I have a very strong suspicion that this is going to be a very unpopular article. No one likes it when the market falls. A stock market crash evokes images of the Great Depression, but the reality is that history never repeats itself exactly. When the S&P 500 (SPY) broke below the 200 day moving average last week, given the fundamentals of an economy in deep trouble, a lot of economists were shivering in their boots. People assume that whenever share prices go down, the event is bad for the economy.
But, what if the market does collapse? What if it really does breaks below the previous lows? Will that be bad...or could it be good for the economy?
There is an increasing chance that the indexes will retest March lows. Speculators (and quite possibly, the Federal Reserve and its PPT banks) are buying heavily, but insiders in almost all industries are vigorously selling stock. Heavy insider selling is usually a sign of things to come.
A falling stock market can be hazardous to the financial health of speculators who are operating on margin. It can temporarily shrink the 401K retirement funds of millions of Americans. But, a falling stock market need not be bad news for the economy in the long run. Indeed, it may be just what the doctor ordered. Smart investors will always welcome falling share prices, when they have cash to buy, because it gives them the opportunity to buy stocks at low prices. But, the most important thing is that, if the stock market falls, it will assist the U.S. dollar in recovering lost value.
Rising stock markets are now associated with a falling dollar, and they impair the ability of the U.S. government to sell Treasury bonds at a reasonable rate of interest. The government desperately needs to sell bonds, right now, because trillions of dollars have been earmarked for huge corporate bailouts. These bailouts are the lynchpin of the Bush/Obama legacy. Whatever money the government cannot borrow, to pay for these bailouts, it will surely simply print, and that will be devastating.
Without the ability to borrow cheaply, America will be default overtly, or, more likely, covertly, through hyperinflation. Also, rising rates on long term debt, which is to a large extent determined by the yield on long term Treasuries, will surely suffocate any hopes of a housing recovery. The government has done a lot of stupid things.
The Federal Reserve and U.S. Treasury have attempted to micro-manage the economy for years, for one thing. For another, crony capitalist bailouts do not tend to create long term economic strength. It would have been better to allow the investment banks to fail, better to have paid off or sold off the deposits of true banks through the FDIC, and better to have allowed irresponsible counterparties to high-risk transactions, like Goldman Sachs (GS), to suffer the consequences.
Instead of suffering consequences, we have seen an unprecedented increase in moral hazard, as incompetents on Wall Street, through the medium of AIG and other bailouts, now receive record bonus payments.
But, like it or not, the U.S. government, and by extension, all Americans, are now on the hook for trillions of dollars. We must either tax ourselves into oblivion, print money, or sell bonds at favorable interest rates. The bond selling route is the best of three bad options.
The connection between a rising market and a falling dollar probably has a lot to do with the U.S. Federal Reserve. It has added huge amounts of so-called “liquidity” to the banking system. Most of this money has not found its way into the hands of any business that has a productive use for it. Most businesses are not inclined to borrow in recessionary times, when they are shrinking.
So, the liquidity injections find their way mostly to investment banks. These banks use the money to buy stocks and commodities, or to make margin loans to hedge funds and other players, who do the same thing.
Investment banks, awash with liquidity, bid up stock and commodity prices. They pay for this in Federal Reserve Note dollars, and that increases the number of dollars in circulation, reducing the value of each one. The cycle then becomes self-reinforcing. Speculators choose to own stocks, gold, silver, oil, coal, iron, copper, and other non-dollar items instead of dollars or bonds. Industrial inputs and consumer goods become more expensive, not because there is more demand, but, rather, because there is more speculation.
When stocks and commodities go up in the midst of a depression, financial speculators at investment banks and hedge funds win. Productive businesses and consumers lose. Gasoline is an excellent example. High gasoline prices are once again putting pressure on the consumer pocketbook. This will eventually have a poisonous effect on retail sales, going forward.
With the exception of Canada, we have few true friends in the oil exporting business. The higher price for oil transfers tens of billions of dollars to generally unfriendly places, like the Arab Middle East, Iran, Russia and Venezuela, some of whom will use those dollars quietly, or not so quietly, to support terrorist groups.
Increased inflationary expectations increase bond yields, and cause the dollar to fall. For example, in mid March, when the rally started, bond yields were beginning to rise. In an effort to damp down long term interest rates, the U.S. Federal Reserve pledged to buy up to a huge $300 billion worth.
Although heralded as a move that would tame bond yields, it has been completely ineffective and, after an initial honeymoon, monetizing the national debt has had exactly the opposite effect. The reason is that when the government buys its own bonds, people begin to fear runaway inflation. The 10 year bond yield recently rose almost 4%. It has since fallen to about 3.5%, but that is still much higher than where it started.
Physics tells us that infinity and zero are simply two ends of the same straight line that goes on forever. If the Fed buys unlimited numbers of bonds, such bonds would eventually need to pay a nearly infinite yield, because, to anyone other than the Fed, the value of such bonds will reach absolute zero.
Thankfully, in spite of strong pressure from many self-interested persons on Wall Street, the FOMC finally found some discipline, and didn't increase the ill thought out program. As a result, bond yields have fallen somewhat, since. Hopefully, they will end their so-called "quantitative easing", at the next meeting, or sooner. Making that announcement would do a world of good for the value of the U.S. dollar.
Rising stock markets, in the midst of economic depression, may well be the creation of the "expectations managers" at the New York branch of the Federal Reserve. The Fed can easily induce an artificial share price rally by heavily buying stock index futures from derivatives dealers, so long as it is willing to print enough money to pay for them. Arbitragers then even out the difference between the cash market and the value of these futures, and the process would have a net effect of forcing the stock indexes upward. The newly printed dollars, flooded into the system, through the derivatives dealers, would cause the U.S. dollar to lose value, however.
That may be the most logical explanation as to why the dollar has fallen so far so fast, even though we are having a "rally" that, if based upon strong economic fundamentals, should ordinarily cause the dollar to rise.
There are many possible reasons why higher share prices are now linked to a lower dollar. One thing, however, is clear. The only way to induce foreigners to continue to buy dollars and dollar based derivatives (bonds), is to make sure the U.S. dollar is not a perpetually falling currency. They will not permanently continue to buy Treasury bonds, denominated in a falling currency, which pay extremely low interest rates.
If the stock market is allowed to fall, and the dollar given a chance to recover, long term Treasury yields can fall, commodity prices can moderate, and both the government and potential home buyers can successfully navigate capital markets.
Assuming the alleged “stimulus” is really ever going to work, the stock market will eventually rise again. For long term investors, who don't indulge in margin based speculations, a falling stock market will be provide some painful portfolio views, but will increase the value of their portfolio in the long run.
Hopefully, before the market rises again, however, the U.S. government will, at least, have finished selling this year's allotment of bonds.
Disclosure: No positions on any stock or bond mentioned in the article.