The Obama Economy's Impact on the Stock Market

My criticisms of Obama's economic policy ruffled quite a few Democrat feathers if the amount of abusive email I got is anything to go by. (Because these Democrats always act in bad faith, they unthinkingly assume that their critics always do likewise.) As expected, the thoughtful responses came from regular readers.

Last week I said that I thought the Dow had some way to fall and that I would not be surprised if it dropped to 3,000. I made a similar comment about P-Es. Readers thought I contradicted myself because I had stated a number of times there would be no Great Depression, and that I had also told readers to focus on monetary policy rather than Obama's phony stimulus. The evident confusion here is entirely my fault - I should have elaborated further with respect to my previous comments.

My view that the Dow would fall further was based on the self-evident fact that share prices are determined by expected future earnings. Given that Obama's so-called economic policy of raising taxes, expanding government, the destructive cap and trade proposal, dissipating masses of capital on green schemes to raise energy prices, attacking the oil industry and on burdening the economy with more costly regulations* is guaranteed to severely damage the prospect of future profits that the markets had yet to fully factored these future costs into present share prices. I still think this might be the case.

It seems to have been forgotten that the central banks' criminally loose monetary policies have caused severe world-wide imbalances in national financial systems. These imbalances (malinvestments) still need to be dealt with - and throwing money at them is no solution. In the light of this situation it is reasonable to assume that the necessary shakeout of unsustainable investments has some way to go, meaning that share markets could very well take another hammering in the near future. (This, however, raises the question of monetary policy.)

Meanwhile there is considerable debate as to what is driving the market rally. (Those who are whooping it up because they think it vindicates Obama's big government program are apparently ignorant of the fact that bear markets are notorious for sudden reversals before resuming a downward trend.) There are those who believe the main reason is the rush to buy shares by those anxious to cover their short bets. Then there was the Citigroup (C) Chief Executive's claim that they were highly profitable with $19 billion in earnings for January and February. (He made no mention of net earnings.) There is nothing here to suggest a sustained upturn in the markets.

I did say that share prices are determined by future earning (discounted of course). It is therefore safe to presume that in this case industrial production must be stirring. (I am aware that the Dow is now heavily skewed to financials.) Yet the latest release from the Fed shows that from January 2008 to last January industrial production fell by 10 per cent with manufacturing falling by 12.9 per cent and construction by 16.7 per cent. The Institute for Supply Management recently reported that its performance of manufacturing index now stands at 38.8 per cent. Moreover, production and employment are still contracting. Clearly no joy is to be found here.

There is an unfortunate tendency to downgrade manufacturing as a key indicator. This is a grave mistake. In fact, because the national accounts are based on the value-added approach, they ignore an enormous amount of business expenditure. If this were taken into account then consumption would fall to about one-third of total economic activity. This also means that the figures for expenditure by manufacturing would zoom. The chart below shows how the Dow moved with changes in industrial production throughout the 1930s. (And this was when the Dow really represented industrials.) The pattern should come as no surprise. As production increased so did earning and vice versa. Naturally the Dow moved with the change in earnings.

But production figures from the ISM and the Fed clearly show that industrial production is contracting. Obviously the Dow is not reflecting this movement nor are any of the other market indexes. So what gives? The next chart might supply the answer. It follows M1 and the monetary base from 1960 to last January. If the difference between the two measures had been maintained then the monetary base would have come in at around 1,000. Instead it came in at $1,740,686. Once would expect such a massive and unprecedented increase to result in a rapid monetary expansion.

Money base — AMS — Austrian money supply definition: Cash+demanddeposits with commercial banks and thrift institutions + government deposits with banks and the central bank + demand deposit at foreign commercial banks and foreign official institutions + sweeps. Monetary base: currency and coins held by individuals, firms, depository institutions and at the central bank. Sweeps: Demand deposits that have been reclassified as savings deposits.

Well, that is just what we got. From September last year to the beginning of this month, the money supply expanded by 56 per cent. It was only a matter of time before this expansion would affect short term rates and steepen the yield curve, something that has now come to pass. Last Friday, the price on benchmark US 10-year Treasury notes turned negative. I believe this was the result of investors selling up in order to get into the market. So how does this monetary effect come about?

It is easy to see how monetary expansion drives down short term rates. It's a straightforward question of supply and demand. The effect of this policy is to widen the profit market for banks by allowing them to borrow at below market rates and lend at higher long term rates. Therefore, lowering the rate of interest encourages more borrowing. But this is not normally possible unless the banks have increased their reserves. And this is where the monetary base enters the scene. It swells those reserves.

Monetary theory argues that the lowering of interest rates raises the public's nominal cash balances beyond the amount it wants to hold. It therefore reduces these balances by acquiring assets such as shares. However, the only way in which cash balances could be increased by a monetary expansion is by an increase in nominal incomes. This doesn't seem to be the case. But by making more funds available through the banking system at extremely low rates, Bernanke has created a situation that might encourage more risk taking in the stock market, particularly if enough people have been persuaded that the bottom has been reached. It is probably this process that caused 10-year Treasury notes to turned negative as holders cashed in to invest in rising stocks. How long can this continue? As Fritz Machlup said:

[The] continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply. (Fritz Machlup The Stock Market, Credit and Capital Formation, William Hodge and Company Limited, 1940, p. 290.)

In other words, it's the very process that created the crisis in the first place. But - and there is always a but - Machlup was describing the classic situation where the whole economy is booming thanks to credit expansion. In my opinion, the only way this could play out in Obama's favour is if Bernanke's monetary gamble gives the economy a sufficiently powerful shot in the arm. That, however, guarantees an inflationary surge, downward pressure on the dollar and rising interest rates. Sooner or later, Bernanke - if he is still around - would be forced to slap on the monetary brakes. Making the situation worse would be a horrendous economic burden of Obama's ideologically motivated program.

As I said before: Monetary policy - not Obama's stimulus - is what needs watching.

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*"As many as 13,000 factories, power plants, refineries and other commercial enterprises that fuel the economy will be required to report to the government their levels of greenhouse gas emissions. From there, it's a small step to regulating hospitals, chain saws, fireplaces, lawn mowers, go-carts - you name it". (Investors Business Daily, 12 March 2009)

Comments

[Patrick22:]

Far too much of the economic and market analysis on this site lately is done from a biased viewpoint. The twists and turns being made to make a case to root for Obama's failure is clouding judgment. Another commentator today was quoting Marxists to make such a case. It is strange times when Republicans turn to Marxism.

People want to make money. That is the only reason to be reading this site. If they want political commentary, there are thousands of sites they can go and get the latest Republican propaganda. Probably the reason you are getting such strong negative feedback is because your bias is so obvious. How can anyone take you seriously when it is obvious you are not objective? Even an anti-Obama Republican would have to question your conclusion knowing it was pre-determined by your bias.

Mar 16 10:32 AM

[Steve in Gr...:]

Another great article, Mr. Jackson. Thanks.

As much as they would like to ignore the U.S. government, investors have to protect their assets and position themselves to profit despite the government's ongoing program of wealth destruction, so investors have to pay attention.

Mar 16 06:41 PM

[grh1212:]

This economy belongs to GW Bush He created it over the past 16 years building upon the foundation of St Ronnie and Poppy. He turned his back on the 8 years of prudent leadership of President Clinton. He could not stand peace and prosperity nor the good opinion of the nations. Therefore, he lied us into a war of aggression, buried us under a mountain of debt we may not recover from in any living person's lifetime, practiced the torturing of people, ignored the environmental laws, built a military machine that is sized to that of the ROW combined for God knows what end since mere defence does not require such mindless waste. ( Of course, the irony is that the war to break in and steal what does not belong to him and his friends has pretty well worn out most of the equipment so much dumping, overhauling, and purchasing anew will be needed.)

He was a stranger to truth, did not value life, and was an incompetent who did not know the way.

Perhaps Obama can set things right over the next 8 years but I doubt it.

Mar 17 02:00 PM