This week has been marked by record equity prices in the US, once again. As I have written in previous weeks, the short-term technical picture of the equity market is robust and continues to point to higher prices in the future. Furthermore, designated Fed Chairwoman Janet Yellen testified before the Senate Banking Committee on Thursday and reassured the world that continued monetary stimulus would be provided for as long as necessary. For additional information, please read Message From Yellen Is Full Speed Ahead on the Stimulus from the NY Times.
Clearly, the current Federal Reserve’s monetary policy is extreme and unsustainable. I can only scratch my head in worry when looking at the chart below that shows the fact that the central bank currently purchases 70% of all US Treasuries and Agency Debt with newly created money. Nonetheless, this monetary expansion supports equity and real estate prices with no end in near sight.
One of the most respected long-term technical methodology to identify and chart financial market movement is called the Elliot Wave(on top). So far, the pattern displayed in US equity prices since 2009 follows the Elliot Wave model very accurately(for further analysis and explanation please click here). We are currently in the beginning of the final wave (4-5, look at top image) of the up move and the model suggests a peak of around 2000 in the S&P500 and 20,000 in the Dow, most likely within 12-18 months. I think this prediction is well in line with the typical psychological pattern of market cycles depicted below. I find the prevalent psychology best described somewhere in between “Media attention” and “Enthusiasm”. Stock tips, IPO’s and high fliers have become fashionable, once again. Historically, this is the time when the biggest gains are made as the market rises in a near parabolic fashion as we are starting to witness today. It is also the most exciting time to be in the market but you have to know when to get out.
My goal is to ride the wave and hopefully be out of harm’s way by the time the wave comes crashing down. Feel free to surf along with me but make sure you understand the inevitability of the end. Caveat emptor!
Loyal readers of this blog know that I have been a harsh critic of quantitative easing across the globe ever since the immediate financial crisis was arrested in 2010. One of the leading professionals conducting QE on behalf of the Federal Reserve, Andrew Huszar, has now come out and explained his view of QE in a Wall Street Op-Ed with the title “Confessions of a Quantitative Easer” . For those of you unfamiliar with Mr. Huszar, he is a senior fellow at Rutgers Business School, is a former Morgan Stanley managing director. In 2009-10, he managed the Federal Reserve’s $1.25 trillion agency mortgage-backed security purchase program.
The article starts very tellingly with the following words “I can only say: I’m sorry, America.” This piece is concise in nature and explains the inner workings and effects of quantitative easing to the public. Please read this article as the consequences of QE will be with us for a very long time.
Should you experience problems opening the article on the Wall Street Journal website, please click on this yahoo link.
In 1913, President Woodrow Wilson signed the Federal Reserve Act into law and regretted doing so in his memoirs six years later. History rhymes…
This past week, ECB governor Mario Draghi lowered the Euro area short-term interest rate to 0.25%, effectively joining the rest of the western world’s monetary masters in removing the reward to hold currency. As a result, we find very stable foreign exchange markets that allow multinational corporations to diminish the cost of currency hedging(insurance). In a way, this coordinated global policy of harmonizing the fx market should provide a stimulus to employers as costs are reduced and certainty regarding future business prospects is added. While I am personally biased as a currency trader who prefers moving markets over controlled ones, I remain doubtful that the long-term implications of overriding free market flow will be net positive to society at large.
Today, I wanted to share this outstanding 30 year US Dollar Index chart. Please note that the Index is entirely focused on the pre-globalization era western economic power distribution. As such, important currencies such as the Chinese Yuan, Russian Ruble, Indian Rupee, Brazilian Real, South African Rand… are largely ignored and would make the dollar decline much sharper on the chart if included.
As all interest rates are next to zero and QE has become a global phenomenon, the US Dollar’s descent has stabilized with respect to other currencies. However, the long-term trend is a market participant’s friend and it is clearly pointing down. Keep that in mind in case you decide to deploy investment money in one currency only.
When I first arrived at college to enroll in the economics program, I was often greeted with a similar public view as shown above. While in school I found most economic theory to be enlightening and sensible. Only after stepping into the real world of financial markets did it become clear to me that there was a visible disconnect between economics and finance. To this day, nearly all models employed be economists don’t fully reflect reality because they either omit crucial inputs or they assume rational behavior at all times.
This week, an interesting interview exchange occurred between Rick Santelli and Nobel Economics Prize winner, Eugene Fama. In case you don’t know Professor Fama, he is clearly one of the most renowned economists in the world. In my judgment, his theories are flawless and groundbreaking while crisp and precise. Yet, in this interview the academic disconnect from reality becomes clear once again. When asked the impact of the Fed ‘Tapering’ or even selling down its $4 trillion in assets, Fama calmly says “it’s basically a neutral event… It’s No Big Deal!” In other words, according to Professor Fama, the Fed has two choices to unwind the biggest monetary experiment in history. It can either “retire”(monetize) the debt that it created which has historically always led to a collapse in confidence of the currency. Or, the Fed can just sell back $4 trillion worth of debt into the markets which would profoundly impact the bond market and interest rates. On paper, Professor Fama is correct, his thinking works with small numbers but in case of $4 trillion(25% of all US equity capitalization), it is at best presumptuous to assume little or no market reaction whatsoever. By the way, my different view of Prof. Fama on this particular subject does not diminish my enormous respect for his work but is meant to illustrate the danger of reliance on economic theory alone in order to predict financial markets. Watch the interview and judge for yourself: http://video.cnbc.com/gallery/?video=3000211021&play=1
Nothing much has happened in recent weeks in the financial markets as the status quo of major inputs remains unchanged. Once again, I would like to point to the difference in view regarding the stock market depending on time frame. As a trader, the stock market looks technically solid and healthy and there is no reason to assume calamity in the near future. As I pointed out before, as long as the Federal Reserve adds $85 billion a month to the financial markets, the risk of a sell off seems remote at best and is reflected by benign market conditions. Watch the Fed carefully for when they stop the printing press as that is the primary driver for all financial markets today as shown below:
For the investor with a longer time frame in mind, I would like to share the following chart with you that John Hussman tweeted
Clearly, the stock market is richly valued and likely to drop significantly in the next down turn. Therefore, short term gains at the expense of long term pain are the probable outcome for buy and hold investors. In my view, the Fed is unlikely to decrease QE anytime soon as that would lead to an immediate recession. However, should the market decide to raise interest rates on the Fed while QE is still in place, we would then find ourselves in a crisis in which monetary policy is without effect and government efforts difficult as the public fiscal conditions are “unfavorable” to begin with. Yet, this is an assessment of the future based on what I know here and now. As of today, the trend points up and hopefully the wealth effect the Fed is aiming for will materialize. Good luck!
When Christopher Columbus set sail to discover a new trade route to India, he hoped to find and establish a quick way to the East by going west. Due to the silk road issues post the fall of Constantinople in 1453, the Spanish monarchy supported his efforts that eventually led to the colonization of the Americas. Many countries in the New World and elsewhere celebrate the anniversary of Christopher Columbus’ arrival in the Americas, which happened on October 12, 1492, as an official holiday. The landing is celebrated as Columbus Day in the United States, as Día de la Raza in many countries in Latin America, as Discovery Day in the Bahamas, as Día de la Hispanidad and Fiesta Nacional in Spain, as Día del Respeto a la Diversidad Cultural (Day of Respect for Cultural Diversity) in Argentina, and as Día de las Américas (Day of the Americas) in Belize and Uruguay. And thus, a bank holiday was observed this past Monday in the United States. In many ways, Columbus set out to find one country and discovered a “new world”. To some extent, the current monetary experiment that is under way is also a voyage into the unknown. Never has the world seen global mass monetization of this size in practically all countries simultaneously. Do I exaggerate? Take a look at the chart below and decide for yourself:
This chart depicts the total amount of securities held by the Federal Reserve and compares it to the total amount of securities of all US commercial banks combined. Historically, the central bank has always owned a fraction of total capital market share to allow it to act as lender of last resort in a crisis. Yet today, it officially owns the largest slice of all assets out there. Aside from the obvious ideological issues that arise with the Fed’s omnipotence, it remains to be seen whether one semi-political institution will be a better allocator of capital than the private, “free” market. What is undisputable is the fact that we are in a new era of economic planning that may or may not work. Clearly, the US government is unable to implement fiscal reform and therefore, the Fed must now conduct fiscal policy via QE on top of monetary policy via zero interest rates. Furthermore, the Fed now intervenes in practically every capital market turning the world’s exchanges into political pin ball machines. In effect, the central bank has morphed from lender of last resort to lender of, well, every resort.
So far so good. Interest rates are kept low, currency markets remain in slumber and equity prices keep rising. As for the long term of this gargantuan experiment I turn to Jim Rogers who tends to have the best crystal ball in these matters. “Two or three years later we’ll be right back where we started, only the debt will be that much higher. Eventually the markets are going to say we don’t want to play this game anymore and we’re not going to lend you money at any price. America will then go into a steep and steady decline just as it happened in the UK, Spain, and many other countries over the last 200 years.”
Of course, there are prominent economists like Paul Krugman who claim that debt doesn’t matter and that everything will be fine. While I cannot understand his logic, I sincerely hope he is right.
Last week, I pointed to the near perfect correlation between the Fed’s balance sheet and the S&P500. As the “taper” has slipped into oblivion, we can assume the $85 billion a month money creation to continue. If you apply the statistical correlation to the future of the stock market the following chart appears:
As I have said many times before, this party is set to continue for all the wrong reasons but if you must dance, make sure you stay close to the emergency exit. What would Columbus think of today’s digital voyage into the unknown?
Eleven years ago, Ben Bernanke said the following regarding the Financial System and the role of the Federal Reserve in it:
“I worry about the effects on the long-run stability and efficiency of our financial system if the Fed attempts to substitute its judgments for those of the market. Such a regime would only increase the unhealthy tendency of investors to pay more attention to rumors about policymakers’ attitudes than to the economic fundamentals that by rights should determine the allocation of capital.” - Ben Bernanke, October 15, 2002
As readers know, I have been very critical of the post crisis QE management of all financial markets as they have stopped reflecting economic reality and have become tools for policy makers. If you think this statement is too harsh, look at the evidence in the chart below. Since 2009, the Fed’s balance sheet and the S&P500 stock index have had a 90% positive correlation. This is obviously statistically significant and points to the fact that capital markets have been centrally controlled since 2009. As for the direction of the (nominal) price of the stock market, just follow the Fed’s deeds…
Every year, about 6 million visitors enter the beer halls of Oktoberfest in Munich, Germany. The one liter glass you see above is the standard size beer served. While The Economist magazine likes to compare Big Macs’ to assess currency valuation and purchasing power, the US relies on the hotly contested CPI to gauge inflation. I personally prefer the price of crude oil as the foundation to price levels but given the Bavarian holiday spirit, let us take a look at the cost of one “Mass”(liter) of beer sold at the Oktoberfest over the past 60 years.
Thanks to Incrementum for the historical info: “The purchasing power of gold should be especially appreciated in Bavaria. While one litre of beer at the
Munich Oktoberfest cost an equivalent of EUR 0.82 in 1950, it will probably be EUR 9.70 in 2013. The annual increase in the price of beer since 1950 has been
an average 4.1%. Relating the beer price to the price of gold, we find that one ounce of gold buys 101 litres of beer at the 2013 Oktoberfest in Munich. The
historical mean is 88 litres, this means that the “beer purchasing power” of gold is relatively high. The all time high was 227 litres per ounce
of gold in 1980. We think it is indeed possible that we will see these values again. Beer drinkers with gold in their portfolio should therefore
look out for sparkling times and lots of fun at the Munich Oktoberfest.”
As you can see, gold has been a great way to preserve (beer) purchasing power in Munich although it is trading above its historical average in terms of beer. Clearly, owning physical gold has its place in a portfolio as much as beer does in a fridge.
As for the value of attending Oktoberfest, that is certainly priceless as is the atmosphere. Prost!
Have you ever seen the 1993 classic Groundhog Day ? If you haven’t, please stop reading and rent the movie. If you have, you may need to view it once again to cheer you up after today’s entry. Groundhog day is certainly one of my favorite movies starring Bill Murray. In it, “Murray plays Phil Connors, an arrogant and egocentric Pittsburgh TV weatherman who, during a hated assignment covering the annual Groundhog Day event in Punxsutawney, finds himself in a time loop, repeating the same day again and again. After indulging in hedonism and numerous suicide attempts, he begins to re-examine his life and priorities.” In the end, he makes the right choices, beats his demons and finds love. By the way, Ground Hog day in Pennsylvania is an American classic that is on my travel list. The town of Punxsutawney displays the following sign:
Anyway, living through the same old event over and over reminds of the almost annual debt ceiling debate. Once again, the federal government faces a debt default unless there is political agreement to borrow more funds from future generations. In a simple cartoon, the issue is quite clear:
As you can see below, the US federal government keeps racking up the debts and every time the official credit limit is reached, it requires political will to increase borrowing. It is truly amazing to observe a once linear curve turn exponential. In fact, according to the US debt clock , the current federal debt per US citizen is $53,544. What is even more stunning is the fact that the US government has nearly tripled its entire debt since 2001 which stands just under $17,000,000,000,000 as of today:
As I have been in finance my entire professional career, I have noticed one universal mathematical truth. Every graph that goes from linear to exponential eventually stalls and leads to trouble. In fact, the beauty in math is that it is indeed universal by nature and so I googled a chart for “airplane stall” and found this:
Apparently, this is the chart to explain how to create airplane stalls in airshows. Do you see any resemblance with the chart above?
The bigger problem
As you may remember, Detroit filed for bankruptcy just a few months ago. The debt load had finally become so large that even interest payments were impossible to make. Unfortunately, adding the unfunded liabilities to the federal on balance debt leads us to an astronomical $218,000 per citizen. Of course, this is only the debt per citizen balance for the federal debt and excludes all state, local and private debt in the US.
So why has the US government not defaulted as Detroit was forced to do? Former Chairman of the Federal Reserve Alan Greenspan explained it perfectly in 2011 when he said that “The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default” . By printing money, the increased service of the debt burden is placed upon the saver and retiree by transferring the purchasing power of his/her savings/pension to the federal government and the receiving entities of QE. How long can this transfer of wealth continue? According to the late Margaret Thatcher “The problem with socialism is that eventually you run out of other people’s money [to spend].” More pragmatically, this agenda can continue as long as currency markets are (kept) calm, bond markets (kept) tame and cash holders remain willing and able to pay the price.
How close are we to the tipping point? According to the US debt clock , the total assets per capita in the US are $331,000. Total household debt is about $15,000,000,000,000 or $50K per capita. Add corporate/state/muni debt of just under $30,000,000,000,000 or $100K per person to the liability(see chart below for breakdown) and we find ourselves having assets of roughly $331K per person facing liabilities of an estimated $218K + 50K + 100K = 368K per person. If we apply sound accounting to the entity at hand it must be concluded that the US is currently bankrupt. In itself, bankruptcy is not the end of the world but it is about time that we identify the problems and deal with them before the financial markets take away the printing press and expose our issues in an extremely painful fashion to all of us.
Another great way to see the madness in the numbers is to watch the video below where a middle class American walks into a bank and wants to address his credit problems by raising his credit limit. Enjoy…
While I am no politician, we may want to listen to the wise words of the quite elder statesman, Cicero, who said the following in 55BC:
Finally, let us hope that a happy ending will be found to the fiscal problems that face America. In Groundhog Day, Bill Murray finds love and inner peace after all his struggles.
Perhaps, John Boehner and Harry Reid will do the same, symbolically speaking of course…
At the end of 2013, current Federal Reserve Chairman Ben Bernanke will leave his post and pursue other interests. Looking back, in coordination with other global central banks, a total of roughly $9,000,000,000,000 have been created in order to change the pricing (mechanism) of capital markets in response to the financial crisis of 2008. For better or worse, the free markets are now an idea of the past. Equity prices are artificially high, interest rates artificially low and currencies artificially stable at unnatural levels due to global monetary policy. Needless to say, central banks hold the keys to present and future capital allocation and have become extremely if not all powerful. Who will be the next Fed Chairman and how will he/she continue or change current policy?
Bye, Bye Summers
Until a few weeks ago, it appeared that Larry Summers might become the next Fed chairman. As an accomplished scholar and politician, Mr. Summers seemed to be an appropriate choice for the enormous responsibility of the position at hand. However, Mr. Summers decided not to pursue this job and I applaud his decision. In the end, his track record in finance is not exactly spotless as the picture below shows:
It now seems certain that Mrs. Janet Yellen, a highly decorated economist and instrumental engineer of current QE policy will take over the Federal Reserve in January. Aside from her eerie resemblance with my daughter’s second grade school teacher, Mrs. Yellen appears to be the natural successor to Ben Bernanke. Not only does she endorse astronomical money creation, she will probably be willing to go beyond the scope of current policy in order to achieve the goals of central banks. I believe she will change the benchmark of monetary policy, namely unemployment and inflation, to nominal GDP growth. By that, I mean that the Federal Reserve will want to achieve a steady growth in nominal GDP and will create money to achieve this goal. How can that be done?
GDP= C(onsumption) + I(nvestments & Savings) + G(overnment spending) + N(et Exports – Imports). Clearly, newly printed money will not be sent out to consumers across the country and also not be given straight to savers, investors or exporters. Therefore, a continuation of printing money to buy government bonds and allow government to expand spending is very likely in the future of monetary policy. Frequent readers of this site know that in my opinion, we are in a stagflationary environment in which the economy muddles along while prices increase. The more “stag” we see, the more “(in)flation” will be created to show, say, a 2.5% GDP growth per year. Of course, this GDP number will not reflect real growth but it will serve its purpose of portraying a steady and stable economy.
In effect, Mrs. Yellen will likely be a very similar leader to Mr. Bernanke and build on the policies of the past five years. Personally, I am appalled by the fact that capital markets have been taken over by central authorities and assets are now being allocated according to central bank decree. History has not been kind to such attempted intrusions into the marketplace and only time will tell whether the largest monetary experiment in human history will be successful in the end.
I shall end today’s post with a thought for the reader to ponder. Is current monetary policy legal? After all, the Federal Reserve, by law, is not allowed to engage in fiscal policy yet by indirectly financing government spending it is arguably doing just that. While I am no legal expert, I have researched this matter and found an informative paper on the subject published by the William & Mary Business Law Review. The author, Chad Emerson, makes a compelling case as to why current monetary policy is in violation of the law and I urge you to check his work: The Illegal Actions of the Federal Reserve: An Analysis of How the Nation’s Central Bank Has Acted Outside the Law in Responding to the Current Financial Crisis Decide for yourself whether the current power of central banks has exceeded the necessary and helpful function of lender of last resort or not. Finally, I leave you with a quote by an infamous banking legend:
This week, financial markets feverishly awaited Chairman Bernanke’s action regarding cutting back daily money creation. While the expected “taper” from $4,250,000,000 per business day to $3,700,000,000 would be cosmetic more than anything, the Fed decided not to taper at all leaving monetary policy as if the economy were in the depths of depression. In response, all asset classes took off simultaneously as more future money supply lowers the value of the $ that is being created. However, the reaction was short-lived and by Friday all gains in the stock market had been reversed. What is going on?
When it comes to economic conditions numbers don’t lie. While QE has been very beneficial to those entities receiving mountains of money at zero interest, the middle class in America has not seen the benefit of that monetary policy. As 70% of the US economy depends on consumer spending, a shrinking middle class points to lower future profits. Take a look at this chart depicting US household income over the past 40 years:
As you can see while incomes are rising, the true increase in wages is rather low. Zooming in for the last decade, the picture becomes more striking:
Furthermore, CNS news reported this week that 23,116,928
to 20,618,000: Households on Food Stamps Now Outnumber All Households in
Clearly, QE cannot and will not be able to address structural problems in the (US) economy but it does buy time. How much time?
As I had written in Running with the Bulls , the trend is a trader’s friend and it is up(stocks) for as long as three conditions are met. First, the Fed must not end its enormous money creation. Second, the bond market must not rebel and force interest rates shockingly higher too fast. Third, the currency markets must not lose confidence in the QE programs that are being implemented globally. Every trend eventually comes to an end and this particular one will be rather shocking once it reverses. When it comes to the stock market as an investment, it is well worth watching what the Oracle of Omaha, Warren Buffett does. Recently, he has been selling equities and raising cash. In a recent interview Mr. Buffett opined that “Stocks have moved a long way. They were very cheap five years ago. That’s been corrected…We’re having a hard time finding things to buy.” Has Warren Buffett Nailed Another Market Top? Caveat Emptor.