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A glimpse of the future

June 22, 2013

Ben Bernanke

A turbulent week has come to an end in the financial markets. Once again, the catalyst has been Fed Chairman Ben Bernanke as he hinted at a possible future reduction in money printing if economic conditions improve. http://www.forbes.com/sites/afontevecchia/2013/06/19/did-the-fed-chairman-just-kill-the-bernanke-put-fed-ready-to-taper-qe-this-year/ Based on the fear of less monetary expansion, all asset markets sold off simultaneously. Stocks, bonds, commodities and gold were all smashed at the same time as traders pulled back. The slide was halted Friday midday as the Fed’s “mouthpiece” Jon Hilsenrath from the Wall Street Journal published an article titled   “Markets might be misreading Fed’s messages” http://blogs.wsj.com/economics/2013/06/21/analysis-markets-might-be-misreading-feds-messages/. In it, Hilsenrath downplayed the possible Fed actions and pointed out again that the central bank would only start to act if economic conditions were to improve  The markets bought the story and the day was saved.

As I have warned many times, there will be a time when all assets will sell off at the same time wreaking complete havoc to portfolios. While I do not believe that it is time to hit the panic button I would urge readers to double-check their thesis that bonds and stocks are hedges against one another. They used to be but they will not be in the next financial crisis.

TAPER

The cut back in QE has also been referred to as “taper” but let us consider the likelihood of those future  actions. Financial markets have revolted this week at the sheer possibility of a cut back in money printing. Now imagine what Fed actions would be necessary to restore a normal functioning financial system:

1) Reduce QE 2) Stop QE 3) Sell off 3.2$ trillion of Treasuries and Mortgage Securities into the markets 4) Raise interest rates

Considering the fact that mentioning a reduction of QE(step 1) causes the financial markets to sell off sharply should be proof that the Fed is stuck and cannot retreat from ever more QE. Imagine what would happen if steps 1-4 were taken in the foreseeable future. Forget a bear market, it would be Jurassic Park. As a result, the Federal Reserve will not be able to cut back its monetary expansion and will continue to print money. The problem with printing trillions of dollars is that inflation will eventually get out of control and will lead to the Jurassic Park scenario as well. Assume a gallon of gas at $10, how would the consumer be able to afford the goods and services of corporate America? As a result, stocks would crater and bonds obviously as well as nobody wants to make 2% interest when inflation is running at multiples of that yield. In the end, there will be either a currency and/or bond crisis. The Federal Reserve at this point can only choose which way to direct this outcome and arguably prolong the period of denial that we live in.

WHAT TO DO

That is the big question of course as all assets are risky but c’est la vie. Stocks and bonds are clearly overvalued and I will take a closer(trading) look at them a little later. Staying in cash is dangerous as well as prices keep rising. Take a look at the long-term purchasing power of the “Federal Reserve Note” below(if you need a reminder of the last 13 years, remember a gallon of gas cost an average of $1.51 in 2000, roughly a third of today’s price)

Dollar purchasing power

The obvious answer to me is real assets that are outside the financial system and cannot be printed. Having said that there are obvious short-term risks to those assets as well as we have recently seen in commodities and precious metals.

IS IT TIME TO SELL?

This section is dedicated to the traders rather than the investors among you. Clearly, bond yields are headed higher(bond prices lower) over the next ten years and I do believe that stocks are overvalued as well. However, let us look at the trading trends that currently prevail. Below is a 1 year chart of the S&P500 ETF(SPY) that I created at Yahoo Finance.

S&P500 chart

The 50 day moving average(green line) is a short term technical indicator of trend while the 200 day moving average(red line) indicates the long term trend of a particular market. While the S&P500 has pierced the 50 day average this week it has so far not decisively broken down below it. Furthermore, the long term trend is still about 5% lower and before we breach that level it would be premature to talk of a bear market. In fact, in order to see a bear market you want to be able to identify declining trend lines and the so called “death cross” that is observed when the 50 day average crosses the 200 day average on the downside. I will illustrate this scenario below as it fits for the bond market. As for the stock market today, there is no technical indication yet that trouble is brewing. That may change of course and I shall keep you posted…

Bonds

Take a look at the chart for the ETF that mirrors the 7-10 year Treasury market(IEF)

10 year bond chart

Here you can see declining short term and long term trend lines and a recent “death cross”. While this particular market appears oversold in the very short run, it looks very bearish from a technical point of view. Yours truly definitely wants no part in this game.

Conclusion

The coming weeks will give us further indication as to whether the stock market will join the bond market in its bear formation or whether the current sell off is a healthy correction. As for the long run, the Federal Reserve is unable to solve the economic issues of the (global) economy. At the end of the day all it can do is create and (re)distribute money but not real wealth. Unless there is structural growth in the economy the markets will eventually catch up with reality. As for Chairman Bernanke, his decison to “exit” at the end of the year is probably the smartest one as Chairman of the Federal Reserve.

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