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.
Most of those
proto-selloffs
were artificially stunted before they even hit the 4% pullback
threshold. The only one that even threatened a correction-magnitude
10%+ came in October 2014. That heavy selling started accelerated
on poor European economic data, and SPY ultimately dropped 7.7% in
20 trading days. But that selloff ended on Fed jawboning and a
parallel surprise European Central Bank easing.
But even in that
only significant selling episode of the Fed?s entire stock-market
levitation, it never got bad enough to generate enough fear to
eradicate excessive greed. The highest VIX close in that whole
episode was just 25.5. While that?s certainly elevated, it was
nowhere near high enough to indicate serious fear. So the extreme
complacency and hubris of 2013 and 2014 spilled into this year as
well.
But the Fed-goosed
stock markets were running out of steam as tinder-dry sentiment
underbrush grew wild. By early March the SPX was up near 2120,
levels that would still barely be exceeded by late May. Not even
uber-dove Janet Yellen?s most-easy Federal Reserve ever seen could
manage to stoke new buying. The writing was on the wall, and
any shift in Fed
policy was a major risk as I warned in mid-June.
It hadn?t just
been the 2.4 years of the Fed?s SPX levitation by its latest record
highs in late May where the US stock markets hadn?t experienced a
normal correction, but a whopping 3.6 years! The last one came in
summer 2011 just after the Fed ended its earlier QE2
debt-monetization campaign. And not surprisingly in stock markets
at price levels that are almost entirely a Fed-conjured fiction, the
Fed dispelled it.
On Wednesday
August 19th, the minutes from the Fed?s latest Federal Open Market
Committee meeting held at the end of July were due out. They were
super-important because they offered the last glimpse into Fed
officials? thought processes and internal debates before the FOMC?s
next meeting. It is coming on September 17th, and has long
been assumed to be the highest-probability target for rate hikes to
start.
This is a huge
deal since the Fed hasn?t raised interest rates a single time in
9.2 years, since June 2006. And the Fed has never, ever
attempted to tighten after a prolonged ZIRP episode. So the coming
rate hikes are wildly unprecedented. The release of those FOMC
minutes was botched when Bloomberg accidentally broke an embargo
nearly a half-hour early. And stock traders didn?t like what they
saw.
There was nothing
in those latest FOMC minutes to dispel the growing fears that the
Fed was ready to start its next rate-hike cycle at its next
mid-September meeting. Since the entire stock-market levitation
since early 2013 was fueled by epic Fed easing and the resulting
extreme corporate stock buybacks, this cast serious doubts on this
extraordinary stock rally?s longevity. So stock traders started to
drift to the exits.
The SPX retreated
0.8% that FOMC-minutes day last Wednesday, which was no big deal.
But the Fed worries really intensified on Thursday. Traders
couldn?t figure out if they were more worried about the Fed hiking
rates in September, or not hiking rates in September. The latter
scenario would mean the US central bankers still perceive the US
economy as too weak to withstand even a trivial quarter-point rate
hike.
So the stock
selling escalated, pummeling the SPX down 2.1% to close at its
lows. This shattered its 200dma, which had been major
support for the Fed?s entire SPX levitation as the SPY chart above
shows. It also dragged the SPX to a new post-topping low of 2036.
That formally forced the US stock markets into pullback territory
with a 4.5% drop since late May. But the selling pressure sure
wasn?t over yet.
Complacency had
become so extreme that there was choking underbrush for that
wildfire to feed on. Last Friday, some weak Chinese factory data
amplified long-festering fears of a global slowdown. So American
stock traders? selling started getting frantic, pummeling the SPX
3.2% lower. That was its biggest down day in 3.8 years,
since November 2011. The SPX?s total pullback had ballooned to
7.5%.
This not only
rivaled that previous-largest-of-Fed-levitation October 2014
pullback, but the VIX closing at 28.0 was the highest levels of fear
seen since December 2011. In other words, American stock traders
had not been so scared for the Fed?s entire SPX levitation since
early 2013! The Fed?s endless selloff-suppression efforts had
finally failed, the wildfire of cascading selling was starting to
rage out of control.
Coddled stock
traders aren?t used to serious selloffs, and had a whole weekend to
stew over the SPX being back at levels first seen in July 2014.
An entire year?s progress had been erased in just two trading
days! So they came back this past Monday morning ready to sell and
get the heck out of Dodge. An exacerbating factor emerged in China,
the further failure of the omnipotent-central-bank thesis.
Since China?s
stock markets had collapsed back down near their initial post-bubble
lows of early July, local traders expected the People?s Bank of
China to again ride to the rescue over the weekend with a rate cut.
But the PBoC failed to act, so the Shanghai Composite
plummeted an astounding 8.5% on Monday! It was down a staggering
37.9% in just 10 weeks. This heavy selling soon spilled into
Europe.
Germany?s flagship
DAX stock index plummeted 4.7% that day, and France?s CAC 40 was
even worse with a 5.4% loss. So SPX futures just collapsed as the
globe spun back to the US, falling over 100 points. The financial
media was calling it ?Black Monday? that morning, although this
selloff was nothing like October 1987?s real Black Monday that saw
the SPX crash 20.5% in a single trading day.
Still the SPX
plunged another 3.9% on Monday, taking its total post-topping
selloff to 11.2% which was well into 10% correction territory.
After a 3.6-year Fed-induced delay, the long-overdue correction
has finally arrived. The heavy selling continued on Tuesday,
where early-day short-covering gains rolled over into a 1.4% closing
loss on heavy mutual-fund redemptions and margin calls. The selloff
was brutal.
While the SPX was
down 12.4% since late May, it had plummeted 10.2% in just 4 trading
days straddling last weekend! This wasn?t crash-magnitude, which
requires 20% in a couple trading days, but was challenging
stock-panic levels which is 20% over a couple of weeks. The Fed?s
surreal stock-market levitation of recent years was finally
failing. Real fear was back, with the VIX soaring to a 40.1
close on Monday.
Although no one
could predict such a catastrophic failure of the Fed?s SPX
levitation, the odds certainly favored a serious selloff. We were
prepared with SPY puts, bets that the SPX was due for a material
drop. We liquidated some tranches of these Tuesday for average
realized gains for our subscribers of +150%! It pays big to be
contrarians when everyone is convinced some manipulated market trend
will run forever.
While such an
extreme selloff guaranteed a powerful oversold bounce on short
covering, the critical question is what happens after that?
It was the illusion of central-bank omnipotency, that the Fed can
boost stock markets indefinitely, that pushed the SPX so high in the
past couple years. With rate hikes inexorably nearing, and the
stock markets cracking, odds are that blind faith in the Fed is
crumbling.
And that has
super-bearish implications. The stock markets are forever cyclical,
bears inevitably follow bulls. This next chart zooms out to
show the entire stock-market bull in SPY terms since early 2009. If
a new bear is indeed looming on the first Fed tightening in over 9
years, the downside from here remains enormous. Today?s
central-bank-coddled investors aren?t ready to face the unyielding
fury of a real bear.
This amazing
cyclical stock bull was righteous and on a normal trajectory until
late 2012, when the Fed launched its wildly-unprecedented open-ended
QE3 campaign. That sparked the decoupling that resulted in the
Fed?s incredible stock-market levitation. Virtually everything
since 2013 is just a Fed-conjured illusion, and there?s going
to be hell to pay as these artificial stock-market extremes
inevitably reverse.
Since it?s been a
record span since the last correction, today?s isn?t likely to prove
mild at just over 10%. There are vast amounts of complacency
underbrush to burn, incredible bastions of greed for fear to bleed
away. So even if this exceptionally long-in-the-tooth and outsized
stock bull is still miraculously alive as stock traders desperately
hope, a full-blown correction approaching 20% is almost certainly
required.
That would drag
the SPX back down to levels first seen in mid-2013, wiping out
the past couple years? extraordinary gains. But odds are the
selling won?t stop there. Today?s stock markets are not only wildly
overvalued and overextended, but today?s spoiled-rotten-by-the-Fed
traders would likely freak out with years of gains vaporized. Once
a selloff crosses the 20% threshold, it formally becomes a new bear
market.
Bear markets tend
to be symmetrical with preceding bulls, the larger the bull the
larger the subsequent bear. And after one of the biggest bull
markets in history thanks to the Fed?s gross manipulations, the
reckoning isn?t going to be small. Even at a 50% bear over the next
couple years, which is merely average in terms of cyclical-bear
size, the damage that would be done to the stock markets is
breathtaking.
A full 50%
cyclical bear would drag the SPX all the way back down to levels
first seen in late 2009! That would destroy all vestiges of
bullish stock-market psychology, and drag stock prices back to
undervalued levels relative to trailing earnings. And that?s
exactly what stock bears exist to accomplish. Bulls leave the stock
markets overvalued and greed extreme, then bears follow to maul away
the resulting excesses.
And contrary to
the Fed-inspired myth today that stock bears are rare, they
certainly aren?t. While we?ve yet to see a stock bear this decade,
the 2000s saw no fewer than two! After seeing similar overvalued
and overextended stock-market conditions to this summer?s, the SPX
suffered a 49.1% bear market over 2.6 years ending in October 2002
and a second 56.8% cyclical bear over 1.4 years ending in March
2009.
This past week?s
extreme stock selloff was exceptional. Apparently there?ve only
been 8 times since 1980 where the S&P 500 has suffered
consecutive 3%+ down days! It?s hard to imagine such an extreme
selloff not severely damaging traders? faith in central-bank
omnipotency. This coupled with the Fed?s coming rate-hike cycle is
almost certain to spawn a new bear market given the topping
conditions leading into it.
But the extreme
selloff this past week is nothing like bear markets, which are
slow and methodical. A typical bear lasts a couple years, which
encompasses about 500 trading days. To get to a 50% total decline
over that time requires an average daily loss of just 0.1%,
nothing. By unfolding slowly, bears work to trap bulls into staying
fully invested for as long as possible without realizing the grave
danger they?re in.
And if the overdue
next cyclical bear is indeed upon us, it?s rarely been more
important to cultivate a studied contrarian perspective on these
markets. That?s our specialty at Zeal. We?ve spent decades
studying market cycles, and understand how to thrive in bears with
investments moving
counter to stock
markets. Since 2001 including those last two bear markets, all
700 stock trades recommended in our newsletters have averaged
annualized realized gains of +21.3%!
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Time is running out on our 33%-off sale.
The bottom line is
the Fed?s extraordinary stock-market levitation of the past couple
years is failing. The stock markets plummeted this past week after
the Fed offered no clues that it was delaying its upcoming rate-hike
cycle any longer. That selling quickly cascaded, greatly damaging
traders? faith in that myth that central banks can artificially
manipulate stock markets higher indefinitely. This has very bearish
implications.
If the Fed can no
longer suppress stock-market cycles, the next cyclical bear market
is overdue to charge in with a vengeance. And it?s likely to be an
exceptionally large one following such an outsized cyclical bull.
Bear markets see average declines near 50% over a couple years or
so, which serve to maul stock prices back in line with underlying
earnings fundamentals. That?s going to crush Fed-coddled stock
traders.
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