The Fed’s unlimited supply of credit in the form of repeated QEs since 2008 has steadily driven down bond yields while driving up equity prices. (See our previous feature - Liquidity Magic). However, a closer look at the dynamics of this process reveals ongoing bouts of speculative extremes. (See our previous feature – Irrational Exuberance of the Fed’s Making). One way to gauge this is to observe the relative behavior of small-cap to large-cap stocks, as measured by the Russell 2000 and SP 500, respectively. Generally speaking, periods of excess liquidity lead to greater appreciation of riskier small-cap than large-cap stocks such as occurred prior to the financial meltdown in 2007 as well as in 2009 and 2010/11 following QE1 and QE2. Moreover, the greater the divergence between small- and large-cap stocks, the higher has been the risk of major equity sell-offs – making it a good counter-trend indicator.
The current growing divergence between small- and large-cap stocks reflects the unchecked excess liquidity created by the Fed’s last QE3 initiated toward the end of 2012 and extended in part to offset the negative impact of the recent fiscal impasses in Washington. But an eventual withdrawal of liquidity, reflected in the uptrend of bond yields starting earlier this year, leading to tighter credit conditions could sharply reverse the speculative extremes now showing up in equities. (See our previous features – Gauging Bond Yields and Unforeseen Outcomes).
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