When There Are No Limits, The Sky's The Ceiling

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Summary

Investors have been conditioned by the bull market to buy on dips. This is reassuring as it means the economy is entering another stage of the boom cycle.

China’s economy is slowing, but the chances of an outright recession remain slim. It is Japan and Europe that pose the greatest risk to the U.S. outlook.

Stocks are flirting again with record highs. But the risk-reward of buying equities at current levels is still favorable.

Fact is sometimes harder to believe than fiction. Britain's shock decision to leave the European Union (NYSEARCA:EU) is a telling example. For all the concerns, however, the S&P 500 bounced back from steep losses and kept setting fresh highs in July. That again was the total opposite of what many traders and strategists anticipated would happen. If there is a case of pure liquidity-driven rally, this is probably it. As I wrote in my previous article:

With so much money chasing so few quality investment opportunities, it is still going to be hard for the stock market to perform badly. Cash-rich investors, for one, will take advantage of every downturn to do bargain hunting.

The bounce back is a clear testimony of this fact.

The zaniness of QE market

To be sure, this line of thinking is hardly conventional wisdom and not everybody is convinced (as can be told from the comments left on my previous article). Many remain skittish about the huge run because the market has gone too long without a meaningful correction. Others just feel uncomfortable about the nature of this rally. But the reality, as I wrote back in 2014, is that quantitative easing (QE) is a no return policy and so no matter what happens to the economy, there is no way for the market to go south. Like it or not, the market has turned on its head in the QE era. Bad news is now read as good news because that may augur more monetary stimulus. All normal calculations are rendered irrelevant by an outsized central bank asset purchase that makes all other parameters look puny (see chart 1). It's the liquidity, stupid! Come what may, the ample supply of money would support equity prices.

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The QE business cycle

Judging by the market's response to the Brexit vote, it seems that investors are increasingly aware of this fact, and finally are waking up to the realization that "stock prices have reached what looks like a permanently high plateau (chart 2)" (and yes, the quotation was made by the great economist Irving Fisher a few days before the 1929 crash, but things are different this time). This is encouraging because when investors are feeling more confident about the future, businesses, sitting on record levels of cash, are feeling more confident to spend. The upshot is a revival in investment activity. Indeed, with the recovery of housing prices (chart 3) and the banking sector returning to profitability (chart 4), lenders are growing more comfortable extending loans. It is just a matter of time before regulators relax their stringency and allow more credit to flow to the real economy. When this happens, domestic demand will grow stronger. Shares in big banks will join the rally. All this will have the U.S. economy entering the second stage of the QE business cycle.

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So the outcome will depend on people's expectations. At the initial stage of QE when everybody questioned the effectiveness of printing money, we had moderate growth with low inflation. But as more and more people accept the bullish case, both inflation and economic growth will pick up speed. At the final stage when everyone is convinced, the business cycle will enter its challenging phase. Progress of inflation might eventually hold back the economy, putting an end to the long-lasting bull market.

Click to enlargeThis is the most likely sequence of outcomes that would occur under QE. Print money and it will lead to inflation, that old rule of thumb still applies today. But while inflation is an undeniable risk surrounding the outlook for stocks, it remains a remote threat far in the distant future. To investors, the more immediate risk is that they might miss out a good part of the historic run in stocks by cashing out too early.

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Click to enlargeJapan and Europe could become a source of instability

That QE is a success story in the U.S. owes much to two things: 1) the dominant status of U.S. currency and, to borrow a phrase from John Keynes, 2) the animal spirits of U.S. people; with the former allows the country to print as much money as it wants, and the latter allows the money to be put to work. These are the strengths that neither Japan nor Europe possesses. Hence it is hard to make a similarly optimistic case for the two markets. The problem is this: When money is free, the animal spirits will induce households to consume and firms to produce. Yet if an economy has lost the animal spirits, people will just hoard up the money and not put it to use. An analogy would be to imagine a tiger that has been locked in a cage for so long that, even now, there is plenty of prey available the tiger just doesn't hunt.

And Japan is this tiger. Having suffered from a post-crash hangover for nearly 27 years, the Japanese tiger has lost its vigor. Ordinary Japanese seem to be content with things the way they are. Thus unless the government put through painful cultural and structural reforms, reckless printing of money is merely the road to ruin. Not only is it unable to stimulate spending, but it also opens the way for a future Yen crisis when other major countries stop printing. This worry factor is not to be underplayed because, as mentioned earlier, only America has the unique privilege to print money out of thin air. The fact that this big brother is printing is why other countries like Japan can go on printing- or else they would have seen a sharp plunge in their currency values.

More worrying of all, Japan is truly addicted to money printing. For now, the country is trying to pursue an even more aggressive QE program, some dub it "helicopter money", to boost demand. But call it what you like- QE, QQE, or debt monetization- all this money printing variety is more toxic than tonic. It creates numerous distortions such as negative interest rates, asset price bubble and wealth redistribution to the economy. The costs of them are elusive but accumulating over time. In the end, money may lose its function not only as a store of value but also as a medium of exchange, leading to a collapse of the whole economic system.

This is a dismal picture. But if the collapse of Japan will be such an orderly affair, then the demise of Europe will come more as a shock- both will have a rippling effect on the global markets. The problem with Europe is that it is a tiger shackled by structural rigidity. Money printing does not work because excessive regulation, along with the disincentive effect of social policy, has taken away much of the lift.

So don't get your hopes up that the European economy will turn around soon. The picture may soon look much worse. If anything, the full impact of Brexit has yet to play out. Then there is a strong probability that continued economic weakness will lead to social upheaval. Lastly, with Britain's departure from the EU, the unexpected may be underway. It is possible that the union may fall apart one day, which could be triggered by some members (like Spain, Portugal or Italy) ditching the common currency and re-introducing their own currencies.

This suggests that Europe, like Japan, is vulnerable to a shakeout at some point. Couple this with a slowing China, and we have a perfect storm of events that may destabilize the U.S. economy. Which raises the question: Can the Dow insulate itself from a global meltdown?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.