There's No Longer A Bernanke Put

Sep.14.12 | About: SPDR S&P (SPY)

With yesterday's "we'll print as far as the eye can see" announcement by the Federal Reserve, the Bernanke put has been laid to rest. There's no longer a Fed put in the market. No, from now on, and considering that the Fed acted as the market was printing highs, it seems that the Fed has chosen to replace the put with naked call buying.

It's been a while since we've known, from Bernanke's mouth no less, that one of the transmission mechanisms for the quantitative easing efforts are asset values, and specifically, stock values. By taking share prices higher, Bernanke hopes to instill the wealth effect, where people feel wealthier as they check their bank/broker statements, and go out and spend as a result. Bernanke has gone as far as singling out the Russell 2000 (NYSEARCA:IWM) as proof of QE2 working.

Usually, the Fed was willing to use this effect in times of distress. When QE1 came to the fore, it was in the context of the 2008 credit crash. It was a measure of exception, designed solely to avert a systemic crisis. It was the unthinkable to avoid the unthinkable.

However, money printing is addictive. We have independent central banks exactly because it's so addictive. The lure of printing money out of thin air and buying stuff and assets with it is so powerful that even democracies felt the need to create an exception, to create institutions away from democratic control to watch over the money printing cookie jar.

This allure is even more powerful when it seems to come with no costs. After all, inflation continues to be controlled and the main cost that money printing entails is inflation, right? Things, however, might not be so simple. If we go back to the Soviet Union's failure, communism's failure happened mostly because returns were disconnected from what one produced for others. You were going to earn about the same, whether you gave others much in the way of production, or not. So you didn't give them much. As they said at the time, "they pretend to pay us, and we pretend to work."

Now, money printing, too, disconnects the capacity to buy others' production, from the need to produce something for others. When the Fed prints and buys debt with it, it becomes possible for the US Federal State to buy stuff from people without really incurring debt or the need for someone to pay taxes, and hence give part of his production in exchange. Although this happens in the context of a much more productive society than the Soviet Union ever was, the effect is similar. The effect is that more and more people live and get production from others without having to produce something in exchange.

This can already be seen in the emergence of entire sectors, such as the mREITs, which are simply based on taking short term debt and buying up long term obligations with a higher yield, as if no risk existed in doing so. This is also apparent in the way the financial sector's earnings constitute a larger and larger share of all profits. It's also seen in the way food stamps are exploding in usage.

So what's the true risk here? All of this is possible because when the Fed prints dollars, someone accepts them in exchange for goods. But if the Fed keeps on printing, such won't be true forever. At some point, dollars will be shunned, and when that happens the US will, for most of its population, turn into an instant China. Not the China of today, though, but the China of 20 years ago. No longer will it be possible to get others' production by delivering them freshly minted dollars. The US will need to deliver production, and production won't show up instantly, so the living standards will take a huge haircut at that point, simply because the central bank did not allow the adjustments to take place slowly before incentivizing production. The adjustment will then take place all at once.

So what about the market?

This course of events doesn't just destroy an economy. It also destroys rationality in the markets. You can have fundamentals for a given sector moving south, and the Fed comes in, prints money and the stocks in that sector move north instead. So as a trader you're left with the option of either following the fundamentals, or trying to guess when the Fed will print and all fundamentals become (temporarily) irrelevant.

A few months ahead, it becomes impossible to guess what a group of few people will decide, so this basically means predicting fundamentals a few months ahead becomes useless as long as it says "south." The market becomes a binary decision: should I stay long or should I buy the next dip?

As time goes by, Bernanke destroys the short ecosystem. For instance, at the onset of QE2 during summer 2010, (NASDAQ:AMZN) had 16-23 million shares sold short. This was a reasonably high short interest, and it was quite prescient, as Amazon was about to embark on a 2 year run of worsening fundamentals, basically putting in 8 or so quarters in a row where it guided earnings lower and lower, to the point where the consensus for this present quarter is already a loss, and the entire 2012 year was brought down from around $5.50 EPS to $0.77 today. What happened to this short interest? Was it rewarded for its uncanny prognostication? No. It was slaughtered. From money printing to money printing to more printing, both from the Fed and the ECB, Amazon shares managed to go from $120-$130 in that summer, to $260 today, or a clean double. Not surprisingly, short interest has since cratered to 8.7 million shares. The shorts have thrown in the towel, unable to fight the unending money creation.

And it isn't just about specific stocks. For instance, during this summer, basically every PMI reading out there (EU, US, China, etc) fell below 50, an event which usually leads to lower stock markets all around. Did those happen? No, the stench of fresh ink in the distance fanned the flames of speculation, and almost every developed market except for China turned upwards in anticipation. This made it all the more surprising that Bernanke couldn't keep himself from hitting the Print key, as the markets were already at highs when he did so. One can only guess that they weren't high enough. That the Fed has somehow established that the markets going up is not enough; that a bubble is required.

This turn of events was the reason why I have, in the past, said that stocks reliant on selling iron ore were still facing headwinds and fundamentally things would get worse (which they have, with iron ore falling from $138 per ton in the end of June to $100 per ton now), but if the Fed printed then all bets were off and the stocks could rally. It's then no surprise that basic materials have raced ahead yesterday and today, even though there's little expectation for an iron ore price recovery in the short term.


The Fed action yesterday, without any significant distress to act upon, makes a mockery of free markets and willingly chooses winners and losers. It distorts markets powerfully and sets the US in a course which, if not revised, can make its economy join such greats as Zimbabwe or China 20 years ago.

Overall, the Fed action won't change fundamentals much, especially in industries whose pricing and volumes will continue to be dictated in China. But it does introduce significant uncertainty and risk to the share prices, by making those less predictable and less tied to the underlying fundamentals.

In short, it would seem that the Fed wants to go from providing a put under the stock market to providing crazed naked call buying at any price.

Disclosure: I am short AMZN. 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.