The markets are at the top of their range, where do we go from here?

March 21, 2012

Simple question but difficult to answer. Here is the long answer.

I still think that we are getting near a tipping point with both the economy and the markets. The “economy continues to improve” groups are basing their argument on headline numbers. For example,

1. Auto sales are up slightly but inventories are even higher;

2. or an average 200,000 jobs have been created over x months but that is not enough and half the jobs are part-time and for lower wages;

3. Or manufacturing and service indexes are over 50 and therefore show “modest growth,” but are higher inventories good for the economy or just GDP index.

4. Corporate profits are high (decades high levels) and going higher (implies margins will continue to expand), but many indications that margins will contract (rising costs, gasoline hurting consumers, increasing housing foreclosures mean people have to move and pay rent rather than spending their mortgage payment on restaurants and cars, etc.)

5. The warm whether is also a factor being ignored by the Fed’s models.

At the same time, the money the Federal Reserve and deficit spending have pumped into the economy is going into the markets as Bernanke wants to get them animal spirits going; and he is being helped by the media: consumer sentiment is improving and the VIX (volatility or risk measure) is now extremely low (what risk can there be?)

“Darth Vader” on the other hand is looking at the fact that the pace of money supply(the key driver of GDP) has started to contract and that means decline for the GDP by June/July unless there is a new stimulus program or QE3+.

I think the Fed is looking for an “excuse” to print more money but it can’t look like a political move so he needs some economic data to point to in order to pull the trigger. This could be some bad economic numbers or a market correction along with a correction in gold and silver. Or it could be done through stimulus as we prepare for to engage in another war.

Net/Net: The economy remains in recession and looks to stay there for some time because we have not addressed any of the issues that brought us into this recession or are keeping us there (spending, debt, central planning, printing money, government interference in the economy and markets, etc. etc.

But, the $8 trillion dollars pumped into the economy has helped GDP’s and increased assets. This is what politicians (including Fed Reserve politicians) do. It seems to be the only thing they know how to do. Therefore, I expect another round of stimulus or money printing in time to help the elections and before the new debate on the debt limit ceiling which will likely be reached by October.

Investments must be flexible (risk on, risk off) because the exact shape and timing of the markets are unknown; and tradable (for protection and opportunities) until the longer trend becomes known.

Net/Net: The short answer is that the market is at the top of its range and can only be held there by more action from the government.

Why Is The Market So Optimistic? What’s Changed?

It’s not the economy. Not much has changed there except for a few of the many antidotal data points that are published each month. The expert’s points to three or four of the 30 reports published every month and conclude that they signal that the economy is recovering. Most don’t look at the context surrounding the data point so they don’t know what it means (do you think the guy writing headlines knows how the CPI index is adjusted for quality improvements verses price increases) or even if ”that data point” can be used to forecast the future.

There are two things that have changed. One, we continue to pile up debt (now exceeding 5 times our revenues) at a rate of $4 billion per day increasing the probability that we will have to eventually default on our sovereign debt. Two, the Federal Reserve continues to print money in increasing amounts and in many different ways like helping the European Central Banks with liquidity, or running a “Twist” program here to bring down long term rates, or the Zero Interest Rate Program (ZIRP) to help the banks and hurt savers (and force them into higher risk investment to earn any return on their investment.)

Then, yesterday, Chairman Bernanke announced that he intends to keep ZIRP in place through most if not all of 2014. Remember, both political parties were angry with Chairman Greenspan for the housing bubble because he held interest rates at one percent for a year. Bernanke intends to hold rates at zero for four years! And then, just to make things worse, he said he would be willing to “be more accommodative or in English, print more money) if the economy gets worse. Oh, by the way, he revised his estimate of GDP growth down another quarter percent.

Money supply data shows that the Federal Reserve has continued to increase the money supply and has increased the pace in the past month. In spite of what Bernanke says, this is money printing (QE3) pure and simple. Since we know that increasing money supply is how you increase GDP, the markets are pricing in the increased money supply.

What's Next For The Market?

Technically, the market is at an inflection point. According to the Dow Theorists, if the Dow breaks 11,823.7 if would signal a correction and even put the market into another bear market. While technical analysis can be correct sometimes, it can also be incorrect sometimes. If it always worked, you could buy the right algorithm, kick back and relax. But, on the other hand, many traders follow the Dow Theory and that alone could move the market for a while.

We do know that the markets are levitated due to government spending and require additional government spending to keep going. So far, talking about cutting government spending is just talk; nothing significant has actually happened. I suspect cuts, if any, will be minor (less than the $1.5 trillion needed to get us a balanced budget.) Therefore, for the moment, I assume overspending and quantitative easing will continue, maybe for years.

also, Fed Chairman Bernanke has the stock market targeted as one of him main objectives. He wants the market to go higher so “animal spirits or greed” will kick in and take over so “real” consumer spending can take place. Therefore, If the market should sell off to 10,000 +/- (about a 15% drop), I think the government will intervene with both stimulus and more quantitative easing (printing money.) After all, it’s only 19 months to the next election…and voter pain will not be tolerated.

It’s Time To Look At America’s Two Economies

Today, when you open the business section of your newspaper or watch financial news on television, it is obvious that we have moved from an entrepreneurial economy toward a very centrally planned economy. Fiscal and monetary policies have become almost an obsession. Politicians and pundits have convinced most people that the government can and should solve any problems we have. And as you know, politics drives fiscal and monetary policy. Therefore, it is important that each of us have a longer-term understanding and outlook of the economy; and it must be as non-partisan as humanly possible.

Following is my view. This view may differ from yours because my assumption is that the economy and markets do not work, except on a very long-term basis, the way most people think they should.

First, we need to put the real economy (not just the political economy we read about every day) into context so we can distinguish the actual economy from the artificial, centrally planned economy. This makes it possible to see the two economies. Once you understand both, you will be in a position to develop a short-term plan for your business and your investments; and a longer-term plan for when these two economies collide.

Most people think that when the economy (GDP) grows, corporate profits grow which causes stock prices to increase. This is true if you are thinking very long-term. But what really causes the economy to grow is when the government increases the money supply (prints money.)

GDP growth, by definition, is only possible if you increase the money supply. If the money supply did not increase, you would have a fixed number of dollars in the economy. Therefore, increased spending in one area of the economy would cause a decline in another area with net, aggregate growth of zero.

If the definition of economic growth was more wealth, rather than more money, the economy could certainly grow if GDP stays at zero. Think about how technology has increased our wealth over the years at the same time that prices were are being consistently reduced.

However, the problem with increasing the money supply is:

1.It decreases the value of the dollar, reducing buying power, which then causes inflation.
2.It causes malinvestments (investments go into marginally productive ventures that cannot sustain themselves once interest rates rise or when credit or money is withdrawn from the financial system.) It can/does cause bubbles.
3.It reduces the ability of productive companies to obtain the capital they need) long-term) crowding out real productive ventures.

Current fiscal and monetary policy

The Federal Reserve Bank, using a government (Keynesian) periscope, has decided that we are not de-leveraging (bringing prices back to equilibrium); we are instead close to falling into deflation. This Keynesian definition means a chronic slowing of consumer spending or demand. It is not the original or traditional definition of deflation which is a contraction of the money supply.) Therefore, the Fed is expected to soon (maybe in November) begin the second round of quantitative easing (printing money.)

Therefore, to increase consumer demand, the Fed plans to hold interest rates artificially low and pump money into the banking system to incentivise the consumer. This, plus continuous stimulus programs and overspending tax collections have not worked to date. Some of the reasons are:

1.Banks have over $1 trillion in excess reserves but are not lending (for several reasons) so credit expansion is not occurring which is necessary to hype demand
2.We have had over $900 billion in stimulus programs plus $2.7 trillion in “additional” government spending over the past two years. GDP has risen by about $800 billion over the same two-year period.
3.A lot of this money has found its way into emerging countries in the form of investments. Two emerging countries have started to tax foreign investment funds in order to slow down their growth.

Conclusion

Government (fiscal and monetary) policy cannot continue down this same path much longer without it causing horrendous inflation. Our debt and committed future obligations already exceed 100% of current, tax collections for many decades into the future.

Plus, we still have many significant economic problems before the economy can really begin to grow including the financial system, housing, over-levered consumers, unemployment, states and municipalities in serious deficits and asking the federal government to bail them out (estimates are around $300 billion now) and many more.

Therefore, unless there is a clear change in government policy (by both political parties,) it appears that additional stimulus, low interest rates and excessive printing of money will continue. Since money supply is the initial driver of our economy, the GDP number may stay positive and above water. But, this printing and spending money plus low interest rates will require investors to make significant changes in all asset classes.