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Is The Stock Market About To Crack?

The stock market may be in for a nasty plunge. The second quarter has gotten off to a very bumpy start and the odds are that there is much worse to come.

Valuations are stretched due to the liquidity that the Fed has been injecting into the financial markets through Quantitative Easing. But QE is being wound down and is due to end by November. It looks like the smart money has begun to get out of stocks before the liquidity dries up. The NASDAQ is now down 8% from its year-to-date high; and the Dow, while still only 2.5% below its all time high, had three triple-digit down days last week.

This skittish behavior now is all the more worrying because the liquidity in the financial markets will continue to be quite excessive through the end of this quarter. Even with “tapering”, the Fed will still inject $145 billion into the markets during Q2. Meanwhile, the government, which normally removes a great deal of liquidity from the markets by borrowing to fund its budget deficits, probably won’t have a budget deficit during the second quarter. It’s likely to have a surplus since Americans pay taxes in April. Therefore, the government won’t have to borrow much, if anything at all, this quarter.

The problem with liquidity only arrives in the third quarter. QE will be reduced to $85 billion then, while the government will have to borrow approximately twice that amount to fund its third quarter budget deficit. Then, in the fourth quarter, liquidity conditions become considerably worse. The Fed will only inject $20 billion as QE comes to an end, while I estimate the government will have to borrow something like $240 billion. From that quarter on, there will be a significant liquidity drain.

The fourth quarter is still some time off, however. If the markets are this nervous now, when there is still so much excess liquidity, just imagine what could happen when the liquidity dries up and then begins to be drained from the financial markets by government borrowing.

The risks are all the greater given that market valuations are already expensive. The Shiller Cyclically Adjusted PE Ratio (the CAPE ratio) shows the Dow to be on 25 times earnings, well above its average since 1881 of 16.5 times. And, more broadly, the ratio of Net Worth to Disposable Personal Income (i.e. Wealth to Income) is also flashing a bright red warning signal that asset prices in general may be unsustainably high. Since 1952, that ratio has averaged 525%. During the NASDAQ bubble it peaked at 615% and then fell sharply when that bubble popped. It hit an all time high of 660% in 2006 during the property bubble; and then fell sharply again during the subsequent crisis. By the end of last year, it had climbed back to 639%. That suggests we may be nearing the limit of how far the Fed can drive up asset prices and net worth through fiat money creation.

I had thought that excess liquidity might push the stock market even higher during the second quarter, before the evaporation of liquidity caused a big selloff sometime during the second half. In this scenario, I had imagined that, as liquidity dried up in the third quarter, the yields on government bonds and mortgages would rise, causing the stock market and property market to fall. It’s too early to rule this scenario out. Things may still play out that way.

However, the market action over the past two weeks suggests a different scenario is also possible. In this scenario, stock investors panic and get out of equities even before the liquidity drain begins to push up interest rates. They then use the cash they receive from selling stocks to invest in “safe haven” government bonds, pushing bond prices up and bond yields down even further.

In either scenario, the Fed would most probably feel compelled to reverse course on tapering QE and announce that it will continue creating fiat money on into 2015. The alternative would be to accept a new recession caused by a stock market crash. I don’t believe the Fed would dare allow that to happen.

So, it looks to me that it is only a matter of time before the Fed has to extend QE. When it does, stocks will surge, net worth will recover and recession will once again be averted – for a while. But, a lot of bad things could happen to the stock market between now and then.

The market may yet recover its composure and, fuelled by excess liquidity, move higher over the next couple of months. It seems to me, however, that the risk-reward tradeoff is becoming less and less favorable by the day. The old stock market adage is “Sell in May and go away”. This year, it’s just possible that May may be too late.

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