Do Or Do Not

To adapt an aphorism from Yoda: “Do or do not… there is no taper.” QE is like heroin for the financial markets – and you don’t taper off heroin. You either keep it going by whatever means necessary until you die, or you accept the violent reaction that comes from withdrawal.

It seems that the market believes that the withdrawal of QE is good for stocks and bad for bonds – I would argue the reverse.

QE has depressed bond prices, as discussed before on this blog, and so it is not unreasonable to expect the converse to apply – as it has in previous QE withdrawals, where stocks have fallen and bonds have risen (in price). The market’s implicit assumption is that the reason for the withdrawal of QE is that the economy is growing on its own, and therefore QE is no longer needed, and risks causing inflation. And if the economy is growing, that will be good for earnings and therefore the stock market.

The flaw in this argument, accepting that the economy really is growing, is the assumption that the massive government deficits will continue to fund corporate profits, which are 70% above normal relative to GDP (per John Hussman). This would be a strange new world indeed. It is much more likely that a return to trend would cut corporate earnings in a big way.

However, it is far more likely that the QE pumping has merely kicked the can down the road a couple more miles and we are still faced with the adjustments that are required to return to a stable economy. We can then expect what one might call 1937 syndrome, which will be very negative for earnings as private sector borrowing dries up and consumption falls..

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