Will the stock market collapse when QE is withdrawn?

This chart in Westpac’s Northern Exposure chart summary implies that US stocks rely on Fed balance sheet expansion (QE) for support.

Fed Securities Held Outright v. S&P 500

The curve shows an almost perfect fit. There are just two things wrong with it. First, the scales on the left and right sides of the chart are not proportionate: the scale on the left compares a 9 times increase to a 3 times increase on the right. Second, while the Fed has expanded its balance sheet to more than $4 Trillion, a large percentage of that money has washed straight back to the Fed — deposited by banks as excess reserves.

Fed Total Assets and Excess Reserves

The impact on the working monetary base (monetary base adjusted for excess reserves) is far smaller: a rise of 66% (or $544 billion) over the past 7 years.

Fed Total Assets minus Excess Reserves compared to Working Monetary Base

A chart since 1985 shows nominal GDP (GDP before adjustment for inflation) normally expanded between 5% and 7.5% a year outside of recessions. But NGDP has not recovered above 5% after 2008. This may be partly attributable to lower inflation, but the Fed would clearly want to see NGDP above 5% — roughly 3% real growth and 2% inflation.

Working Monetary Base Growth compared to NGDP

We can also see that growth of below 5% in the working monetary base is often precursor to a recession, 1995/1996 being one exception. The second is when the Fed took their foot off the gas pedal too early, after QE1 in 2010, but were able to resume in time to head off a major contraction. They have been far more circumspect the second time and are likely to maintain monetary base growth North of 5%. Too sharp a slow-down would be cause for concern.

When we calculate the ratio of total US stock market capitalisation to the working monetary base [blue line] it is apparent that market response to the increase in monetary base is far more cautious than it was in 1998/1999.

Working Monetary Base Growth compared to NGDP

With Forward Price to Earnings Ratios for the S&P 500 and Nasdaq close to their long-term average (Westpac Northern Exposure, Page 118), I consider the likelihood of the QE taper precipitating a major market collapse to be remote.

Are corporate profit margins sustainable?

Market capitalization as a percentage of (US) GNP is climbing and some commentators have been predicting a reversion to the mean — a substantial fall in market cap.

US Market Cap to GNP

But corporate profits have been climbing at a similar rate.

US Corporate Profits to GNP

Wages surged as a percentage of value added in the first quarter (2014) and profit margins fell sharply, adding fresh impetus to the bear outlook. But margins recovered to 10.6% in the second quarter.

Employee Compensation and Profits as Percentage of Gross Value Added

Further gains in the third quarter would suggest that profits are sustainable. Research by Morgan Stanley supports this view, revealing that improved profit margins are largely attributable to the top 50 mega-corporations in the US:

Mega cap companies (the largest 50 by size) have been able to pull their margins away from the smaller companies through globalization, productivity, scale, cost of capital, and taxes, among other reasons. We argue against frameworks that call for near-term mean reversion and base equity return algorithms off the concept of overearning. Why? The margins for the mega cap cohort in the last two downturns of 2001 and 2008 were well above the HIGHEST margins achieved during the 1974-1994 period. To us, this is a powerful indication that the mega cap cohort is unlikely to mean revert back to the 1970s to 1990s average level.

(From Sam Ro at Business Insider)

Also interesting is The Bank of England’s surprise at the lack of inflation in response to falling unemployment. One would expect wage rates to rise when slack is taken up in the labor market, but this has failed to materialize. It may be that unemployment is understated — and a rising participation rate will keep the lid on wages. If this happens in the US it would add further support for sustainable profit margins.

Is the market overpriced? Episode II

Using Warren Buffett’s favorite broad market valuation metric of market capitalisation over GDP*, we can see valuations are on the high side, near to levels from early 2006, but nowhere near the alarming bubble of two years later. The Dotcom bubble (not shown) was even more severe.

NYSE Market Cap/Nominal GNP

*I have used GNP (or GNI as some call it) as this more accurately includes offshore income.

Australian investors will be relieved to find the ASX, at 100, reflects fair value. Even if we ignore the 2007 property/resources bubble.

ASX Market Cap/Nominal GNP