Why Stocks Continue To Levitate In The Face Of Eroding Economic Metrics: Ask Elizabeth Warren

Jul.16.13 | About: SPDR S&P (SPY)

Elizabeth Warren, John McCain, Maria Cantwell and Angus King are introducing the 21st Century Glass-Steagall Act that plans to once again separate traditional banking activities from investment banking activities. Here is what Elizabeth Warren had to say on the matter:

Despite the progress we've made since 2008, the biggest banks continue to threaten the economy," said Senator Elizabeth Warren. "The four biggest banks are now 30% larger than they were just five years ago, and they have continued to engage in dangerous, high-risk practices that could once again put our economy at risk. The 21st Century Glass-Steagall Act will reestablish a wall between commercial and investment banking, make our financial system more stable and secure, and protect American families.

Here is what John McCain had to say:

Since core provisions of the Glass-Steagall Act were repealed in 1999, shattering the wall dividing commercial banks and investment banks, a culture of dangerous greed and excessive risk-taking has taken root in the banking world," said Senator John McCain. "Big Wall Street institutions should be free to engage in transactions with significant risk, but not with federally insured deposits. If enacted, the 21st Century Glass-Steagall Act would not end Too-Big-to-Fail. But, it would rebuild the wall between commercial and investment banking that was in place for over 60 years, restore confidence in the system, and reduce risk for the American taxpayer.

On the issue of risk taking by the "to big to fail" banks here is what Dr. John Coates - author of The Hour Between Dog and Wolf - says:

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.

Coates ran a derivatives trading desk in New York prior to becoming a world class neuroscientist and author. Here is what David Stockman - former Director of the Office of Management and Budget under Ronald Reagan and author of The Great Deformation: The Corruption of Capitalism in America - has to say on the matter:

But what was actually going on in the interior of the stock market was nightmarish. All of the checks and balances which ordinarily discipline the free market in money instruments and capital securities were being eviscerated by the Fed's actions; that is, the Greenspan Put, the severe repression of interest rates, and the recurrent dousing of the primary dealers with large dollops of fresh cash owing to its huge government bond purchases. This kind of central bank action has pernicious consequences, however. By pegging money market rates, it fosters carry trades that are a significant contributor to unbalanced markets. Carry trades create an artificially enlarged bid for risk assets. So prices trend asymmetrically upward

The Greenspan Put also compounded the one-way bias. For hedge fund speculators, it amounted to ultra-cheap insurance against downside risk in the broad market. This, too, attracted money flows and an inordinate rise in speculative long positions.

The Fed's constant telegraphing of intentions regarding its administered money market rates also exacerbated the stock market imbalance. By pegging the federal funds rate, it eliminated the risk of surprise on the front end of the yield curve. Consequently, massive amounts of new credit were created in the wholesale money markets as traders hypothecated and rehypothecated existing securities; that is, pledged the same collateral for multiple loans.

The Fed's peg on short-term rates thus fostered robust expansion of the shadow banking system, which as indicated previously, had exploded from $2 trillion to $21 trillion during Greenspan's years at the helm. This vast multiplication of non-bank credit further fueled the "bid" for stocks and other risk assets.

The statements above set up the discussion going forward and deal with the matter of how the markets continue to defy gravity. The statements support the fact that the major money center banks - many serving as primary dealers for the Fed - are engaged in high risk asset purchases. This last sentence from Stockman drives home the point: "This vast multiplication of non-bank credit further fueled the "bid" for stocks and other risk assets."

My thesis on why stocks continue to levitate

Elizabeth Warren and John McCain seem convinced the big banks never changed their MO. I agree. In fact I think Stockman is right on this point:

The Fed's constant telegraphing of intentions regarding its administered money market rates also exacerbated the stock market imbalance. By pegging the federal funds rate, it eliminated the risk of surprise on the front end of the yield curve. Consequently, massive amounts of new credit were created in the wholesale money markets as traders hypothecated and rehypothecated existing securities; that is, pledged the same collateral for multiple loans.

This situation works only to prop risk assets - not to drive economic growth. In traditional credit creation M2 is increased and the new money is then used to drive GDP. The process is quite simple - a bank makes a consumer or a business a loan and the accounting entry on the banks books is a credit to deposits and a debit to the banks loan account. The consumer or the business then spends the money and that adds to GDP which in the aggregate increases corporate sales and profits assuming margins remain constant. This is a good thing and what must occur if we are ever to achieve economic escape velocity.

The shadow bank system fueled by the Fed's low interest rate policy does nothing for GDP growth but it does drive money into risk assets. That process too is quite simple. Here's how the process is described in an IMF working paper entitled The (sizable) Role of Rehypothecation in the Shadow Banking System:

Rehypothecation occurs when the collateral posted by a prime brokerage client (e.g., hedge fund) to its prime broker is used as collateral also by the prime broker for its own purposes. Every Customer Account Agreement or Prime Brokerage Agreement with a prime brokerage client will include blanket consent to this practice unless stated otherwise. In general, hedge funds pay less for the services of the prime broker if their collateral is allowed to be rehypothecated.

Here is an example of the clause that allows hypothecation of assets:

TD Ameritrade Section 9.g, Customer Agreement: Pledge of Securities and Other Property. You may pledge, repledge, hypothecate, or re-hypothecate, without notice to me, all securities and other property that you hold, carry, or maintain or for any of my margin or short Accounts. You may do so without retaining in your possession or under your control for delivering the same amount of similar securities or other property. The value of the securities and other property that you may pledge, repledge, hypothecate, or re-hypothecate may be greater than the amount I owe you, and any losses, gains, or compensation that result from these activities will not accrue to my Account.

Here is how the IMF working paper explains how the collateral is treated on the books of the banks acting as prime dealers:

On-balance sheet data do not "churn," where churning means the re-use of an asset. If an item is listed as an asset or liability at one bank, then it cannot be listed as an asset or liability of another bank by definition; this is not true for pledged collateral. Since on-balance sheet items are the snapshot of a firm's assets and liabilities on a given day, these cannot be the assets or liabilities of another firm on that day. However, off-balance sheet item(s) like 'pledged-collateral that is permitted to be re-used', are shown in footnotes simultaneously by several entities, i.e., the pledged collateral is not owned by these firms, but due to rehypothecation rights, these firms are legally allowed to use the collateral in their own name.

One last point on this that seems necessary to understand how this process works. Again I will refer to the IMF's working paper:

A key reason why hedge funds have previously opted for funding in Europe (especially the United Kingdom) is that leverage is not capped as in the United States via the 140 percent rule under Rule 15c3-3.5 Leverage levels at many U.K. hedge funds, banks and financial affiliates have been higher, as the United Kingdom does not have a similar cap. Thus, prime brokers and banks would rehypothecate their customers' assets along with their own proprietary assets as collateral for funding from the global financial system.

It is of some significance that US banks have elected to circumvent the intent - if not the letter - of the law by hypothecating assets in the first case in the UK and in so doing circumventing the limits imposed on them by US law. That is the situation that occurred with Lehman through Lehman Brothers International Europe, UK. A more recent example is the losses incurred by MF Global under John Corzine's leadership.

So on to the point - why are US stocks remaining at such lofty levels in spite of some rather serious problems on a global scale that would suggest a pull back in US equities is in order. I will posit two different theories for why this is occurring.

The first theory is that the economy is improving in the US and that US equities are the best investment in light of these economic improvements. Additionally, this theory includes the mistaken belief that QE works to boost equities based on the assumption that flooding the system with newly created money will increase M2, devalue the dollar and drive GDP. This is the argument the pundits set forth time and time again - as long as the Fed keeps on printing stocks will continue to move higher.

I fully reject that theory. QE is a simple exchange of assets that raise the reserve levels of banks. The money remains on the Fed's books as a credit to the bank unless the bank chooses to re-invest it in another asset purchase. And if they do that merely works to drive asset prices - not the economy.

Additionally the idea that the economy is slowly improving is a major stretch. We know that the quality of jobs we are creating are of a sub-standard nature, disposable income is shrinking, GDP is slowing, top line sales are falling and corporate profits are falling as well. We also know that disinflation is the state of things at the present and deflation is a real possibility. These are not the conditions that tend to support all time highs in stocks.

Here is a look at the recent price action in the S&P (NYSEARCA:SPY) to put things in perspective:

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The second theory is a little more contentious but I think well supported by the fact that the leverage resulting from credit creation in the shadow banking system that isn't subject to regulatory review is driving stocks. More to the point though is the need for those who have leveraged into risk assets to protect those investments.

I have made the point numerous times over the last several months that the market is being supported by market makers and that true price discovery is being avoided. Most tend to see what I see but there are always a few who summarily reject this thesis as the ranting of a conspiracy theorist. At the risk of once again being labeled in that manner I want to put forth a supposition that I think has substantial empirical support.

To start with what I have set forth above suggests that banks have leveraged assets through hypothecation and re-hypothecation. Those assets can be fixed income assets or equities. Keep in mind it is occurring in the off balance sheet shadow system. The motive for doing this is no different than you or I electing to increase returns through our own version of leveraging our assets in order to make more money through the use of margin accounts.

If I use margin debt to acquire stocks I can double my return if right on my market call. Of course I can also lose twice as much if wrong. The limit imposed on banks that choose to hypothecate and re-hypothecate is many times greater than what you and I can achieve but again is based on the desire to make more money than they would otherwise.

What happens though when the asset you have leveraged into suddenly begins to move in the wrong direction exposing you to substantial loss - not increased profits? More importantly what happens if the sheer size of your positions are so significant relative to market volume that liquidity disappears and you can't exit the trade without significantly moving the market in the wrong direction? The answer of course is that you are stuck.

Here's what makes no sense in the context of a normal market situation. As Congress engaged in what should have been a very serious and troublesome debate over the matter of the fiscal cliff the stock market began to levitate. A normal market response would be to sell off as the prospects of the withdrawing of fiscal stimulus from the economy was being discussed but that is not what happened as the chart below shows.

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In fact not only did the market not sell off it went into a very impressive ramp hugging the +2 standard deviation band and actually exceeding it a good portion of the way up. Keep in mind when price is above the 2 standard deviation band it is in that area that only occurs 5% of the time. Moves of this nature are typical of very bullish fundamentals but clearly the fiscal cliff issue didn't fall into the category of very bullish fundamentals.

I've argued for a long time that monetary stimulus has done almost nothing to drive economic growth but fiscal stimulus has managed to keep GDP in positive territory over the last several years. The chart below shows just how significant fiscal stimulus has been:

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The chart above shows US public debt, GDP and GDP assuming a balanced budget. The assumptive scenario is calculated by reducing GDP by the amount of the quarterly increase in public debt. The truth is GDP has been driven substantially by fiscal stimulus and fiscal stimulus is not inflationary - rather it simply routes money from investors to the government and then back into the economy. No M2 expansion occurs in this instance and therefore fiscal stimulus is not inflationary but it does support GDP.

As you can see under the balanced budget assumptive scenario the US economy would have had a steady decrease in GDP each and every quarter starting in the 3rd quarter of 2007 without fiscal stimulus. In other words the idea that the Fed is supporting economic growth with monetary policy is quite simply not supported in any way by the facts. On the other hand without fiscal stimulus we would have been in a recession for 22 straight quarters.

We did go most of the way over the fiscal cliff by the way so one wonders why the market would react with a spike in stocks that produced a more overbought situation than at any other time since coming out of recession. The withdraw of fiscal stimulus will exacerbate an already stagnating economy and that should be bearish - especially at current price levels.

My thesis is so outrageous to some that they just reject it as nonsense but for my money there is no other plausible explanation for the "bad is good" stock market ramp starting back in November. Here is the thesis - the major players have taken very large and very leveraged positions in stocks beginning several years ago at the time the Fed began their extraordinary monetary policy measures. Today we find ourselves at all time highs in stocks at a point where economic metrics are sounding warnings across the globe.

Most troubling about this divergence is the lack of liquidity. Some will argue that this isn't the case and there is ample liquidity and if these major banks wanted to take profits they could do so without significantly impacting market price. I disagree and offer the following from JP Morgan's 10 K filing (NYSE:JPM) as evidence that the bank understands the issue of illiquidity even if the average investor doesn't:

The Firm generally maintains extensive positions in the fixed income, currency, commodities and equity markets to facilitate client demand and provide liquidity to clients. The Firm may have market-making positions that lack pricing transparency or liquidity. The revenue derived from these positions is affected by many factors, including the Firm's success in effectively hedging its market and other risks, volatility in interest rates and equity, debt and commodities markets, credit spreads, and availability of liquidity in the capital markets, all of which are affected by economic and market conditions. The Firm anticipates that revenue relating to its market-making and private equity businesses will continue to experience volatility, which will affect pricing or the ability to realize returns from such activities, and that this could materially adversely affect the Firm's earnings.

Here is another excerpt regarding Eurozone risks:

Further, the effects of the Eurozone debt crisis could be even more significant if they lead to a partial or complete break-up of the EMU. The partial or full break-up of the EMU would be unprecedented and its impact highly uncertain. The exit of one or more countries from the EMU or the dissolution of the EMU could lead to redenomination of certain obligations of obligors in exiting countries. Any such exit and redenomination would cause significant uncertainty with respect to outstanding obligations of counterparties and debtors in any exiting country, whether sovereign or otherwise, and lead to complex and lengthy disputes and litigation. The resulting uncertainty and market stress could also cause, among other things, severe disruption to equity markets, significant increases in bond yields generally, potential failure or default of financial institutions, including those of systemic importance, a significant decrease in global liquidity, a freeze-up of global credit markets and a potential worldwide recession. Any combination of such events could negatively impact JPMorgan Chase's businesses, financial condition and results of operations. In addition, one or more EMU exits and currency redenominations could be accompanied by imposition of capital, exchange and similar controls, which could further negatively impact JPMorgan Chase's cross-border risk and other aspects of its businesses and its earnings.

And here is another statement on the issue of market liquidity:

In addition, disruptions in the liquidity or transparency of the financial markets may result in the Firm's inability to sell, syndicate or realize the value of its positions, thereby leading to increased concentrations. The inability to reduce the Firm's positions may not only increase the market and credit risks associated with such positions, but also increase the level of risk-weighted assets on the Firm's balance sheet, thereby increasing its capital requirements and funding costs, all of which could adversely affect the operations and profitability of the Firm's businesses.

The point is simple - the firm bears substantial risk if liquidity dries up. You won't hear JP Morgan explaining these liquidity risks to market participants anywhere except in their own 10-K but the repeated mention of liquidity risks establishes that they see exactly the same thing I see.

As I finish up with this piece we just got retail sales numbers and they weren't good. The market of course ignored the numbers. Additionally I just saw a 2nd quarter GDP forecast of .7%. If that ends up being accurate we will have an average of 3 quarters that is below 1%. As Bernanke stated in his Q&A session last week the Fed is not getting the job done on either mandate. He noted that the headline number for unemployment - as bad as it is - is really much worse even than the number suggests due to low job quality and a significant fall in the participation rate. On the matter of inflation he noted that disinflation was the reality and deflation was a very great concern.

In other words the Fed's monetary policy hasn't really worked all that well, He also noted that the Fed has serious concerns about the decision to pull back on fiscal stimulus. In other words to sum it up the Fed's monetary policy isn't working but what else can we do but "remain accommodative". Apparently investors only heard "remain accommodative" and had the sound turned off when he explained that the Fed's policies have been relatively ineffective.

Here's the real point though - market makers have a vested interest in keeping control of the stock and bond market as they hold leveraged long positions in both markets. That is admittedly supposition but the performance of the banks that reported 2nd quarter earnings indicate that their stellar results are due to market related earnings. Here is what Anthony Polini with Raymond James said about JP Morgan:

'It's a legitimate beat, but the quality of earnings was not optimal,'' said Anthony Polini of brokerage firm Raymond James. "Credit quality and market-related revenue were the highlights. Loan growth and margin were the lowlights, but the outlook for the second half of the year is more positive.''

Here is my conclusion - the market will continue to resist a market sell off for as long as market makers can back stop high volume sell offs. Investors have become accustomed to the fact that the markets no longer move in rational ways and they attribute that phenomenon to the "Bernanke put" psychology that has been in play for quite a long time now. More important to the discussion is the fact that the market makers have a very real vested interest in keeping the market stable for the very reasons set forth in the JP Morgan 10-K filing - if liquidity dries up they are in trouble.

My take away here is that low volumes and high leverage levels suggest that there is very little cash on the sidelines to move into the market on a high volume sell-off. In other words there is no real liquidity if volumes normalize. That is the "to big to fail" banks biggest concern and I suspect they will jawbone the market with comments like this from Jamie Dimon for as long as they can:

"Our earnings reflected strong performance across our businesses,'' JPMorgan Chief Executive Jamie Dimon said in a statement. "We continue to see broad-based signs that the U.S. economy is improving and we are hopeful that, as jobs are added and confidence builds, the U.S. economy will strengthen over time.''

It is your choice - you can believe that Jamie Dimon really does see "broad-based signs that the U.S. economy is improving" or you can believe what is stated in JP Morgan's 10-K. Perhaps when weighing the matter in the balance one should also look at the economic metrics that show without question that the economy is not improving.

Disclosure: I am long UVXY, VXX, TECS, FAZ, TZA. 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.