The Short Story On The Long S&P

by: The Other Street
Summary

In volatile markets, everyone has an opinion. Time to cut the verbiage down.

I will only show you three pictures, each worth a thousand words.

Then we can talk about The Invisible Hand - but it's not pointing where you think it is.

Everyone has an opinion when the markets become unusually volatile. No doubt this has been the case since we reached the intraday high of 2,940 on October 3, 2018, then down some 20% to 2,346 on December 26, followed by the largest one-day gain ever, and now back up 10%, climbing a wall of worry - no pun intended. So we hear it all, from the Wall to the Shutdown to the Trade War to the Yellow Jackets to the Caravan to the Democrats to the Fed to General Mattis to Syria to Erdogan to Putin to PEs to Unemployment to the Debt to Global Warming, back to the Wall, and so on. However, in all this Capernaum babble, I have not seen the three charts that were the pillars of my first book, "Anatomy of The Meltdown - 1998-2008," published in 2009 and 2011. At the time, the talk of the day was TARP and QE, much like it is today, so I thought they needed to be dusted off. They make Jerome Powell's position so much easier to understand.

One is simply the Federal Reserve Balance Sheet Total Assets:

It does show, indeed, that the Fed has slightly reduced its balance sheet in recent weeks, by about $400 billion to $4 trillion. And it has everyone crying wolf, waiting for the liquidity death spiral to constrict the markets after the euphoria of the past 10 years. Now, if my memory serves me right, euphoria was not exactly the prevailing mood 10 years ago. In fact, the reason for my book's second edition was just that, extreme skepticism about QE, notably in the US and in Europe. Remember the PIGS, anyone? So whomever is worrying about the sugar high going away probably needs to reassess his/her initial read. Which brings me to picture # 2, the M1 Money Multiplier.

I use M1, not M2, because M1 is real liquidity as opposed to near real money. That's a monetarist choice which best illustrates my point. Any question on that, please email me. But the reason why this picture is worth many words should be crystal clear. The Multiplier is now back above 1.1, higher than when it broke below 1.0 in 2009.

Why is this important? Simply put, it means we no longer need QE. Or at least, not as much as we used to. QE was put in place because the banking system was moribund. So many skeletons in the derivatives, bad loans and low credit rating closets that banks were simply not lending. As picture # 3 shows below, banks are holding a large chunk of the QE piggy bank in what was just that, Excess Reserves, i.e. money the Fed gave to them "just in case." Now that the economy is back on track, there is no need for this $1.6 trillion in Excess Reserves, and money is "multiplying" again. Hence the draw-down, and the concomitant reduction in the Fed's Balance Sheet.

Still with me? Now, if things were that simple, why the 20% sudden drop in late 2018 then? And why the bounce? Well, in all the babble, let's call it the Invisible Hand. Actually, I am surprised not to have heard from the Black Swan guru, Nassim Taleb, because if I am correct, this comes from the far away left field. As you read what follows, please remember there is a reason our imprint is called The Other Street. We don't fit in a box…

Did I say we hit the intraday high on October 3? What else happened on that day? Jamal Khashoggi. You are going to ask, what does this have to do with the markets? Fair question, and the answer is geopolitics. In this particular case, renewed saber-rattling in the Middle East.

The break occurred when the Media, the Monday Morning Generals, and all of the Administration's pundits, local and worldwide, decided the U.S. should part company with Saudi Arabia - and in doing so, with its allies in the Middle East. The next thing, Putin and bin Salman became ostensibly BFF at the G-20, and the Senate, oblivious to geopolitics 101, voted to repeal U.S. support of Yemen. For those who don't know, the only geopolitical relevance of Yemen is the Bab el-Mandeb Strait in the Gulf of Aden on the West side of the Arab peninsula, with Hormuz on the East side; if Putin gets access to both via its proxy Iran, he de facto would control the access to the Arabian Sea, which is the gate to India and Eurasia - see map below. The bottom line goes like this. If the U.S. was to pull out its regional support, the odds of a Russian offensive would increase, and thus would the risk of a much worse situation, with Israel, KSA, UAE and the Kurds on one side, and Iran, Syria, Yemen and Russia on the other. We reached the climax on December 19, when President Trump abruptly decided to pull out of Syria, leaving the pundits to ponder their newly-laid scenario, and Erdogan to pounce his chest with the likely massacre of the Syrian and Turkish Kurds (let's not forget the relationship between Turkey and Moscow's S400). And the market hit its trough on December 26.

Why the bounce then? I posit the scenario has been rolled back, witness Secretary of State Pompeo's speech in Cairo yesterday, and John Bolton's track in the region. As the risk of war and unchecked Russian expansion fades, so does the market risk - and concurrently the price of oil rises. QED. For the long version, see my just published book, "Between Obama's Lines - How We Almost Lost The Middle East, The Cold War, and The Atlantic Alliance," here.

Disclosure: I am/we are long DY, GVA, URI, HL, BBY, URBN, FNMAT, IR, WCC, PWR, GILT. 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.