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By Michael Pento of Pento Portfolio Strategies

June 24 (King World News) - Global Markets & The U.S. Are Being Systematically Destroyed

I’ve written exhaustively about the real purpose behind the Fed’s quantitative easing strategy.  So one more time for those who still don’t get it:  The primary goal of QE is to bolster banks’ balance sheets by re-inflating equity and real estate prices.  If investors look back at the history of QE they will be able to clearly see what happens when the Fed steps on the monetary gas -- and what occurs once it takes the foot off the pedal. 

For example, though interest rates were already near 0, the Fed felt it necessary to begin purchasing massive amounts of bank assets in late 2008 to get the money supply and stock prices moving in the positive direction.  The Fed announced a $500 billion mortgage-backed security purchase program (QE1) on November 25, 2008....

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The central bank followed up on March 18, 2009, with a $300 billion plan to buy long-term Treasury bonds.  The total amount of $800 billion in planned QE did exactly what was intended -- the U.S. markets, not so coincidentally, ended their massive decline and started a huge secular advance in March that year. 

Most investors now agree that massive QE can be extremely positive for asset prices.  But most on Wall Street either are not aware or refuse to acknowledge what occurs when the central bank stops printing.  Therefore, a brief history lesson seems especially prudent:  QE1 ended on March 31, 2010.  The market soon headed south, and just over three months later the S&P 500 dropped by 12.6 percent. 

The second round of QE ($600 billion) ended on June 30, 2011.  This time stocks began to decline within days after the last bond was purchased, and after three months investors experienced a correction of 16.7 percent.  In both instances a new round of QE came to the rescue of stock prices, just about when the depth of the correction extended into the double-digit range. 

Now that the Fed’s QE3 is officially ending, asset prices have lost most of their momentum.  The Dow Jones Industrial Average is only up just over 2 percent and most other major averages are either flat to up by low single digits so far this year.  This is true even though we are over halfway through 2014, and that compares to the 30 percent gains experienced last year. 

QE1 and QE2 ended abruptly, whereas QE3 is being slowly wound down.  Therefore, the mere announcement of the Fed’s taper back in January this year did not cause a similar market reaction to that of the other QE terminations.  Also, the correction from QE2’s end was more profound than that of the first, because equity values become more disconnected from economic fundamentals with each round of intervention. 

So investors need to ask why the stock market would be immune from the Fed getting out of the QE business this time around.  The truth is that asset bubbles have become more inflated and debt levels have greatly expanded during each iteration of QE.  Given this progression, the end of QE3 should bring the major averages down somewhere in the neighborhood of at least 20 percent about three months after QE3 ends in the fall. 

However, before the Fed launches yet another QE rescue program as it did after QE1 and  QE2 failed to generate solid growth, it would have to admit that the previous five years and $3.5 trillion worth of QE have been a complete failure and that the U.S. economy is addicted to continuous central bank credit expansion.  This might not come to fruition as quickly as most on Wall Street now believe it will, and could worsen the selloff. 

Until now the weak economic growth experienced since the Great Recession ended just didn’t seem to matter for the stock market.  This was because interest rates were falling from a benign level that already offered little competition for equities.  And the central bank had an overwhelming desire to increase its balance sheet and launch another round of QE at the first sign of falling asset prices. 

Contrast that with the situation today:  The Fed has become distressed over the amount of bonds it already holds and wants completely out of the QE business.  In addition, interest rates have ended their decline and must increase along with the rising rate of inflation and the end of the Fed's bond market manipulation -- unless, of course, rates fail to rise because of a deflationary collapse of the economy. 

The overwhelming consensus on Wall Street is that the economy will produce vastly improving growth during the second half of 2014, in the context of low inflation and interest rates.  The pervasive belief is also that the end of QE will not have the negative effect on stock prices that it did after the last two rounds ended.  Given that this scenario is already fully priced into markets, investors would be wise to maintain a very defensive posture during the next few months.

IMPORTANT - To read Michael Pento’s other fantastic piece CLICK HERE.

To learn more about Michael Pento’s financial management services CLICK HERE.

© 2014 by King World News®. All Rights Reserved. This material may not be published, broadcast, rewritten, or redistributed.  However, linking directly to the blog page is permitted and encouraged.

UPDATE - KWN has many more interviews being released today.

The audio interviews with Grant Williams, Andrew Maguire, James Turk, Jean-Marie Eveillard, Egon von Greyerz, Dr. Paul Craig Roberts, Ben Davies, David Stockman, Bill Fleckenstein, MEP Nigel Farage and Dr. Marc Faber are available now. Other recent KWN interviews include Jim Grant and Felix Zulauf -- to listen CLICK HERE.

Eric King

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