In my last article here I had clearly articulated how market swoon in May (that continued in June too) was a good buying opportunity. And now S&P 500 (SPX, SPY) is making a new high every day. Currently at 1676 it is 100 points higher than the lowest point in June when market was selling on Bernanke's comments. As I identified in my previous article, Federal Reserve officials are too scared themselves to scare this stock market. They will do anything to support their hypothesis that QEs work in the long term. And the only evidence they have to show as the success of ongoing QE is the stock market performance. But in reality QE has zero to minimal effect on the real economy contrary to the firm belief of our central bankers. More on that in the later part of this article. But let's start with the short term investment strategy in the light of central banks all around the world obsessed with QEs.
Short term strategy - As we saw last month, a paltry 200 points drop (which is less than 2% at these levels) in Dow Jones index (DJIA) is more than enough to bring out Fed officials in droves to say that they are really not talking about making any changes to QE. They even hinted at increasing QE if market did not immediately start going up. With so much artificial and unprecedented support, the next target for S&P 500 (SPX, SPY) is 1750 in the next 3 months.
Also, we are looking at the next level of S&P 500 as a conditional variable of the choice of next Fed chairman (or chairwoman). We want a person at the helm who can not think beyond QE and/or increasing QE for the next few years. So far, all the proposed names fit that criteria very well. If we can get more clarity on the final choice of next Fed chief then S&P 500 can even hit 1800 by the end of this year. In fact, choice of Larry Summers or Tim Geithner can help S&P 500 hit 1800 level within a week of their nomination. Essentially we want a Fed chief who has no idea of real economics, mathematics or any other subject for that matter. He should also have a firm belief in utilizing the special powers of printing money that are vested in him/her by our political structure. We want the Federal Reserve to bring forward all the earning and saving potential of the future generations to the present value so that the current investors can maximize their return on investments in the next 12 months.
Given the almost blind faith of our central bank in QE, S&P 500 can even hit 2000 within next two years before markets, technology (bitcoin and other alternatives) and public (mainly the top 10% who control 90% wealth) become mature and start discounting the credibility of our central banks. Until then investors should take long positions on a continuous basis and add new positions in any market weakness.
In the rest of this article as I'll try to explain why QE really does not work outside of financial markets.
Lets consider the following to understand that QE has no impact on the real economy:
As the details of US unemployment rate above show, it has normally taken three to four years for the unemployment rate to drop below 7% in the past four recessions/contractions (1975, 1982, 1992 and 2009). Now if we recall correctly, in the past three of these recessions we did not have any QE and still unemployment rate fell below 7% after a certain period. We can also see in the above picture the cyclical nature of unemployment rate that can not be controlled by QEs. In fact, this time QE is creating more economic distortion as on one hand asset prices are rising up like we have a very strong economy but on the other hand our central banks are acting as if we have a very weak economy. So any future action to reduce this distortion and align asset prices with the real picture of the economy is bound to disrupt the financial markets and thus create more employment troubles for the broader economy as well.
However, our central bankers have started to harbor this foolish idea from Allen Greenspan's time that stock market drives the economy. So by manipulating the stock market through central bank interference, we can have a strong economy. But the history of market tells us that companies are formed and stocks are traded because of the economic activity and not vice versa. Economies have existed much before the time the stock trading began. In fact, most important inventions of our times (light bulb, airplane, engines and electronics) happened before central banks and markets existed. And as the market events of 2007-2008 showed us, the asset price manipulation was actually hemorrhaging the economy internally.
Now Bernanke has brought the idea of QE through his myopic study of economic history which for some strange reason stops in 1930s. And his ideas are plaguing the central banks all across the world. And now asset prices are being distorted artificially at an unprecedented level as central bankers have become activist investors.
But internalizing this idea that central banks create or drive economies is FATAL. This is fatal not so much for the economy but for the existence of central banks themselves. Central banks were created and exist because of the trust of people in the "fiat money" that they control. If that "fiat money" starts distorting fundamental economic incentives established much before these central banks came into existence then those incentives will eventually drive people to other alternative systems of economic exchanges (i.e. another form of "money"). If that process starts then central banks will quickly become obsolete.
2) Market based proof - I don't have to write much about it as the events of past two months are a clear indicator that markets are not setting new highs because of the economy but because of the QE. A mere talk of tapering is enough to roil the markets from Japan to Brazil. And our central bankers still seem to believe that their policies are making real economic improvement around the world.
Well, house prices in US have gone up and global markets have gone up to benefit the current owners and holders of these assets.
But who is paying the price? It's the people who are buying these assets now. Like a young couple who is now being forced to buy a house which has already appreciated 20% in value in the past two years. Or like a young 401(NYSE:K) investor who is being forced to buy S&P 500 which has already soared 38% in the past two years. Unless these newcomers sell these investments very quickly (also called "flipping"), they will be left holding the bag. Because eventually, if ever, central banks remove the liquidity after what they call the "foreseeable future", asset appreciation will revert to real economics driven appreciation. A lot of which has already been brought forward by the foolish policies of our very short-term oriented central banks. Essentially central banks are distorting the economic incentives of the next generation of investors through their myopic policies.
3) Numbers based proof - Federal Reserve is printing $85 billion of "fiat money" every month. This is in addition to our regular economic activity. Consider the facts that currently there are 11.8 million unemployed people (i.e. 7.6% unemployment rate) and average US worker salary is $45,000/year. This implies that if there were a ghost program that automatically employed all the currently unemployed people irrespective of their qualifications and willingness to work then such a program would cost only $45 billion monthly. Such a program will bring unemployment rate to 0%.
With $85 billion/month, Federal Reserve is printing money at double of that rate. Still we have seen only marginal improvements in unemployment rate. Such improvements also seem to take place naturally as shown in the unemployment rate picture above.
Essentially, Federal Reserve officials seem to have absolutely no idea where the money that they are printing every month is going. We have to keep in mind that this is the same Fed that claims being capable of monitoring huge financial institutions. How a Fed which is so clueless about its own actions and programs can justify its capabilities?
4) Relying on an equation - Most central bankers seems to rely on the money equation to justify their actions. The money equation MV=PQ governs modern day monetary policies. In this equation, M is the money supply, V is the velocity of money, P is the aggregate prices and Q is the real output. Essentially it says that total supply of goods and prices charged for them should equal the total money available and how many times it was used. It's that simple. But what is not so simple is realizing the fact that while left side of this equation is somewhat controlled by central banks today, the right side of it is totally independent and driven by real economy.
But our central bankers seem to treat this equation as a two way street. They are exerting all their power to change the left side of equation in the hope that it will drive the right side of the equation. However, this is not a physics equation (e.g. F=MA) which holds true in both directions, but this is rather like a chemical equation (e.g. 2HCl + 2Na -> 2NaCl + H2) which holds true for one direction but not as much for the reverse direction. Unfortunately this kind of critical thinking is not imparted in our Ivy Leagues today from where we seem to be importing most of our central bank chiefs, treasury secretaries, and other officials off late.
MV=PQ will be better understood if it is written as PQ=MV. That is, for a given price and output, we need to have an adequate base of money supply. If output or prices are more than the money supply then they can be restricted. But not vice versa. Or think about a picture where you control a tap on a pipe, you can restrict the water flow by turning the valve. But trying to open the valve beyond the width of the pipe will not increase the water flow. In the process we might just break the valve itself.
This "Bernanke Plague" aka. the money printing disease is also infecting other central banks. Which will eventually prove FATAL not so much for the economies but for the central banks themselves. But right now, central bankers are reveling in the state of "Bernanke High" which makes them believe that they control the economies through asset price manipulation.
However, none of this reasoning is going to dissuade our central bankers from doing what they are doing. So as an investor we have to play the market accordingly. We have a long term strategy to deal with the eventual outcomes described above but in the short term buying S&P 500 is the right choice. Of course, at the expense of those unfortunate folks who will buy this market later.
Disclosure: I am long SPY. 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.