The words to the Jimmy Dean ballad - Big John - were ringing in my ear as the sell-off began with earnest on Friday. I could see Big John "grabbing a sagging timber" and pushing with all his might to make enough room for the miners to escape. I kept saying to myself that Ben Bernanke was not at all unlike Big John as he pushed back against the collapse of the banking system.
We all remember Big Ben standing in the gap in 2009 at the depth of the recession pushing back against the weight of the pressure created by a multi-decade credit bubble that had collapsed sending the stock market and the economy into a tailspin. Fear was the order of the day as traders abandoned stocks and investors, businesses and consumers alike took cover. Cash was king and spending ground to an instant halt. It was sentiment driven by fear that caused the collapse as much as the credit bubble itself.
Government had fought back against the weight of the bubble that had popped back at the turn of the century - a bubble created by an almost giddy and euphoric faith in the promise offered by the dotcom stocks - and it had worked as stocks had moved up from the depths of the 2000 trough to the pre-bubble highs. How did government push back against the dotcom bubble crash - they decided to inflate out of the hole by ramping up mortgage debt. Here's an excerpt from an article I wrote back in November that explains how the government orchestrated a stock market recovery after the dotcom crash:
In 1992, President George H.W. Bush signed the Housing and Community Development Act of 1992. The Act amended the charter of Fannie Mae and Freddie Mac to reflect Congress' view that the GSE's ... have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return; For the first time, the GSEs were required to meet "affordable housing goals" set annually by the Department of Housing and Urban Development (HUD) and approved by Congress. The initial annual goal for low-income and moderate-income mortgage purchases for each GSE was 30% of the total number of dwelling units financed by mortgage purchases and increased to 55% by 2007.
Government was more interested in the immediate relief of pain than a responsible response to the situation and so they acted irresponsibly and relegated mortgage backed securities to junk bond status in order to fuel a recovery. We all know the outcome of that move - a debt crisis of such systemic proportions that it threatened to collapse the banking system.
Once again the stock market crashed and the economy ground to a halt but Big Ben grabbed his version of a "sagging timber" and with "all his strength he gave a mighty shove." He pushed back with a strength unparalleled in history - a 4-fold Fed balance sheet expansion.
It worked just as Big John's "mighty shove" worked. Just as the miners saw a "light up above" so did investors. Big Ben was their hero and as the miners managed to escape from the depths of the mine so did the investors who were decimated by the 2nd market crash in this new century that is still in its infancy.
Now we find Big Ben - just like Big John - standing all alone "like a giant oak tree." Big Ben's "last mighty shove" finally provided the room for investors to exit the market unscathed but the big question now is this - will those investors survive or will they suffer the same fate as Big John.
The problem is really quite simple - the structural defects created by a multi-decade policy of avoiding healthy cyclical corrections with massive fiscal and monetary stimulus are similar to the structural problems Big John faced. Today the Fed knows their efforts have failed. They certainly won't tell us that as to do so would be as irresponsible as the actions they have taken to try and invigorate the economy one last time but trust and believe - they know it.
There are lots and lots of metrics we can look at to prove the Fed's policy has failed but here is the one that is most telling. Chart is courtesy of Doug Short:
Doug notes here that the April PCE is the lowest on record:
The BEA's Personal Consumption Expenditures Chain-type Price Index for April shows core inflation well below the Federal Reserve's 2% long-term target at 1.05%, the lowest Core PCE ever recorded; the previous all-time low was 1.06% in March 1963, fifty years ago.
If PCE is at record lows and it is that metric that drives 70% of GDP growth then why are we so ridiculously giddy about the stock market? Are we to assume GDP no longer matters? Can corporate profits continue to rise at the same time PCE and GDP contract? I am certainly interested in how that might be accomplished for anyone who can provide a credible answer.
Here is my own contribution to the subject comparing the S&P 500 (NYSEARCA:SPY) to the CPI:
My chart uses CPI, not PCE but the divergence between inflation and stock price is extreme even using this metric. You can take this for what it's worth but I am telling you this divergence can't stand. Either CPI and PCE do an about face and surge higher immediately as it did in 2009 or we are about to see one of the most devastating market crashes in our lifetime?
I will explain why I think stocks haven't fallen significantly in a minute but first a look at gold. Gold's sharp fall a few weeks back is much more significant than anyone seems to recognize. Here is (NYSEARCA:GLD):
Here's what's significant about this chart - GLD fell by 4.7 standard deviations in 4 trading sessions. That is a huge move in a very short time frame and even more relevant is that the fall came at a point where the market had already fallen to the minus 2 standard deviation level.
The S&P 500 is currently 2 standard deviations above mean and would need to fall a full 9 standard deviations from current levels to equal gold's fall. If it were to fall 9 standard deviations from current levels here is where we would be:
Can't happen you say - why not and what do you think will prevent it from happening? That's only a 27% pullback. Let's do a little math and see where we would be if the S&P moved back to the CAPE mean value. Assuming earnings could remain at current levels going forward a reversion to mean on CAPE would put the S&P 500 at 1371. But the big question is this - can earnings remain at current levels in a deflationary environment?
So how does an industry steeped in the notion that one must be invested deal with a market where there is no safe investment? What do you do if your contractual mandate is to avoid cash and remain invested? What happens when all stock market sectors are over extended, bond markets are over extended and precious metals are over extended. In short how do you deal with a deflationary spiral when your mandate is to remain invested no matter what. The answer - you lose money.
Is Ben a hero or a villain?
What I find most unusual today and unlike virtually any period in our history is the power exerted by Mr. Bernanke. The industry wants and needs bull markets to thrive and the participants have placed all their hope in a failed policy and a Fed Chairman that appears more and more to be acting irresponsibly and outside the scope of his mandate. At times I listen to Bernanke and get the sense that he is trying to do the right thing. At other times I find his actions as irresponsible as any of the infamous Ponzi schemers throughout history.
To put things in context I will remind readers of those moments back in 2009 when Hank Paulson and Ben Bernanke were doing all they could to rescue the big financial institutions. There was a very legitimate criticism of Bernanke at the time that centered around his role in forcing Bank of America to absorb Merrill Lynch.
There is no denying Bernanke coerced a very unwilling Ken Lewis and Bank of America (NYSE:BAC) into absorbing Merrill Lynch. Here is an excerpt from the text of a letter penned by Andrew Cuomo - then New York Attorney General - on his investigation of the events surrounding the merger:
Bank of America's attempt to exit the merger came to a halt on December 21, 2008. That day, Lewis informed Secretary Paulson that Bank of America still wanted to exit the merger agreement. According to Lewis, Secretary Paulson then advised Lewis that, if Bank of America invoked the MAC, its management and Board would be replaced:
"[W]e wanted to follow up and he said, 'I'm going to be very blunt, we're very supportive on Bank of America and we want to be of help, but' --as I recall him saying "the government," but that mayor may not be the case -"does not feel it's in your best interest for you to call a MAC, and that we feel so strongly," --I can't recall if he said "we would remove the board and management if you called it" or if he said "we would do it if you intended to." I don't remember which one it was, before or after, and I said, "Hank, let's deescalate this for a while. Let me talk to our board." And the board's reaction was of "That threat, okay, do it. That would be systemic risk." "
In an interview with this Office, Secretary Paulson largely corroborated Lewis's account. On the issue of terminating management and the Board, Secretary Paulson indicated that he told Lewis that if Bank of America were to back out of the Merrill Lynch deal, the government either could or would remove the Board and management. Secretary Paulson told Lewis a series of concerns, including that Bank of America's invocation of the MAC would create systemic risk and that Bank of America did not have a legal basis to invoke the MAC (though Secretary Paulson's basis for the opinion was entirely based on what he was told by Federal Reserve officials).
Secretary Paulson's threat swayed Lewis. According to Secretary Paulson, after he stated that the management and the Board could be removed, Lewis replied, "that makes it simple. Let's deescalate." Lewis admits that Secretary Paulson's threat changed his mind about invoking that MAC clause and terminating the deal.
Secretary Paulson has informed us that he made the threat at the request of Chairman Bernanke. After the threat, the conversation between Secretary Paulson and Lewis turned to receiving additional government assistance in light of the staggering Merrill Lynch losses.
Most of us have probably forgotten those days and the controversy surrounding the bailouts and the passage of TARP. Here's another one of those questionable moments - this time regarding Bernanke's role in the AIG bailout. The following text is from a Huffington Post article entitled Is "Bernanke Hiding A Smoking Gun"?:
A Republican senator said Tuesday that documents showing Federal Reserve Board Chairman Ben Bernake [sic] covered up the fact that his staff recommended he not bailout AIG are being kept from the public. And a House Republican charged that a whistleblower had alerted Congress to specific documents provide "troubling details" of Bernanke's role in the AIG bailout.
Sen. Jim Bunning (R-Ky.), a Bernanke critic, said on CNBC that he has seen documents showing that Bernanke overruled such a recommendation. If that's the case, it raises questions about whether bailing out AIG was actually necessary, and what Bernanke's motives were.
Lest we forget Bernanke has close ties to Wall Street. During his Harvard years Bernanke lived in Winthrop House with Lloyd Blankfein - CEO of Goldman Sachs. There was a lot of controversy surrounding Goldman's short side bet on mortgage debt and their collusion with John Paulsen at the time. Here is an excerpt from Wikipedia that summarize the issues at that time:
AIG was required to post additional collateral with many creditors and counter-parties, touching off controversy when over $100 billion was paid out to major global financial institutions that had previously received TARP money. While this money was legally owed to the banks by AIG (under agreements made via credit default swaps purchased from AIG by the institutions), a number of Congressmen and media members expressed outrage that taxpayer money was going to these banks through AIG. In January, 2010, a document known as "Schedule A - List of Derivative Transactions" was released to the public, against the wishes of the New York Fed. It listed many of the insurance deals that AIG had with various other parties, such as Goldman Sachs, Société Générale, Deutsche Bank, and Merrill Lynch.
Bernanke said to Paulson on September 17, "We can't keep doing this. Both because we at the Fed don't have the necessary resources and for reasons of democratic legitimacy, it's important that the Congress come in and take control of the situation."
I admit I don't like what Bernanke has done with regard to the bail-outs or with regard to his efforts to distort natural forces and prevent a business cycle contraction that was needed and should have been allowed to happen. It is just these kinds of short-term fixes that have produced the massive bubbles that have occurred in recent years at an ever increasing rate. Unlike the majority of market participants I have no problem with cyclical bear markets. I think they are necessary to eliminate the excesses created by periods of expansion that result in markets getting a little ahead of themselves.
Distortions and lies
Here's the problem - we are being deceived into believing everything is OK. Stocks are at all time highs on a nominal basis and up 15% on the year on the S&P 500 and the markets have become so conditioned to the idea that Bernanke is omnipotent that we simply ignore negative data.
I am so tired of hearing "when will the Fed ease" as if that is the only thing that matters. It is not the only thing that matters - the economy matters, jobs matter, and GDP matters. In other words the consumer matters and without the consumer there is no way that corporate profits can continue to support current stock price valuations.
Here's the point - corporate profits are a function of top line sales less costs. Top line sales are dependent on the consumer buying goods and services and that only happens if the consumer has the money needed to buy those goods and services. At the onset of the recession when unemployment soared the government stepped in and provided a back stop that allowed those without jobs to remain in the consumer pool. We extended unemployment benefits, issued food stamps, gave capable but unemployed workers disability checks and the result was the consumption pool wasn't reduced as much as one would expect.
The arrangement was a boon to corporate America - they could cut costs through layoffs and still hold top line sales at pre-recession levels. That produced record corporate sales and profits and created the illusion all is well but it isn't well and it isn't a sustainable trajectory.
Bottom line - we need workers with jobs and paychecks and we are being deceived into believing that the jobs situation is improving. The government manages this deception with a "smoke and mirrors" approach. Rather than look at the unemployment rate we might want to look at the employment rate.
No "smoke and mirrors" here - just raw, unadjusted data. And the data tells us that fewer people have jobs and paychecks today than in July of 2012. In July of 2012 there were 156,526,000 workers and today there are 154,739,000 workers.
Here's another chart that looks at the number of employed as a ratio of the total population:
Again just raw unadjusted data and what it shows is that we simply haven't made any progress at all on the unemployment front.
This next chart is the "smoke and mirrors" version - the headline unemployment chart:
The official headline version shows that we are making real progress with unemployment down from the high of 10% in October of 2009 to 7.5% in April of 2013. That should fuel some real growth in GDP right? Wrong - we have 1,787,000 fewer workers today than we did a year ago.
Here is a graphic of what happens in a deflationary spiral:
We know that real jobs growth peaked in July of 2012 -that's the layoffs part. Let's look at weekly earnings:
With layoffs and wage reductions clearly identified and moving the wrong way we would expect that to reflect in falling demand in a deflationary spiral. Let's look at personal consumption expenditures growth to see what that shows:
Sure enough personal consumption expenditures are on the decline.
Let's look at the consumer price index to see if prices are falling:
Again, what we see is falling prices and that too is consistent with a deflationary spiral.
One wonders what the prospects are for debt defaults and bankruptcies - the next thing that occurs in a deflationary spiral. Well, despite the positive trend in housing and the promise of a housing recovery leading the nation into economic escape velocity I have my doubts. Here is the most recent update on housing from Zillow:
Zillow Q1 2013 Negative Equity Report Summary: Zillow Q1 2013 Negative Equity Report Summary: According to the latest Zillow Negative Equity Report, 25.4 percent of U.S. homeowners with a mortgage were in negative equity, or "underwater," at the end of the first quarter, owing more on their mortgage than their homes are worth. This represents approximately 13 million homeowners nationwide, and is down from 31.4 percent (or 15.7 million homeowners) in the first quarter of 2012. American homeowners with a mortgage were collectively underwater by approximately $950 billion at the end of the first quarter of 2013, the first time this figure has fallen below $1 trillion since Zillow began using our current methodology to track negative equity. As home values rise, more homeowners can expect to be freed from negative equity. Zillow currently predicts that the negative equity rate will fall to 23.5 percent by the end of the first quarter of 2014, bringing almost 1.5 million more homeowners into positive equity. Still, despite widespread home value appreciation recently, millions of homeowners remain trapped underwater. Of the top 30 metros covered by Zillow, 25 were underwater by more than 20 percent in the first quarter, and 20 had negative equity rates above the national average.
Perhaps we should be encouraged by the fact that we have finally moved back under $1 trillion in negative equity. According to Zillow 91% of the 13 million underwater mortgages are being serviced. I doubt that would be the case in normal times as banks wouldn't be so agreeable to working with borrowers but then what are they going to do with 13 million homes - put them on the market for sale all at once. Talk about depressing house prices.
Is there going to be a day of reckoning?
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" Upton Sinclair
I am reminded of that quote every time I hear a pundit speak on why this market has legs and why we are going much higher from here. The standard spiel is that we are fine as long as the Fed continues to expand excess reserves with more and more useless QE. Actually the pundits don't say it like that but that is nonetheless the thrust of their argument - as long as Big Ben is on the job stocks can't go down.
I want to suggest that not only can they go down but they will go down and when they do it will not be a gradual or minor pull back as so many industry pundits believe. I am reminded of a chapter from John Coates' book - The Hour Between Dog And Wolf - where Coates describes the transformation that occurs to traders in a bull market:
As March slips away and winter's chill lifts, a spirit of youthfulness descends on Wall Street. With the Fed's voice of authority all but silenced, the markets take on the appearance of an unsupervised playground. A bull market over the past two years may have taken stocks up 40% and bonds about 20%, but traders and investors believe this is just the beginning. With wild eyed enthusiasm they conclude that a historic epoch, amounting to nothing less than a renaissance for the American economy, with permanently high growth rates and low inflation, is dawning so bonds and stocks caper from high to high. News, no matter what its content, arrives with the breathless promise of unparalleled opportunity. Financial journalists warn investors against dithering, and now is seed time in the fields of investment.
Coates goes on to explain the physical impact of these bull market runs:
But as the rally progresses, traders feel something else added to the mix, something more profound, more physical, like the rumble of some large engine switching on. For as profits rise, so too does testosterone. In fact, the two systems, the dopamine and the testosterone, are thought to work synergistically, with testosterone achieving its exciting effects largely by increasing the dopamine in the nucleus accumbens, testosterone constituting the bass line of euphoria, dopamine the treble.
Keep in mind Coates isn't talking about the average retail investor getting caught up in this euphorically driven recklessness - he is talking about the professional traders - the so called smart money. Here is how he explains what takes place:
The positions can end up being several times larger than the entire value of the bank itself. To put this leverage in perspective, these traders' positions can be compared to a home owner who borrows $20 million against the collateral of his $500,000 house in order to buy some rental properties. Were the rental properties to drop in value by a mere 2.5% the home owner's capital would be wiped out, bankrupting him. It was leverage on this scale that in 2008 bankrupted the investment bank Lehman Brothers.
A look at margin debt shows that we have now surpassed the levels reached in 2007 and are very close to the levels reached in 2000. I am always amazed at the inclination of investors and traders to ramp up their stock holdings by borrowing money at market peaks.
Lest you think this time will somehow be different than all other times in the past I will remind you of the fact that a lot of metrics are pointing to a deflationary spiral as the market rise continues to be fueled by the euphoric giddiness that comes from success as Coates so aptly describes. The truth is every single cyclical bull market has been followed by a cyclical bear market - every single time without exception. This time will be no different and the only question one must ask is this - will I get out in time.
Disclosure: I am long TZA, FAZ, TECS, UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.