Is QE setting markets up for a crash?

As highlighted today by my colleague Houses and Holes, a growing number of commentators — most recently Richard “Balance Sheet Recession” Koo — are weighing in on on the folly of quantitative easing and the risk that it poses for asset prices. The main charge is as follows. As The Bernank himself has hinted at a number of times, one of the main aims of QE was to reflate equity prices, which, in turn, was supposed to lead to a virtuous circle of greater consumer confidence and spending, a revival of credit, and so on and so forth. But what if the huge rebound in asset prices has outpaced the improvement in the economy’s fundamentals? Are we now facing a Wiley E Coyote type moment with our legs spinning in thin air on the edge of a cliff?

Here’s what Koo has to say:

Viewed objectively, the central banks are trying to push up asset prices using quantitative easing and the portfolio rebalancing effect. The resultant rise in asset prices based on this effect represented a potential bubble—or at least a liquidity-driven event—from the start.

The question is whether the real economy can keep pace with asset prices formed in those liquidity-driven markets. If it cannot, higher asset prices will be considered a bubble and will collapse at some point. The resulting situation could be much more severe than if quantitative easing had never been implemented to begin with.

…if stock and commodity prices are in fact in a bubble and if those bubbles were to collapse, the balance sheets of the financial institutions and hedge funds making investments with the expectation of higher asset prices could suffer heavy damage, exacerbating the balance sheet recession in the broader economy.

In his recent quarterly letter, Jeremy Grantham (who is on quite a roll of late) made a similar argument, advising his clients to start lightening up on risk assets and stating that “the environment has simply become too risky to justify prudent investors hanging around, hoping to get lucky.”

Simply put, the prospective returns from the stock market (in developed markets) in coming years are so miserly that they do not sufficiently compensate for the multitude of risks that we face today.

Now, the perennially optimistic investment banks may still have a “constructive” view on growth and asset prices, but as readers of MacroBusiness will be familiar with, the global economy today faces a number of risks. To rattle off just a few, the possibility of a sharp growth slowdown in China, ongoing sovereign debt woes in Europe, rising oil prices, not to mention the recent turmoil at the IMF. Despite all these risks, stock prices have continued to power higher in 2011. And this is a direct result of QE.

In the words of the fund manager John Hussman:

The effect of QE has been to increase valuations – producing high short-run returns by borrowing from long-term prospects. This has now produced a degenerate menu of long-term investment options (for passive investment strategies).

Quantitative easing cannot produce wealth – it can only shift the profile of returns from the future to the present by forcing all assets to compete with zero-return cash. Now that it has done so, it is urgent for investors to weigh the prospective returns that remain, against the likely long-term risks.

In other words, we are borrowing from the future. And according to this view, even if QE3 were to eventuate and push markets higher, we would only be setting ourselves up for an even bigger crash in the future.

With respect to the prospective returns from the stockmarket, Hussman states:

The stock market continues to be strenuously overvalued here, with a variety of historically reliable methods indicating probable total returns for the S&P 500 of only about 3.5% over the coming decade.

Now, keep in mind that these are nominal returns, so if Hussman is right, he is saying that after adjusting for inflation, real returns will be close to zero over the coming decade. Obviously if you are in the camp that expects inflation to spiral out of control, you would expect even worse real returns on stocks.

Indeed, valuations today certainly do look stretched. The following chart from Doug Short suggests that, depending on which metric you choose, US stocks are overvalued by somewhere between 40% and 65%.

This raises some uncomfortable questions for proponents of the passive “buy and hold” equity story. If prospective returns really are so low for the coming decade or more, a smarter approach is probably needed.

So what’s an investor to do? Grantham’s guess is probably as good as anyone’s:

Investors should take a hard-nosed value approach … having substantial cash reserves around a base of high quality blue chips and emerging market equities, both of which have semi-respectable real imputed returns.

My very long-term personal recommendations remain the same: forestry and good agricultural land, “stuff in the ground,” and resource efficiency plays.

Should commodities crash in the near term because of good weather, problems in China, or both, I think it will create another “investment opportunity of a lifetime,” much like the several we have had in recent years.

In other words, this could be a good time to keep your powder dry.


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  1. I believe that US share prices up because US corporate is borrowing money to inflate profit. QE lowered interest rate on US Treasury, that made a lot of corporate bonds a lot more attractive. The debt level of US corporate is heading toward 50% of GDP, from 30% of GDP in 2007.

    The effect of QE is also prominent in commodity and oil prices, with cheaper money resulting in more speculative activities.

    Of course, the alternative is to push up interest rate, which makes even less sense. If Corporate America cannot make money when borrowing is cheap, they are definitely NOT going to make money if borrowing becomes more expensive.

  2. “This raises some uncomfortable questions for proponents of the long-term “buy and hold” equity story. If prospective returns really are so low for the coming decade or more, a smarter approach is probably needed.”

    Not really. It suggests that “buy and hold” investors should be patient, and wait for the upcoming bargains. Then, they should “buy and hold”.

    • Here here!

      On the QE2 strategy, I always thought increasing income created higher asset values, not the other way around.
      Maybe things operate differently at the Fed.

    • I totally agree with you David (and Q!). What I should have said is “passive” buy and hold strategies (have updated the post). Essentially I am making an argument for active management.

  3. “This raises some uncomfortable questions for proponents of the long-term “buy and hold” equity story.”

    Only if you believe the prognostications repeated here. However, I have yet to see any evidence that today’s forecasts are any better than the millions of forecasts published in the last 100 years.

    In any case, the assumption behind buy and hold is simple: nobody can forecast the future, but historically, equities do okay over time frames of 10+ years. This is statistical observation and does not apply to individual shares, so to put it into action, you buy the index and ignore where it goes. In that context, the current situation is not special.

    • > historically, equities do okay over time frames of 10+ years

      Try telling that to an American Investor who bought in early 1929, they were behind til the mid 1950s.

      Try telling that to a Japanese investor who bought shares in the 1980s, they are currently a long long way behind.

      Try telling that to an American investor who bought in 2000… the S&P500 and Nasdaq are still below where they peaked in 2000.

      I could go on.

      • In fairness, the proponents of such things usually recommend diversifying over time using value averaging or good old DCA. Japan is likely an exception, but in the two American examples those who were steadily buying through the periods you identify probably did pretty well. The dollars people put in in 1929 didn’t go so well, but those invested subsequent years made up for them.

        That said, I haven’t bought much for a while. It makes pretty good sense to me that the end of QE2 will cause a fall in prices. That said, you can’t trust this Bernanke guy not to screw around with QE3, QE4 … QEn.

    • Phil H – I am not saying that Hussman or anybody else has any particular prescience it comes to forecasting equity returns for the next 10 years, and I didn’t mean to imply that “buy and hold” is completely dead.

      But the fact that equities have traditionally done well over 10+ year periods doesn’t matter (and there are plenty of exceptions like Japan). The point is that if you are going to simply buy the index and sit on it, starting valuations are important, and valuations right now look to be very stretched.

      Hence the advice from Grantham to keep your powder dry and wait for some very nice opportunities when valuations are a lot lower. I think this is pretty sensible.

  4. My reading of Koo’s paper is a little different as I explained on H&H’s original Koo post. I’ve cobbled a few bits together here:

    The timing of Koo’s paper is perfect, just prior to the ‘end’ of QE2 – enough time to digest the contents and the meme to spread.

    Whilst Koo does not explicitly recommend further quantitative easing, he implicitly warns that QE3, in some form or other, must be undertaken. Any decision not to continue QE would result in a potentially cataclysmic situation, certainly worse than pre-QE1. Continue stimulus, because although Bernanke’s ‘gamble’ has not succeeded to date, to end stimulus will ensure the economy crash and burn.

    A clever position – the reader is left with the awful realisation that without stimulus, the economy will deteriorate even more severely. Allows others to come on board without coercion, to accept there is no alternative. Like that medicine you had as a kid, hated it, tasted terrible, but you knew it was good for you.

    A masterwork of Keynesian proportions!

    • 3d1k – I think you’re reading Koo correctly. He’s not against QE per se, but he does talk about the risk of asset prices getting ahead of fundamentals, and as you say, on this score he is of the view that without further stimulus the recovery will falter and we are in very big trouble.

  5. ceteris paribus

    OK. We have now got the nessage about the downside risk to the asset values of property and shares-reduce all speculative exposure and stay highly conservative. Thank you for your plausible work.

    Your hypothesis is clear and set to be tested.

    Can we now talk about something else for a while?

    • Just Broadcasting ,all the angles..cp,
      I would say….Drops n Feeds and
      Which Mouth to put the Quick-Ease, starvation ,head-aces
      and the constipation gain ,can be very testing to put a finger on… Times..arr.
      Have a good one…
      RA cheers JR

  6. Oil was at $70 when QE2 was announced back in August 2010. Gold and silver appreciated 50% since then. It’s a totally different world toady. Oil touched $120 recently and even at $100 is a drag.

    To announce QE3 something major has to happen, stock, commodities and oil have to drop significantly.

    Otherwise, no QE3 and no interest rate rise in the US for a while. I would not be surprised if basically the fed keeps the status quo until the end of year. And my guess is that the stock market will be around these levels by then.

  7. IMHO, one key feature of a stable economy (among others) is that it is worth simply holding onto the system’s base currency.

    In systems where this is not the case, we can be sure that there is something quite wrong with the system.

  8. The image of Bernanke in a helicopter chucking out $1 million bills on to the footpath is looking increasing dumb since M3 hasn’t grown in the past few years.

    John Hussman makes the rare observation that he’s also trying to engineer zero-return cash to stoke inflation and the market. The US actually has negative real returns on bonds, and to sustain that condition we have to ask how low can their yields go down and stay down (when does the 20-year secular bull market end?) and what might knock inflation of it’s comfortable 2-4% perch?

    It’s worth listening to Russell Napier on this. He reckons rates might be pushed up by emerging markets tightening first, and not the Fed:

    • Alex – Yes, what the Fed is really trying to do (and has succeeded in doing) is engineer a steep yield curve. They have made the real returns on cash and short-term bonds zero, which is essentially pushing investors to take on credit risk, buy equities, etc. They can do this for as long as they want, but the question is what are the costs of doing so. As you say, higher inflation, etc.

      • I think that one of the biggest reasons for QE was to devalue the dollar. Not saying that was the only reason. With the Chinese appreciating their currency and alot of US companies looking to bring jobs home then I dont see a QE 3. The world problems are due to China maniplating their currency and not balancing their economy to consumption. Their trying but it isnt working. The US retaliates with by pushing their inflation back to China and devaluing their currency. Its a game of chicken with the US and China. Every one else is caught in the middle.