I am the animal at the head of the pack... I either get eaten, or I get the good grass. (David Tepper)
I enjoy listening to the most intelligent minds in Wall Street disagree about something when presented with the very same set of facts. David Rosenberg has been taken by David Tepper’s assumption that we are in a win-win situation. Tepper postulates that with the government poised to jump in when the time is right, stocks have nowhere to go but up. Rosenberg, however, has a different angle that reflects the bear side of the debate, where the market has plenty of room to go down and is coupled with low volume, high uncertainty and correlation. Tepper said simply:
Either the economy is going to get better by itself in the next three months or its not...What assets are going to do well? Stocks are going to do well, bonds won't do so well, gold won't do as well …or the economy is not going to pick up in the next three months and the Fed is going to come in with QE.
Then what's going to do well? Everything, in the near term… I got two different situations: One, the economy gets better by itself, stocks are better, bonds are worse, gold is probably worse. The other situation is the Fed comes in with money.
This is the win-win situation that Tepper is talking about. Either the economy will recover in a more rapid fashion, which will push the market in favor of bulls, or it will struggle, which will bring in the Fed for QE2. That would also push the balance of returns towards the bulls.
David Rosenberg counters with the argument that there is a third scenario Tepper is not considering: QE2 doesn’t work. It is difficult to argue against the idea that in the short term, another round of significant easing will pump up markets and give confidence to investors. However, what if the next round of QE does not leave a lasting, long term impression? What if companies do not use the stimulus to hire people and lower unemployment? In that scenario, Rosie says quantitative easing round two does not work and the economy falls deeper into a depressionary state that he thinks major economies are flirting with already. Mr. Rosenberg says:
Too bad we weren’t invited as a guest on CNBC last Friday to engage in a friendly debate with [Tepper] because he didn’t outline the third scenario, either because he doesn’t believe it or he just plain didn’t contemplate it or he’s simply not positioned for it. That third scenario is that the economy weakens to such an extent that the Fed does indeed re-engage in QE, but that it does not work. In this scenario, the stock market does not go up; it goes down.
Is it possible that QE2 won’t work? The answer is yes. How do we know? Well, because the first round of QE didn’t work. After all, if it had worked, the Fed obviously would not be openly contemplating the second round of balance sheet expansion. If the objective was narrow in terms of bringing mortgage spreads in from sky-high levels, well, on that basis, it did help.
But it did not revive the housing market any more than the litany of other government programs, and the fact that the economy has slowed so sharply to near stall-speed in recent quarters is all anyone needs to know about the true success, or lack thereof, from the first round of QE.
The Fed has cut its growth forecast twice in the past three months and has sliced its inflation forecast three times. This was not was envisaged when the first round of QE was unveiled last year. Normally, the pace of economic activity is accelerating to over a 5% annual rate in the second year of recovery, not slowing down to below 2% — especially with all the monetary, fiscal and bailout stimulus that is in the system.
Here’s the bottom line: if not for the stimulus and the inventory swing, the economy would have actually contracted this year.
I think Rosenberg is being too hard on a number of fronts. First, he is acting like he was expecting a U shaped recovery, which very few analysts expected given the breadth and depth of recent economic hardship. Secondly, he says that the first round of quantitative easing did not work. I think this might be jumping the gun a little bit, and is certainly difficult to prove. Did the first round of easing solve every economic problem? No, of course not, but it is impossible to tell, especially right now, how much damage that first round of QE may have prevented.
Finally, the market atmosphere that existed during the first round of QE was very different than it is now. There was pervasive fear and paranoia in markets that banks had hidden bombs amongst the assets on their balance sheets. These bombs took the form of toxic assets, convoluted “insurance” agreements, swaps and other complex instruments that the banks themselves didn’t even understand (and may still not). For the risks present then, the QE might have done its job; if the purpose was to prop up banks and remove balance sheet risk with piles of freshly printed cash, then that goal was accomplished. It isn’t fair to call the first quantitative easing a complete failure.
So, what does that mean for the battle of the Davids? I think there is a scenario where they both end up right. It is almost a certainty that QE2 will take place in the near future. How much can it help an economy that has yet to find its footing? Corporations are cutting earnings guidance. Growth in the first half of 2010 was very encouraging when measured year on year, but not as “Rosie” when you consider seasonally adjusted quarter or quarter trends. Barron’s also reports that analysts are cutting profit forecasts, with 521 downgrades to 391 upgrades in the past four weeks. Housing is pointing downward and consumer confidence is at unhealthy lows. When you take all this into account, what signals are there that the market is positioned to go up over the long term?
None. However, it is possible that the market will rally in the short to medium term. Then, both Davids would be absolutely correct. If there is a round of QE2 combined with perhaps another government housing initiative, we could see recovery on both fronts. This could prop up markets looking for any sign of rally to new highs, albeit temporarily. Jim DeMasi of Stifel Nicolaus put it well when he said:
QE can provide a short-term bounce to the economy, but to have a lasting impact companies must be willing to hire workers to reduce unemployment and increase personal income.
Tepper might be able to take profits from his coming win-win situation in the short term while Rosenberg predicts eventual financial Armageddon. However, Rosie would rather sit this round out:
Folks, we are in a period of extreme economic uncertainty. The Fed is being forced to be doing something that they don’t even know is going to work. It does not leave us with a very warm and fuzzy feeling.
Like I have said many times, these markets are not for the faint of heart.
Disclosure: No positions
