Not Holding My Breath for QE3
(July 14, 2011)
Dear Subscribers and Readers,
As I mentioned in our last week's mid-week commentary, I do not believe the Fed will implement a “QE3” policy. While Fed Chairman Bernanke testified that all options are on the table, we are still far away from such a move, especially given higher inflationary expectations versus that of last summer—as well as higher asset prices. Any more asset purchases by the Fed will only fuel commodity prices and devalue the dollar—policies which disproportionately penalizes the poor (whose food and energy costs make up a bigger part of their budgets) and benefits the wealthy (since they hold the majority of financial assets). This is counter-productive, as quantitative easing is meant to benefit the broader economy, especially those in the lower-to-middle-class. Again, unless a deflationary wave sweeps the financial markets (resulting in lower commodity and equity prices), I would not bank on a QE3 policy from the Fed. Think of QE3 as a “Bernanke Put” with two strike prices based on the S&P 500 and the S&P GSCI Commodity index—this “put” will only be exercised if the U.S. economy undergoes another deflationary bust.
Of course, nothing is impossible when it comes to the financial markets. Yesterday, the Greek Prime Minister published an open letter suggesting the country has done all it could to prevent a default. It will not impose any more austerity measures; and state asset sales are behind schedule. With Italian 10-year yields rising above 6% for the first time since 1997 on Tuesday, it is now “put up or shut up time” for the EU, Germany, France, and the European Central Bank. In fact, the market is now pricing in a >50% chance of a 25 basis-point cut by the European Central Bank at the next meeting. At this point, there's a higher probability of the ECB implementing another round of quantitative easing policy than the Fed does!
I now want to provide a brief update on US liquidity and market technicals. As mentioned before, the overall U.S. (and global) liquidity picture remains tight, especially with respect to the stock market. One measure is the amount of cash sitting on the sidelines, as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background. Since its February 2009 peak, it has declined very quickly. As of the close yesterday, it is still near its cyclical bull market low, despite the market weakness over the last several months, as shown in the following chart:
Note that we have updated the numbers as of Wednesday evening. As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been consistently declining since February 2009. The ratio temporarily bottomed at the end of April 2010, with the ratio rising by 4.00% from the end of April 2010 to the end of August 2010 (from 32.59% to 36.59%). However, with the stock market rally since the end of last summer, this ratio sits near a cyclical bull market low of 29.21% as of yesterday at the close. More important, it has declined too far, too fast, and is very low compared to its readings over the last three years. The low reading in this liquidity indicator suggests that the market's upside is limited and that market conditions should remain tough this summer.
Another indicator—one that is more relevant to the broader US economy is commercial bank lending. With the asset-backed markets remaining challenged, both the Fed and U.S. commercial banks still need to play a big role to revive bank lending and economic growth. Over the intermediate to long run, bank lending needs to revive for a sustained uptrend in asset prices and economic growth. Following is a monthly chart showing the state of U.S. bank lending—i.e. the year-over-year change in loans and leases by held by U.S. commercial banks for the period January 1950 to June 2011 (updated to June 29, 2011):
While the decline in bank lending in 2009 was unprecedented (unless one cites data from the Great Depression—when one-third of all US banks failed), it has steadied in the last 12 months. However, bank-lending growth remains dismal. In fact, the absolute amount of bank loans and leases outstanding (seasonally adjusted) actually declined by $40.5 billion (to $6.73 trillion) from the end of December 2010 to June 29, 2011. Again, the lack of liquidity creation within the U.S. commercial banking system does not bode well for the short-term outlook of the stock market or the U.S. economy. Because of this, the market action will likely remain tough this summer.
Finally, while the NYSE Common Stock Only Advance/Decline line (not shown) did make a marginal high in the recent rally, the vast majority of our other technical indicators are still indicative of a weak market. One such measure is the percentage of NYSE stocks above their respective 200-day EMAs and 50-day EMAS. As shown in the following chart (courtesy of Decisionpoint.com), both peaked in January of this year and have since steadily weakened—suggesting that the market's internal conditions are deteriorating. Combined with a weak global liquidity condition, I advise our subscribers to remain cautious this summer.
Henry To, CFA, CAIA