- The Fed's policy & how the markets react.
- The quest for yield and how disproportionate it is to the 'real' economy.
- Bernanke's past vs. Yellen's future.
- Effects on the DIA, SPY, NASDAQ, & QQQ.
David Hume, a philosopher of the 18th century, could only lean back on his chair and ponder what human nature desires most. If indeed desire rather than reason governs human behavior towards this bull market then the bull market can communicate to the masses that it has given them great wealth because it is the only thing that we have directly experienced. What the American stock market requires is a passionate and subjective belief rather than an objective proof. For example, it becomes passionate and subjective to purchase a stock and get a dividend for holding it, thus creating wealth. It only becomes an objective proof when it is sold and profit is materialized by proclaiming one has established wealth that is real and tangible. But markets are constantly changing; they are ongoing rather than a fitted and stable product to itself. It is no different than saying that faith has reward but isn't rational. Before the real estate crash, Bernanke demonstrated faith in 2007 by stating, "Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that in the long run markets are better than regulators at allocating credit." The startling rationale of what Bernanke said that "now is too severe and too late for a pullback" indicates that the credit market was too far gone for them to pullback the credit under all circumstances. Bernanke may have been a scholar of the Great Depression, however, he capitulated with the institutions that socialized his viewpoint that to do nothing is to be part of us.
Janet Yellen's point of view is focused exclusively on a single and limited role, and that is jobs. She never disappoints the markets. She has a soothing character trait. A few months ago at the Economic Club of New York meeting, she rocked Wall Street by suggesting that the Fed may begin tightening rates six months after finishing their asset purchases. Her dovish statement only came to play when the market violently swung in the opposite direction. Subsequently, she needed to backtrack by stating, "Interest rates will likely stay at current levels for a considerable time after asset purchase program ends." The market was jubilant following the Fed's announcement that it was cutting back on its bond-buying program and would no longer use a 6.5% unemployment rate threshold as a determinant for raising interest rates.
Understanding the stock market is the mirror image of our world and has its own built-in language of how to deceive not just one individual, but the multitude. During Janet Yellen's Fed confirmation hearing, Yellen announced, "The financial crisis could have been worse." She credits the wise and skilled leadership of Ben Bernanke. She then articulates her passionate belief that the Fed monetary policy works best when the public understands what it is trying to do. At the same confirmation hearing, Senator Tim Johnson, the chairman of the Senate Committee on Banking, Housing, and Urban Affairs, seized the opportunity to ward off any criticism by questioning if there's "any danger tapering bond purchases too early?" Janet Yellen's response was short and to the point, "There are dangers on both sides: tapering too early or not in time." The general public of America feels that they require more time to accumulate more wealth. The markets know that time does not have the same appeal for everyone.
There is an absurdity that one cannot profit from a market. The absurdity that one cannot preserve capital because the experts believe that their timing of the market is more correct than yours. The professionals seem to believe they are superior to the herd by commenting if one stayed in the market without cashing in they would have made more money.
Stock analysts continually try to use the past to justify the present. It becomes their calling card to substantiate whether a market is overvalued or undervalued. The bull market relies on the herd mentality to gorge itself. Then, they try to use technicals to smooth things over, filtering out any irregularities that may arise in the analysis. The herd follows the trend, for every dollar made another will pay two, and another will pay six. The ones who paid six need to justify their own fear to the ones who will pay 20. The continuity of a bull market is based on fear that one should always pay more.
On May 7, 2014 during the economic outlook, Janet Yellen identified the vulnerability of the financial market by saying that the "Committee recognizes that an extended period of low interest rates has the potential to induce investors to 'reach for yield' by taking on increased leverage, duration risk, or credit risk." Economists want to know how far and to what extent the public uses equity from their property to invest in the stock market. If the quest for yield is pushing the general public to get into debt to buy stocks then it defeats the purpose.
Senator Bob Corker brought up an interesting comment in Janet Yellen's Fed confirmation hearing. Corker argued that the "Fed had become a prisoner to its own policy" as the market reacted to earlier fear of tapering. Yellen slipped, she stated "we are not a prisoner of the markets, and there have been improvements in the labor market." Corker shot back, "just a little bit of a prisoner, maybe not fully." Perhaps now if the market crashes, unemployment will crash with it. Janet Yellen's single-minded focus to provide jobs would be permanently damaged. Just like Ben Bernanke indicated in 2007 that it was "too late for a pullback," now the markets can't even pullback and Yellen knows it. If the markets provided the illusion for Yellen to believe in her comment "valuations for the equity market as a whole and other broad categories of assets, such as residential real estate, remain within historical norms" then why is the recent flattening out in housing activity more protracted than currently expected? Now we know that the markets follow a standard pattern. That is why economists try to prove to mathematicians that the norm of a real number is its absolute value.
On June 24, 2013, Ben Bernanke indicated that he wanted to cut back on the $85 billion per month quantitative easing program. The SPY and the DIA tanked. He stated that he intends to cut back on buying bonds when unemployment rates drop from 7.6% to 7%. It triggered a sell-off in Treasuries. However, what was unexpected by Bernanke and Yellen was that the People's Bank of China told the largest banks to rein in risky loans and to improve their balance sheets. This resulted in the biggest sell-off on the China Shanghai Composite Index in nearly four years. That's when Bernanke and Yellen realized that illusion is better than truth. Yellen had to soothe the markets and China's sentiment by indicating it was all a misunderstanding.
During Janet Yellen's Fed confirmation hearing, Senator Richard Shelby spoke about China buying U.S. bonds. He asked Yellen if "it's true that it's actually the U.S. that is buying its own paper?" She responded with "the Fed is not aiming to help the government out with its deficit." She added that "once the interest rate hits zero, the Fed had to look at alternate measures." At the same hearing Richard Shelby questioned, "what is the real unemployment reflected in people giving up looking for work?" He cited 13% or 14%. Yellen agreed by saying "there is a significant decline in labor force participation." Patrick Toomey expressed concern in the stimulus program by noting that "middle-class savers have been punished." He added "what happens when this morphine drip starts to end?" Yellen replied indicating rates will go up but acknowledged low interest rates would hurt savers. She followed up pronouncing "we can't have normal rates unless economy is normal, and low rates are the best way to normalize the economy."
Janet Yellen should be aware that with natural and normal interest rates, investors are not speculating in the stock and bond market with savings. Artificial signals set by low interest rates are what drives nearly all boom and bust cycles in our economy. Investors are now in the quest for yield. It is risky for banks to loan to a small business for such a small interest rate, the money is now flowing itself into the stock market. Richard Fisher, president of the Dallas Federal Reserve, may have touched a nerve in the way the DIA, SPY, and the QQQ operate together. His words were very simple, "Were a stock market correction to ensue while I have the vote, I would not flinch from supporting continued reductions in the size of our asset purchases as long as the real economy is growing." Perhaps the state of Texas values truth more than the nation itself. Fisher eluded what is happening with all of the money created by quantitative easing. Thus far, much of the money we have pushed out into the economy has been stored away rather than expended to the desired degree. Fisher adds, "We have seen a huge buildup in the reserves of depository institutions of the United States." However, Yellen needs to do some soul-searching to where the bankers are putting that free money to work.
David Hume's philosophy between what is real and what is not real also follows economic thinking. To drive this point home, a wounded soldier only has faith to guide his belief. The objective proof lies on the soldier who believes his life is equal to his. That's when he grabs him, and it becomes real for the both of them. All we're saying is that if the quest for yield is disproportionate, then the real economy may disappoint the public in the future.
I'd like to thank my colleague Fiorenzo Arcadi for contributing his exclusive insight into this article.