Stocks Have Worst Week In 5 Months: Fed's Guitar Solo Has Fizzled

Includes: QQQ, SPY
by: Colin Lokey

Call it the market's disdain for four more years of a democrat in the White House, call it the fear of the end game in Athens, or call it an obsession with the fiscal cliff, but whatever you call it, call it the worst week in five months for U.S. equities. The Dow, S&P 500, and Nasdaq fell 2.1%, 2.4%, and 2.6% respectively on a week which saw President Obama reelected, and in which Greece passed 13.5 billion euros in new austerity measures amid violent protests only to see international lenders delay its aid package yet again.

The following chart shows the weekly rate of change on the S&P 500 dating back two years:

Source: ZeroHedge

Notice the number of poor weekly performances we have witnessed since the September FOMC meeting. In fact, the S&P 500 has lost nearly 7% since the intraday highs reached on September 14. Clearly, quantitative easing has lost its luster in terms of its ability to boost equity prices.

Given this rather unfortunate turn of events, it is worth revisiting the September 13th edition of CNBC's "Fast Money," wherein Brian Kelly, co-founder of Shelter Harbor Capital, said the following about what investors should do with their money going forward (ZeroHedge also posted this Friday):

"Buy everything that's not nailed cannot fight the Fed. You buy everything. Buy copper, which I did today, [Freeport-McMoRan] (NYSE:FCX), which I mentioned last night. Anything else? Emerging markets! Everything! Just buy it. Buy it all. You never have to short again. Buy it."

Shelter Harbor Capital also assured its clients on September 13th after the Fed announcement that"

"...this is NOT more cowbell, this is a fingertip bleeding, turn it up to 11, Jimi Hendrix guitar solo."

This "Saturday Night Live" reference was meant to convey the same thing Kelly said on CNBC -- namely, "Buy it." Kelly's predictions have performed comically bad. As mentioned above, the S&P 500 is down nearly 7% since then, and that is the best performer of the group. Here's a chart that shows Comex December copper since Kelly's call:

Chart: CNBC

As you can see, copper has fallen steadily and hit fresh two month lows this week. Given this, it probably goes without saying how Freeport-McMoRan (Kelly's other pick) has performed -- down 11% since September 14.

The explanation for this is something I suggested on August 24:

"They say you can't fight the Fed. Ultimately however, the Fed cannot fight reality."

By keeping rates low, the Fed can try to discourage saving and push investors out of bonds and savings vehicles and into riskier assets, but ultimately the goal of expansionary monetary policy has to be to push the aggregate demand curve to the right. Only in this way will the economy kick back into gear.

If banks are still reluctant to lend, or consumers are still reluctant to borrow and spend, all the new money pumped into the system simply piles up as excess reserves and the economy remains stuck in neutral. With this in mind, consider the following chart, which shows banks' excess reserves over the past 32 years:

Source: St. Louis Fed

In short, the money is just sitting there. Without lending, borrowing, and spending, businesses won't feel confident investing for the future.

This is exacerbated by the uncertainty surrounding the fiscal cliff -- CEOs are afraid a cliff dive will send the U.S. back into recession, making banks even less willing to lend and making consumers even less likely to spend. All of this curtailed capex and essentially killed topline growth in the third quarter. As soon as this became apparent during earnings season and investors began to see firms cutting guidance, the party was over.

What Kelly and many others seem to have lost sight of is that it isn't the money printing itself that is important. It is expansionary policy's anticipated effect on aggregate demand that is important. If expansionary policy doesn't produce the desired effect, the economy remains mired in recession and excess reserves pile up at the Fed. Meanwhile, the Fed continues to lean against the wind, driving rates even lower and inflating asset bubbles with nothing to show in terms of economic growth for their trouble.

Meanwhile, economic fundamentals (both domestically and globally) continue to deteriorate, and even with the recent sell-off, stocks are a long way away from reality. The following chart shows the S&P 500 and its divergence from the International Economic Surprise Model:

Source: ZeroHedge

In order for the relationship above to return to normal, either global economic indicators need to begin surprising to the upside in dramatic fashion, or the S&P 500 has to take a long hard fall. I will leave it up to readers to decide which is more likely in the current environment. Investors should remain short U.S. equities (NYSEARCA:SPY) (NASDAQ:QQQ), as it seems "reality" is back in style this winter.

Disclosure: I 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.