We have all seen the chart below. It shows the S&P 500 plotted with the Federal Reserve balance sheet. The message seemed to be quite simple; when the Fed was expanding its balance sheet (and extending the duration through Operation Twist) the equity market rose and when the Fed stopped printing, the market has suffered fairly sharp reversals.
Despite this assumption, it is interesting to note that, since the Fed started tapering (announced at the 18th December meeting last year) the S&P is up a mere 5 points, during which time the balance sheet has risen by $240 billion. QE is losing its potency. Since starting the tapering process, the Fed has reduced QE by $10 billion at each meeting and, although they claim that tapering is not on a preset course and could be altered, the precedent has been firmly set. We should expect QE to be reduced by $10 billion at each meeting unless something changes materially. It is therefore highly likely that QE will be set at $45 billion per month from the end of April and $35 billion per month going into the second half of the year. Our point is that the more the Fed reduces QE the less potency it has. The equity market is now down for the year to date and is very vulnerable to a negative swing in sentiment and any shocks to growth.
We would make two further points on QE. First, the FOMC have questioned the efficacy of QE for some time now so they will find it incredibly difficult to justify more QE if either the equity market or the economy stumbles. Second, the Fed claimed that QE tapering was not tightening policy when they unequivocally made the case at the time of QE2 that it was the only way to loosen policy. They cannot have it both ways; reducing QE is tightening policy, and the equity market is beginning to react to that fact.
So what is driving equity markets lower? In a word, sentiment. It appears that the most speculative issues peaked in late February and have already entered bear market territory (e.g. Nasdaq Biotech index down 22% from the high). It is highly likely that buyers of these speculative issues were using leverage to boost returns, and when gains turn to losses whilst leverage is used, risk has to be managed more closely. Simply put, sentiment has soured because investors are losing money in equities, and further losses will depress sentiment further.
The chart below shows the Nasdaq 100 Index. The index is quickly approaching chart support and may try to bounce a bit from here but it is clear that serious damage is being done to the long term uptrend. The two moving averages have crossed bearishly; the first clear bearish crossover since late 2012 and momentum is solidly down as shown in the lower panel. If support in the 3,420 area is broken then that should be seen as another bearish signal.
So our message is simple this week. US equity markets are down for the year to date now, and with less and less support coming from the Fed, we believe that further selling will be seen in the weeks ahead. There is a chance that markets may try and find support in the short term, however that support could be very temporary. We believe we have entered a much larger corrective period than any seen in two or three years and rallies should be sold into.