S&P 500 Declines as the Fed Drains Liquidity

Mott Capital Management |

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The stock market finishing lower for the seventh straight week and down almost 20% from the intraday peak during the first week of January. The 7-week losing streak for the S&P 500 is the longest since March 2001. Many people are desperately searching for the bottom or trying to call the bottom in the S&P 500. While we may be closer today than we were in January, the market may still have ways to go before this all is said and over, perhaps as much as 15% more. The market has moved from a period of multiple compression to deleveraging. Unfortunately, the deleveraging process has only started. Low real yields were only half the story. The other part of the story is the liquidity provided by the Fed, which created the expansion of margin and leverage. Now, reserve balances are declining quickly, and stock prices are deflating along the way. As the Fed started to conduct QE, it inflated the size of its balance sheet, and as a result, the reserve balance of depository institutions held at the Fed increased. These credits appear to have worked their way into the stock market by increasing margin levels. The chart shows a clear relationship between FINRA Margin balances and changes in reserve balances over the last decade. We can see the relationship between the two over the years. The S&P 500 has seen its PE ratio come to within its historical norms, at 16.6 versus its historical average of 16.6 since the year 2000. It doesn't make the S&P 500 cheap but fairly valued when using earnings estimates for the next four quarters. However, over the years, the PE ratio during market turmoil tends to bottom at much lower levels. The uncertainty of the future of the US economy and the deleveraging process that is taking place is likely to result in the S&P 500 trading closer to 14 times futures earnings estimates, which would value the index at roughly 3,300. Can the market rebound and bounce? It can, but don't expect a big one. The latest data shows that reserve balances have fallen dramatically and continue to push lower. The chart shows that reserve balances have plunged, and the decline has been reflected in S&P 500. The data also shows that there may be no significant rebound for stocks, maybe just a small one at best, because the reserve balances have continued to fall. Eventually, reserve balances will fall enough that margin levels will normalize, and the market should begin to function normally. But given the size of the balance sheet and how much there is more to go, it may take some while longer for that balance to be reached.