tolerate any material stock-market selloff. The Fed kept saying that it was ready to ramp up quantitative easing if necessary. Stock traders understood this exactly the way the Fed intended, assuming the American central bankwas effectively backstopping the US stock markets! Broken Markets: How Hi... Saluzzi, Joseph C. Best Price: $7.44 Buy New $24.98 (as of 05:40 EST - Details)

This short-circuited the normal and healthy way stock markets operate, cyclically. In normal times when stock traders grow too greedy and bid stocks up too high too fast, corrections periodically arrive. They drag overextended stocks back down, kindling fear and restoring critical sentiment balance. But with the Fed convincing stock traders it was ready to arrest any significant selling, they naturally lost all fear.

With the Fed printing money with reckless abandon, every minor stock-market dip was quickly bought. But with no significant selloffs to rebalance sentiment, greed flourished out of control. That eventually forced the stock markets to today’s immensely overextended and overvalued levels, which stock-market history shows are exceedingly dangerous. The Fed distortion in these markets is extreme beyond belief.

The Real Crash: Americ... Schiff, Peter D. Best Price: $3.00 Buy New $9.55 (as of 12:25 EST - Details) And it has to end badly. The material selloffs in ongoing bull markets that the Fed foolishly chose to suppress keep sentiment balanced. They prevent greed from growing so extreme that it sucks in too much near-future buying. If euphoria pulls enough buying forward, there aren’t enough new buyers left to continue propelling the bull higher so it collapses under its own weight. We’re reaching that point.

Wildfires are a fantastic analogy. The longer a forest grows without suffering any significant fires to clear out flammable underbrush, the greater the conflagration when some wildfire inevitably erupts. Fire-suppression efforts, however noble, simply ensure the wildfire fuel sources will balloon to dangerous proportions. Stock markets are like the forest, and periodic corrections are like smaller fires that burn away fuel.

By aggressively inflating its balance sheet through money printing, the Fedartificially suppressed all the normal healthy stock-market selloffs that should have rebalanced sentiment. But back in late October, it ended its latest QE3 bond-monetizing campaign. And with this new year ushering in a new Congress dominated by anti-Fed Republicans, it is politically impossible for the Fed to launch any kind of QE4.

So the Fed’s wildly-unprecedented balance-sheet growth of recent years is over. 2015 will actually be the first year since 2007 without any quantitative easing! And as this stacked chart of the Fed’s balance sheet shows, a year without monetizing bonds is going to be a big shock to stock traders. Orange is the total balance sheet, red is monetized US Treasuries, and yellow shows the Fed’s mortgage-backed securities.

Today’s stock-market mess began with 2008’s epic once-in-a-century stock panic. In its dark heart that October, the benchmark S&P 500 stock index (SPX) plummeted a sickening 30.0% in a single month! The Fed, fully realizing stock-market levels exert a huge influence over national economic activity, panicked. It slashed interest rates to zero in December 2008, and started printing money hand over fist to buy bonds.

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