I am hearing rumblings from some of the bulls of late that the stock market can no longer be trusted. This week's economic data offered very little for those in the bull camp, and considering the rather lofty price we have attained since we went half way over the fiscal cliff with tax hikes and spending cuts that everyone chose to celebrate - for what reason I don't know - you would expect a modest sell off. A 40 point negative close on Friday after a really horrible jobs report doesn't fit the definition of "modest sell off".
The market rally since the start of the year - precipitated by the resolving of the "fiscal cliff" issue - has a very contrived appearance. Note I didn't say solved the "fiscal cliff" issue as we surely didn't do that. The resolution was only a little better than the original "fiscal cliff" as we did end up raising taxes and cutting spending - a decision that will plague us going forward. The resolution was certainly no reason for celebration and no reason for stocks to rally.
I used the word "contrived" as it has a less sinister ring to it than rigged. According to my thesaurus, "contrived" means artificial, unnatural, manufactured, fixed and false.
The words to the Buffalo Springfield song "For What It's Worth" keep ringing in my head - over and over - "There's something happening here, What it is ain't exactly clear . . . "
I think those words aptly describe the market today. If you ask a bull why the market should go higher, they will respond by stating that you can't "fight the Fed" - as long as the Fed keeps printing, stocks will keep going up. It's as simple as that - sales growth; profit margins; unemployment; GDP; eurozone recession; China slowdown; bank deposit confiscation to bail-in depositors to bail-out banks; tax hikes and spending cuts - none of that matters as the Fed is still printing.
That is the logic and that is honestly what most bulls see as the driver of stock prices. The chart above shows that since the announcement of QE4 - just 3 months after QE3 - the markets have developed a renewed vigor. If one actually believes that the Fed's QE will improve the economy, there is little to support that conclusion based on recent economic health metrics.
Notwithstanding the truth of that statement, the markets are highly resistant to negative data, and the very brief sell-offs that occur when we get a bad report are seen as reasons for the Fed to continue to devalue the currency which should make all assets move higher. In other words, each bad data print is a reason to "buy the dip." And buy they have, hence the scrunched-up looking chart segment reflected in the box above.
What puzzles me the most though is why stock traders think that the Fed's monetary policy is bullish for stocks. Oh, I do understand the logic -- inflation is bullish for stocks and all other assets. If inflation is high enough, everyone will try to outrun the higher prices by spending now instead of waiting as the purchasing power of the dollar will be less over time. That drives GDP which drives demand which drives the need to hire which increases the demand further as more have money to spend.
In other words, inflation is - in certain instances - a good thing. Furthermore, it is what the Fed wants to see. The problem is they are not seeing it regardless of a very aggressive effort to produce it.
Here is a look at the number with QE reflected. QE1 had a significant impact. At the onset of the recession, deflation was the result as the CPI plunged by more than 7% in about 6 months. QE1 finally pushed the CPI up into positive territory. As QE1 ended, the CPI once again headed down and didn't begin to move higher until QE2 started. At the end of QE2, the CPI again headed south.
An attempt to keep inflation in positive territory by going to twist with sterilized purchases was a complete flop as CPI continued to decline until the Fed introduced QE3. QE3 had a very modest impact but CPI fell off after one month. QE4 likewise had a very modest impact even though Fed balance sheet expansion had moved to $85 billion a month.
The Law of diminishing returns seems in full play as far as QE is concerned. This should not be an esoteric concept but maybe it is.
Law of diminishing returns:
A concept in economics that if one factor of GDP - (Government spending) -- for example is increased while other factors - (Personal consumption), (exports - imports) and (investment) are held constant, the output per unit of the variable factor will eventually diminish.
In the case of QE, the output is definitely diminishing much to the chagrin of those who are absolutely certain that dollar destruction is the ultimate outcome of QE. A look at the Dollar Index chart below suggests those who see QE as destroying the value of the dollar are simply wrong.
On October 1 of last year, I wrote Making A Case For Buying The U.S. Dollar Now. The Dollar Index was at 80.02. The Dollar Index closed out March at 83.17 - up 4% since the first of October and that is in spite of the Fed's move with QE4 to a balance sheet expansion of $85 billion a month. My expectation of a strong dollar is also the reason I turned bearish on gold (GLD).
There are a multitude of reasons for why QE isn't working, but one must have a basic understanding of monetary policy as it relates to where the money goes to fully understand why QE is not working. Many apparently think that when the Fed prints, the money moves into M2 and therefore into the economy. That is just not true and a fact that eludes most - even those who should understand. Those who look at M2 can't seem to fathom how all this isn't inflationary.
Maybe we need to take a closer look at how QE really works. Here is a chart of M2. The trajectory of M2 has been up but not a lot more than normal. It can be argued that Fed QE has had a modest impact on M2 but not as much as many think.
Here is part of the problem though - M2 velocity. We will talk about this metric further in a minute.
If you don't understand how QE works - and there are a lot of pundits who simply don't understand it - you probably have a hard time seeing how dollar destruction isn't the ultimate outcome of such aggressive money printing.
The M2 velocity chart is useful in explaining why inflation is so subdued, but it doesn't really explain the problem. The only way to understand why QE isn't inflationary is to understand what is happening to the money the Fed is printing. Here is what happens in the most basic of terms when the Fed engages in QE:
- The Fed buys a bond from a bank by crediting the bank's reserve account and debiting the Fed's bond account.
- The bank ends up with more cash (reserves) and fewer bonds.
On the surface, this doesn't seem to be changing anything but consider what happens when the Fed makes a conventional sterilized purchase of bonds:
- The Fed might sell a short-term bond and buy a long-term bond. The Fed credits their short-term bond account and debits cash. The Fed then uses that cash to buy the long-term bond.
- In the aggregate, reserves don't change in this scenario as the Fed sold a bond to a bank reducing reserves and then bought a bond of a different maturity ending up increasing reserves. The net impact to reserves is unchanged.
Here's a chart of the monetary base (MB) which clearly reflects what has happened with QE. This is where QE shows up and the metric most affected by QE.
And finally, here is a look at excess reserves - the single biggest component of the Monetary Base number.
The table below helps one to understand exactly what the various money supply metrics are composed of and that will help a lot to explain why the Fed's monetary policy has not been inflationary.
Type of money
Notes and coins in circulation (outside Federal Reserve Banks and the vaults of depository institutions) (currency)
Notes and coins in bank vaults (Vault Cash)
Travelers' checks of non-bank issuers
Other checkable deposits (OCDs), which consist primarily of Negotiable Order of Withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.
Large time deposits, institutional money market funds, short-term repurchase and other larger liquid assets
All money market funds
The monetary base (MB) is composed of currency, coin and bank reserves. Bank reserves are bank cash and reflected as an asset on a bank's books. Deposits are liabilities of the bank. Bank deposits are reflected in M2 but not in MB. Bank deposits are assets of businesses and consumers and can be used to buy goods and services - in other words to drive GDP.
Bank reserves are assets of the bank - not the depositor - and are not available to businesses and consumers to drive GDP. The only part of MB that actually works to drive GDP is notes and coins not in bank vaults - a very small portion of the total MB.
Once again, when the Fed buys a bond under QE, the money ends up in bank reserves - not in customer deposit accounts where it can be used to drive GDP. M2 is where we need the Fed's money to end up and under monetary policy theory that is where it should end up.
The idea is that excess reserves allow banks to make more loans and that is where M2 expands - not through the Fed's QE. All the Fed's QE does is increase the monetary base and bank reserves. That is all and that is not inflationary despite the perception by most that it is. That is why the dollar has gotten stronger and inflation keeps moving lower in spite of QE. It is only through the fractional bank multiplier that M2 actually increases and it is only an expansion of M2 that can produce inflation.
The table below (in millions) is useful in explaining where the Fed's money has gone.
Fed balance sheet
Here is the take away from the table above - the Fed's QE has expanded the monetary base and the increase in the monetary base is largely reflected in excess reserves. In fact 77% of the increase in the monetary base is in excess reserves and not being used to drive GDP or inflation.
M2 expansion has increased since November of 2008, but it is not necessarily the result of Fed QE. The increase in M2 is a function of loans in the private sector fractional bank system and only dependent on QE if excess reserves are not at a level that is high enough to allow the loans. The excess reserves in November of 2008 would have been adequate in the aggregate to fund the loans that constitute M2 increase without QE.
One more chart that is really the reason why M2 velocity is so low. This time we will look at M2 but reflect the savings component of M2.
This chart is the one that explains the extraordinarily low level of M2 velocity. The blue line is M2, the purple line is the savings component of M2 and the yellow line is the difference between the two. This chart explains why QE is not inflationary. For inflation to occur, money supply needs to be used in the economy to buy goods and services. That money that is held in savings is obviously not being spent in the economy.
The facts are that the savings component of M2 has increased at a much faster rate than M2 and the net difference - the amount of M2 that is actually circulating in the economy - has declined since the start of QE. Keynes described this as a "liquidity trap".
The take away from this is that if we could get the savings component to decline substantially we would reach escape velocity and inflation would increase as would GDP. It is so important that our experts understand this and it is also clear that hardly any actually do understand it or if they do they refuse to explain it adequately.
The truth is the stock market is on a Fed induced high based on the misnomer that QE must be inflationary. That is simply not true and the markets -- excluding the stock market -- are reflecting that truth.
I am, for the most part, in the camp that sees a lot of problems going forward but I differ in my take on the problems the Fed is creating with massive QE. I just don't see it as a problem nor do I see interest rates climbing or inflation getting out of hand as many do - the most recent being David Stockman.
The subject gets way too much play in the media and for whatever reason the Fed chooses not to challenge that view - probably because they want inflation and the expectation of inflation can actually induce inflation as people begin to spend in anticipation. It hasn't happened yet, but there is always hope I suppose.
For what it's worth I have been bearish since QE3 was announced back in September of 2012. Here is a chart on my bearish calls. I have been wrong on the S&P (SPY) and the financials (XLF) to date. The other calls have been right. My short calls on the commodities -- gold and crude (SCO) -- have been profitable as well as my short call on Apple (AAPL).
As noted above, I am bullish the US dollar (UUP) and for all the reasons set forth in this article. My position on US treasuries (BND) has been less clear until recently. At the time of this writing, I am now of the opinion that treasury yields will fall from current levels and bond prices will move higher.
I do believe we will move into recession by the end of the 1st half of 2013 and stocks will move much lower as it becomes more evident that the Fed's QE is really not justification for higher stock prices. On the other hand, I see no reason for the Fed to unwind their balance sheet. In fact I see them continuing for a while along the path they are currently on and to eventually discontinue QE purchases as we enter recession.
The idea that they will actually withdraw liquidity or that they need to do so is patently absurd in my opinion. The rhetoric will continue, but there is simply no reason for the Fed to withdraw liquidity. On the other hand they will eventually slow down on further balance sheet additions.
There will be ample demand for US treasuries in a recession - even at lower yields - as it will be seen as a safe haven. In fact, based on the template that calls for a bail-in of depositors to bail-out banks, I see the demand for US treasuries as increasing dramatically in coming months. That will allow the Fed to back off of their QE purchases without risking a sharp uptick in interest rates.
Fundamentals do matter and stocks won't defy gravity forever. We are starting to see a number of economic metrics reflect the fact that QE is not a sufficient reason by itself for stocks to move higher. More of these problems will be exposed as we enter earnings season for the 1st quarter. Additionally, we will get the first set of numbers on 1st quarter GDP this month and I don't expect a good number here either.
Price matters and the price of stocks aren't based on anything other than the Fed's QE. The perception that stocks can continue to defy gravity is simply wrong. Many see a correction at some point but not a big one. I disagree and see a very severe recalibration in stock prices as it becomes apparent that the Fed policy of QE is not a magic elixir. When markets move too far in one direction, there is a propensity for those markets to overcorrect in the opposite direction.
That is what I see in the next few months and for the reasons set forth herein. I am sure I will chastised for these views and accused of being a "sour grapes" bear for having missed the big rally. That said, I've got to call it as I see it and that is how I see it.