On June 11 of this year I wrote that we were in the midst of a paradigm shift regarding Fed policy. In that article, "The Paradigm Shift Has Begun - This Isn't Going To Be Pretty," I stated the following:
There's ample evidence of late that the Fed is trying to talk investors into moving back away from the edge of the cliff. My personal opinion is they are a little late and that opinion is based almost entirely on the structural flaws in the market today that leave very little dry powder left -- in other words, there isn't enough money on the sidelines to backstop a high volume sell-off.
I went on to make the following comments regarding the role the primary dealer banks have played in the Bernanke bull market:
How much extra and unaccounted for leverage are we talking about here? Well, if my thesis is correct, it could be well in excess of the number reflected above. Here is why -- the primary dealer banks who are buying stocks are doing so on borrowed money -- i.e., through the hypothecation of securities they have purchased equities with depositor funds.
The Fed has expanded their balance sheet since QE4 by roughly $600 billion and that sets up the case for arguing that almost all that money has gone into equities -- at least that is the extreme case. Consider also that if that is the case the historically high level of margin debt -- at roughly $380 billion -- is dwarfed by the potentially massive leverage being employed by the primary dealer banks under my hypothecation scenario. The number just since QE4 was announced could be as high as $600 billion. And we don't know how much of the QE money prior to QE4 was employed in the same manner, but we do know however much it is, it doesn't show up in the numbers anywhere.
A year ago such assertions that the primary dealer banks have propped the markets would have been summarily rejected as the ranting of a kook conspiracy theorist. Not so today. Citing the article I referenced above in his opening comments Wall Street Journal columnist George Melloan stated:
On the blog, 'Seeking Alpha,' market analyst Joseph Stuber theorized that the JPMorgan Chase (JPM) CEO was sending out a message on behalf of the Federal Reserve that it is mulling an early wind-down of its latest round of quantitative easing and that things might get rocky.
Melloan goes on to acknowledge that the thesis I set forth is plausible, and, in fact, the Fed's own William Dudley gave some support for the idea that the primary dealer banks have been doing the very thing I am suggesting. Melloan states:
But it may not be that easy to contain $2 trillion in inflationary cash-and some analysts believe that excess reserves are a direct factor in the run-up in stocks. Their arguments are abstruse, involving such possibilities as "hypothecation" of those deposits, that is, using them as collateral to raise money in the "shadow banking" market for investment in stocks.
Banks have constant dealings in the shadow market with non-bank entities like money-market and hedge funds and other big money pools. It's not a big stretch to imagine them using excess reserve deposits as collateral to raise money.
A modicum of support for such theories comes obliquely from New York Fed President William Dudley, a member of the FOMC. In a February speech, he raised concerns about the failure of the massive Dodd-Frank financial reform legislation to adequately regulate shadow banking. Mr. Dudley complained that Dodd-Frank actually raised the risks to the financial system by barring Fed intervention if a shadow bank is in danger of failure. He was referring to the huge business that money-market funds do in raising collateral for 'tri-party repos,' where third parties manage the temporary sale and repurchase of securities that banks use to raise short-term cash.
As much as I appreciate Melloan's views on this subject and his willingness to at least give due consideration to my thesis, I think JPMorgan's own 10-K filing makes a much more compelling argument. Here is an excerpt from the 10-K that I cited in another article, "Why Stocks Continue To Levitate In The Face Of Eroding Economic Metrics: Ask Elizabeth Warren":
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.
Melloam sums up his point as follows:
In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That's not good for investors.
Stocks have had a big ride under the Fed's near-zero interest rate policy as investors have accepted greater risks for better returns than those available on bonds. But there may be another reason for the stock run-up. The Fed's huge bond purchases may impact stocks directly. Hence, the 15,000 Dow may be a bubble that will deflate if the Fed starts 'tapering.'
So, have we reached the end of the "Bernanke bull" market? It seems reasonable to me to conclude that we have. But are there clues that the Fed's aggressive and admittedly experimental monetary policy is finally over? I think so, but you have to look for them and you must think outside the box a little.
Let's start with Bernanke's meeting with President Obama in February of this year. In fact, let's look at a sequence of events along a timeline to see if we can infer anything from them:
- Feb. 5, 2013 -- Bernanke meets with Obama
- April 11, 2013 -- Obama meets with big bank CEOs
- April 12, 2013 -- Gold falls $65
- April 15, 2013 -- Gold falls another $141
- April 22, 2013 -- Fed spokesman announces Bernanke will skip Jackson Hole
To put these events in perspective, a Fed Chairman announcing he won't be in attendance at the premier event of the year for a Fed Chairman is not to far removed from the idea that the president of the United States will skip his State of the Union Address to Congress. And for gold to lose $200 in two days ranks with some of the most severe two-day sell-off events in history. Consider that gold's (GLD) close on April 15 was almost five standard deviations under mean. A close that is three standard deviations under mean only occurs roughly 1% of the time.
Do you suppose Obama might have said something to the bank CEOs that shook them up a little? What do you suppose it might have been? Maybe he put the banks on notice that the game was over and he -- Barack Obama -- was going to take a more direct role in reigning in the "too big to fail" banks and starting with Fed Chairman Bernanke.
We do know he summarily dismissed Bernanke in an unusual and provocative interview with Charlie Rose on June 16. We also know the Justice Department has finally made a move to go after the "too big to fail" banks. Consider this article from the New Yorker, titled "The Justice Department's War on Wall Street: Still No Criminal Charges." Here is an excerpt from that article, published Aug. 8:
It took them a while, but the Feds are finally going after some of the country's biggest banks for alleged wrongdoing during the great housing and credit bubble. In the past few days, the Department of Justice has sued Bank of America (BAC) for willfully understating the risks attached to hundreds of millions of mortgage-backed securities it sold in 2007, and J. P. Morgan Chase has revealed that two different U.S. attorneys' offices, one in California and one in Philadelphia, are investigating whether it broke securities laws and duped investors with some of the mortgage deals it put together.
But while the new cases are significant and likely to go on for some time, they don't answer the question of whether anybody on Wall Street will ever end up in court, or face the possibility of prison time, on criminal charges arising from the mortgage mess. My take: there is no need for anyone on Wall Street to lose much sleep, and that includes Brian Moynihan, the chief executive of Bank of America, and Jamie Dimon, the head of JPMorgan. About the worst that is likely to happen is that the two big banks will be forced to pay some hefty fines, which, with both making billions of dollars of profit in the latest quarter, they can easily afford.
Nothing like getting it wrong though as just six days later the Justice Department filed criminal charges against two JPMorgan execs, as noted here by the Wall Street Journal:
U.S. prosecutors announced criminal charges against two former JPMorgan Chase & Co. traders who were accused of hiding losses on runaway bad bets that cost the bank more than $6 billion.
Here is another interesting revelation from the New Yorker on the matter of JPMorgan's hiring practices in China that was published on Saturday:
Western companies have been aggressive in trying to snag a share of riches in China's fast-growing economy in recent years. Some have come under fire over their business practices there, including GlaxoSmithKline, whose employees are said by Chinese officials to have confessed to bribing doctors to increase pharmaceutical sales.
Global companies also routinely hire the sons and daughters of leading Chinese politicians. What is unusual about JPMorgan is that it hired the children of officials of state-controlled companies.
It is even less common for American authorities to scrutinize such practices. Only a handful of Wall Street employees have ever faced bribery accusations, including a former Morgan Stanley (MS) executive in China who pleaded guilty to criminal charges in 2012, admitting to 'an effort to enrich himself and a Chinese government official.'
The push back against "too big to fail" banks isn't just happening in the courts. An article from Business Insider sheds light on the goings on in the commodity markets. Here is an excerpt from that article:
Right now, bankers might be daydreaming of an alternate reality where they didn't build the huge, now tenuous, commodities portfolios which are drawing increased scrutiny.
Such scrutiny as the July 20 The New York Times story that accused Goldman Sachs (GS) of using its aluminum warehouses to manipulate the price of the commodity -- an assertion the bank emphatically denies -- costing consumers billions.
Then there's JPMorgan, which just agreed to pay a $410 million fine for using trading strategies to manipulate energy markets -- the bank neither confirms nor denies the manipulation charges.
It won't stop there.
In September, The Fed will rule on whether or not to allow Wall Street banks -- specifically JPMorgan, Goldman Sachs, and Morgan Stanley -- to keep the physical commodities they purchased during a five-year, post-financial-crisis shopping spree.
Makes you wonder what Obama said to the big banks back in April that preceded the two-day crash in gold doesn't it? It makes me wonder if the party is over and President Obama is now taking charge of the situation. We didn't get a public announcement from Obama that he is doing that but there sure seems to be a lot of circumstantial evidence that he is.
Congress is getting into the act as well. As I noted in my July 16 article referenced abovem Elizabeth Warren and John McCain are co-sponsoring the New Glass Steagall Act that will reverse the actions taken by Congress back in 1999. Here is an excerpt from an article by James Rickards entitled "Repeal of Glass-Steagall Caused the Financial Crisis":
In 1999, Democrats led by President Bill Clinton and Republicans led by Sen. Phil Gramm joined forces to repeal Glass-Steagall at the behest of the big banks. What happened over the next eight years was an almost exact replay of the Roaring Twenties. Once again, banks originated fraudulent loans and once again they sold them to their customers in the form of securities. The bubble peaked in 2007 and collapsed in 2008. The hard-earned knowledge of 1933 had been lost in the arrogance of 1999.
As the pendulum swings the other way, will there be unintended consequences?
A lot has happened since that fateful day in February when Obama and Bernanke met. It seems obvious to me that the days of "too big to fail" are coming to an end. In fact I am sure of it. So what does that mean for investors. Well, as Jamie Dimon correctly noted back in June:
'It's a different world when central banks are managing interest rates,' Dimon said, referring to the Federal Reserve's orchestrated effort to keep long-term rates low. He reminded the audience that 10-year bond rates haven't been set by the Fed since World War II, and rates didn't normalize until around 1950. 'Until it gets back to normal [this time], it's going to be scary and volatile.'
I don't think Jamie got that quite right though. What he should have said: It's a different world when "too big to fail banks" like JPMorgan are manipulating markets. In my opinion he did get the last part right: "Until it gets back to normal, it's going to be scary and volatile."
I guess the important question is how scary and how volatile. We've already seen a little of this volatility in the bond market and precious metals. How about the stock market, though? Let's take a look at a few charts to get a perspective on the matter:
Here is what happened to the S&P 500 (SPY) in 2011:
Click to enlarge images.
The chart above is strikingly similar to the chart we see today. The market had climbed for several months clinging tightly to the upper Bollinger band in 2011. Then the market sold off a little only to bounce back, but the bounce fell well short of the upper Bollinger band and the market moved in a sideways band for a couple months before falling 18% from the July 25 high to the Aug. 9 low.
Here is today's chart for comparison purposes:
It's that bounce back that falls well short of the upper Bollinger band and moves into a multi-month sideways pattern that shows the market senses something is about to happen. In 2011 that wait-and-see pattern was based on the continuing battle in Congress relating to the debt ceiling. Today we have the same issue before us as Congress once again must deal with the debt ceiling, but we also have the other things I have mentioned. We have a concerted and focused push back against the "too big to fail banks" and we also have the Fed Chairman that is on his way out and seems to have assumed a "lame duck" position at this point.
So here is the important question: Will dealing with the "too big to fail" banks result in unintended consequences? In other words will the market crash (20% correction or more)? I am on record as stating that I think we will crash this year, but I am also on record as stating that I see no other choice as the abuses of the big banks since the repeal of Glass-Steagall are potentially systemic and they must be reigned in.