Curious why recently the US stock market has dislocated from its most trusty correlation counterparty: the size of the Fed's balance sheet (which increased another $13.4 billion last week [7] and up $939 billion Y/Y to a record $3.75 trillion)? Simple: the market is now starting to factor in the end of QE, because while tapering may have been delayed it has not been cancelled. And while the Fed has done everything in its power to destroy the market's discounting function, when it comes to frontrunning the Fed the market can still think ahead. Especially when frontrunning is no longer on the table.
Which is precisely the basis for the just released forecast by SocGen's Alain Bokozba, which extrapolates what will happen when the Fed's balance sheet stops rising, and applies the same drop to stocks as was seen at the end of QE1 (-16%) and QE2 (-17%) and concludes that the "end of QE3 would cost the S&P500 15%" and that following that, absent even more QE of course, "the US equity index should remain relatively flat, burdened by higher yields (rate hikes in mid-2015), a higher US dollar and limited earnings growth (Return on Equity is already high), but supported by better economic prospects and a new shareholder value cycle, staving off a bear market." Or, as SocGen calls it, "the Big Sleep."
Charting SocGen's latest expectations:
[8]
SocGen's commentary:
Between now and the end of the year, any decline in the S&P 500 is likely to be limited given that the Fed is still injecting liquidity. We expect the S&P to be at 1600 by year-end, in line with our technical analyst’s forecast (1560+/-10pts).
SG economists expect the January FOMC meeting to be the most likely timeframe for tapering. They look for the first move to be $20bn (instead of the $5-10bn previously expected by the market).
We expect the drop to accelerate at the start of 2014 as the market starts pricing in the end of asset purchases (i.e. well before the market’s Fed tapering expectation). The S&P 500 should dip to 1450 on our estimates, down c.15% from the peak.
Keep in mind the S&P500 fell by -16% after QE1 stopped and by -17% after the end of QE2. From Q2 2014, the S&P 500 should start to recover slowly after a technical rebound (c.+7%), as "Growth" returns to the forefront. We see the S&P 500 at 1600 by the end of the year, so 2014 should be rather flat.
In the two to three years that follow, the US equity index should remain relatively flat, burdened by higher yields (rate hikes in mid-2015), a higher US dollar and limited earnings growth (Return on Equity is already high), but supported by better economic prospects and a new shareholder value cycle, staving off a bear market.
Or visually:
[9]
But perhaps the best way to prepare for the Fed's withdrawal is not through risk assets, but their volatility derivative: the VIX, which SocGen expects to soar once the transition from QE3 to nothing begins.
History shows that the implied equity volatility (VIX) regime is highly sensitive to the Fed Funds rate. When the Fed tightens its monetary policy, the VIX tends to rise. QE has pushed the theoretical Fed Funds rate in negative territory. Now the start of the exit strategy process (including tapering, follow by the debate on the first rate increase) should cause the VIX to rise.
[10]
Of course, the reflexive corner the Fed has found itself in means that a large enough VIX surge and a big enough drop in the S&P, would simply usher in QE4 (and 5, and 6, etc.) as the stock market is the only thing the legacy status quo regime has left to preserve confidence in a failed monetary and economic regime.