My God," complained Arthur, "you're talking about a positive mental attitude and you haven't even had your planet demolished today. I woke up this morning and thought I'd have a nice relaxed day, do a bit of reading, brush the dog ... It's now just after four in the afternoon and I'm already thrown out of an alien spaceship six light years from the smoking remains of the Earth!" He spluttered and gurgled as the Vogon tightened his grip.
"Alright," said Ford, "just stop panicking."
"Who said anything about panicking?" snapped Arthur. "This is still just the culture shock. You wait till I've settled down into the situation and found my bearings. Then I'll start panicking."
- Hitchhiker's Guide To The Galaxy, Douglas Adams
I was one month early in predicting the market's reaction to the realization that QE3 would not be coming, at least not so easily. I point this out only to highlight the perils of trying to outwit the market's infinite stupidity. Now, two weeks before the end of QE2, has it sunken in that QE3 is not coming, at least not so easily?
S&P 500 is still above 1200, gold is still near an all-time high, and VIX is only 21. So I guess that's a no.
There's still too much hope, as exemplified by Tuesday's strong rebound on a single piece of news that could pass as moderately OK only when put on a stretcher. Apparently there are two isotopes of hopium. One is that recovery will finally, really, honestly be here this time, any minute now. I shall not embarrass myself by refuting it, since economic data so far have done a better job than I ever could. The other is that some knight will ride in on a white helicopter and drop some computer printout with more 0s than human intuitive capacity on it. It is regarding this more radioactive and longer lasting hopium isotope that I'd like to say something.
Here's a refresher on the events leading to Lehman in 08:
- Bear Stearns was in trouble. Treasury/Fed engineered a bailout. In retrospect, they grossly underestimated the problem and overestimated their ability to sooth the little booboo and shush down the market. They should've let Bear go and save the ammo for later.
- Fannie (FMNA.OB) and Freddie (OTCQB:FNMA) were in trouble. Treasury/Fed engineered a bailout. Same as before - underestimated problem, overestimated ability. Well this time we at least got the perennial bazooka as a souvenir.
- Lehman was in trouble. Everybody was sure there would be a bailout. They had no choice. Plus blasphemy really becomes routine by the third time. But by then they'd spent all their political capital and exhausted the goodwill and benefit of doubt. Paulson decided to let Lehman go, was immediately cheered by the Capitol Hill and looked like a principled hero for a day. The prior assumption is the Zeroth Order Moral Hazard born from the earlier bailouts. But like the classic humor construction, they give you two points so that you can see where this is going and then BANG, the punchline goes a totally different direction. (This is not to allege any conspiracy but life is too funny.)
Here's a refresher on the brief history of QE:
- In the beginning, the whole civilization was collapsing, the story began. God made QE1 and saw that it was good. In fact it was better than sex. The Fed fixed everything "at no net cost to the federal budget or the taxpayer." Future philosophers will have a perpetual funding source from the question of "why had humans been so stupid as to mucking around making things before inventing the Fed," and in the off chance this dries up there would be an even more perpetual one - "what is transitory?"
- Then PIIGS happened just as QE Lite was tapering off. And they realized that there had been no trickling down from all the free money given to the banks, which was for the specific purpose of rebuilding banks' balance sheets and helping them deleverage. Nobody could've possibly foreseen that, of course. But no worries. QE2. This time it was better than a national party.
- Now the QE2 needle hasn't even been pulled out yet and the patient is wailing already. Of course, everybody was sure there would be QE3. They had no choice. Plus blasphemy really becomes routine by the third time. This would really fix it now. For real. I'm 100% sure. And if it doesn't, the Fed could always do more, at no cost, remember?
The risk is, like the Treasury in the Lehman case, the Fed has prematurely spent its ammo. There's no political appetite unless and until there's a real disaster. I'm talking a Dow < 10,000 type of disaster, regardless of the cause. The adversity has been vividly demonstrated by the outspokenness of hawks in the Fed and the outrage stirred by Bernanke's "no cost" comment, not to mention the transitory inflation not caused by the Fed.
Also like Treasury in the Lehman case, the reason why the Fed has prematurely spent its ammo is that it grossly underestimated the problem, or otherwise completely missed the ball along with the whiff of it, and grossly overestimated its ability to fix the grossly underestimated problem, even though it's grossly underestimated. For brevity's sake, I'll leave out the cause and focus a little on the effect of the misjudgment: inflation.
- Inflation is exactly as transitory as Fed printing is. As soon as Fed printing stops, inflation pressure will subside and we have a chance to deal with it. As long as Fed printing continues, it'll become every bit as perpetual. Look at commodities before and after May 1. Even Fed PhDs from decent departments, I suspect, will not talk about the disconnect between Fed printing and inflation at home, which would put them at the grave risk of permanently and irreversibly losing their kids' respect.
- While it's true that the U.S. could afford printing and the pain of the ensuing inflation more than anybody else, it's a lose-lose game the Fed has played. If inflation only comes directly from commodities, we would've had an easier time dealing with it. But it also comes from higher import prices as the double whammy of the dollar tsunami and higher commodities prices force everybody who's making anything to raise prices. The Fed exported the problem, now the chicken has come home to roost. This is a bit less transitory than the direct commodities effect alone. Its resolution depends on other countries (China, India, Brazil, among others) successfully solving the inflation problem that's been at least partially forced upon them by the Fed.
- I get emotional watching analysts analyzing the lack of inflation based on supply and demand (wage, unemployment, etc). I want to laugh and cry at the same time and, even worse, inevitably fall at both. The narrow supply-demand approach to inflation has lost its relevance since the onset of the global village in the 90s! Otherwise we should've had hyper-inflation back then. Don't these people have the intellectual shame to go beyond the mere convenience of an argument? Ok, I'll go cuddle up in a corner and calm down now. But it felt good. Ha. Whew. Ahem. Alright.
Coming back to the market, I doubt the no-QE3 non-surprise has run its course yet. And the recovery so far has been nothing more than a cancer patient on oxygen. We will not have a self-sustainable recovery until the housing market becomes a market again after the foreclosure overhang is cleared. The foreclosure overhang will not be cleared until they figure out how to solve Fannie/Freddie and how not to expose banks as insolvent. And banks will not be solvent until they are forced to recognize the foreclosure problem. For now, we have a perfect solution out of this Catch 22: Homeowners pretend to pay, banks pretend they're fine, everyone pretends they're happy. If not for that darn little bugger called inflation, we could live happily ever after like this.
And the faltering recovery will no doubt be helped along by various interests wanting more free money from the Fed.
So I expect the doom and gloom to continue sinking in until commodities, gold, stocks and high yield bonds all lose hope. Then QE3 may come. If the Fed is actually as clueless as what I think that would break my grip of hope. The marginal benefit of each successive QE decreases and the marginal damage increases. There may be a spike in stocks when/if QE3 comes. But it'd surely lose value when priced in gold or even other fiat currencies.
In summary, either way we're screwed.
I haven't even mentioned the eurozone yet. The eurozone might be able to, or so I hope if only for the sake of humor, push through this second round of a bailout, if only barely, thus prematurely spend the ammo, set the Zeroth Order Moral Hazard firmly in place, raise impossible expectations by the third time, and cause a much bigger disaster than what had to be. This would complete the trifecta of the Third Time Curse.
Then I'll start panicking.
Disclosure: I am long DBA.
Additional disclosure: I am short GLD and SPY.