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How long can the party in stocks last?

Wednesday, February 2, 2011, 12:23 PM

The headlines are screaming at the top of every financial media outlet tonight:  The Dow Closes Above 12,000 For the First Time in Two Years!

What's going on here?  Is the recovery well and truly underway?   And, if it is, why is the Fed dropping hints again that "QE3 may get discussed" at future Fed meetings, as Kansas City Fed President Thomas Hoenig said on Feb 1st?

Given the raft of good economic news lately, one might be forgiven for wondering what the Fed has in mind here.  If everything is so economically rosy, why are they already dropping trial balloons about more Quantitative Easing?  What are they seeing that we are not seeing, that justifies more than $100 billion in thin air money each month, and why won't they just tell us what it is? 

Here's how PeakProsperity.com member dbworld put it earlier today:

I thought I heard CNBC state the other day that there was seen an inflow into the US Equities market which hasn't been seen in a while. I didn't catch the details, but I'm hoping that Chris has a read on this and an explanation on why the US stock market is so strong.

While it's true that retail investors have only very recently begun moving more money into stock funds than they have been removing, reversing a 33-week-long outflow, this is focusing on the wrong element in the equation.  Retail investors provide only a minor amount of the rocket fuel used to elevate the stock market over the past several months.

Look at the amounts here, and also pay attention to the timeframe:

 

Over a 36 week period spanning from May 2010 to the end of January 2011, there was only one instance of 'investors' putting more money into stock mutual funds than they withdrew, and that one ,outlier was well under a billion dollars.  Over that 36 week period, over $100 billion was removed from the markets by investors.  Even when money started moving back in over the past two weeks, I want you to note the scale; the combined total is $6.7 billion.  Keep that figure in mind.

Instead, we should first focus on the massive injections of raw, potent, thin-air money (a.k.a. "credit easing") by the Fed into the financial system.  Sometimes this is referred to as "liquidity," which it is.  But that's too narrow a definition, because it is much more; it also happens to be high-powered base money (a.k.a. 'Wall Street rocket fuel').

Here's the stock market story over the past eight months:

Note that QE II began in early November of 2010 and that the stock market is up 20% since the end of August.

As an aside, I used to track the Fed's thin-air money programs very closely, and if you had told me as recently as three years ago that the Fed would have been running 11-figure POMO operations each and every month, I would have told you it was unthinkably impossible.  But here we are, that is exactly what is happening, and I am largely numb to the process, which worries me somewhat, as it means that my baseline has shifted.

At any rate, the point here is that from those August lows to now, retail investors have taken out far more money from the stock market than they've placed back in; a total of around minus $38 billion.

But over that same period, the Fed has placed nearly an entire order-of-magnitude more thin-air money, some $350 billion dollars, into the hands of financial institutions, some of whom consider the stock market their personal playground.

Here's a chart of the cumulative POMOs by the Fed from the end of August 2010 to now:

Should we consider the injection of more than a third of a trillion dollars and a stock market that is up by 20% to be a coincidence?  No, not in the least.  The stock market has become, if anything, a liquidity gauge first and a discounting machine second.  The fundamental that matters most is how much money is flowing into the machine.

So it is my view that the trillions of dollars of thin-air money and deficit spending are finally finding their mark (asset prices) and doing their work, just as I predicted they would.  Where some called for deflation to be the irresistible force that would drag us all down, I've consistently leaned towards the side of inflation.  Although, to be fair, I have always hedged that view somewhat, with a 70/30 split held for nearly 5 years that was recently amended to 80/20 (in 2010 shortly after QE II was announced).

On a Tear

Unfortunately for the rest of the world it's not simply the stock market that is the lucky beneficiary of all this Fed largess.  Thin-air money, once released into the wild, tends to have a mind of its own.

Commodities are now setting new records almost daily.  Where the stock markets still have some catching up to do, commodities are exploring virgin territory.

This is serious business, folks.  The future is not going to arrive 'someday.'  For the billions of people who spend a huge portion of their income on food and fuel, it has already arrived.

Looking at the above chart of the past 12 months, what we see is that everything, from metals to stocks to bonds to grains to energy, has experienced profound price increases. That pretty much covers everything you need to live on and the bulk of the paper universe.  Such a chart is a historical rarity for any one country, yet it currently happens to apply to the entire world.  You are living in historic times, which certainly belabors the obvious.

Your Lying Eyes

On the flip side, the story we are being told almost daily is that inflation is very low -- too low, even -- in a worrisome sort of way.  I am reminded here of an old Richard Prior skit where his wife walks in on him in bed with another woman.  To her increasing agitation, he denies that he has been cheating on her, finally shouting, "Who are you going to believe, woman?  Me, or your lying eyes!?"

Well, my lying eyes see something very different in that chart above from what I am being told; instead of worryingly low inflation, I see rapidly rising inflation that is very close to slipping out of control.   

I spend as much time on this subject as I do because the decisions you make based on whether you are protecting yourself from inflation vs. deflation are as different as to whether you grab an anvil or a life raft on your way out the door when facing an emergency. 

I do my best to let the data do the talking, and right now it is saying inflation.

How long will it last?

The old saying is, Don't fight the Fed.  That's good advice.  I have dutifully been following the developing story by watching what the Fed does, not what it says, and by letting prices tell me which way the wind is blowing.  It's a regrettable position to be in, because it's nearly impossible to make any long-range plans when you have no idea what the Fed is going to do next.  But here we are.

How long the stock market rally will last is therefore unknowable, but stocks and bonds and commodities will remain elevated in price for as long as the Fed continues to dump hundreds of billions of thin-air money into the markets.  The only problem is that there's no clear exit strategy for the Fed.

Putting money into the markets is a very easy thing for the Fed to do.  Letting rope let out under full sail is easy; tugging it back in is difficult.

The Fed faces a similar asymmetry.  Market participants are always eager to take fresh money hot off the press.  An infinite number of things can be done with that money almost instantly.  But coming up with money to give back to the Fed for Treasury of MBS paper?  All sorts of difficulties arise.

"Wait, we'd have to sell a lot of things to free up that kind money and what, exactly, are you proposing to hand us in return? Treasuries? Um, no thanks, not right now. Agency debt? Uh, no, that doesn't fit our portfolio needs right now either.  Perhaps next week?"

Further, when the Fed goes to get its money back from the marketplace, that action will drain liquidity, creating ripples throughout all sorts of markets, especially and including knocking the stock market down.  Very few people complain about adding thin-air money; a crowd roars its disapproval for the reverse.

Too Late

The bottom line is that by the time the Fed becomes institutionally aware that inflation is raging across the globe - and I often wonder when they'll finally awake to the threat - it will be too late.  Inflation will have the momentum, and it will take a vast overreaction on the part of the Fed to restrain it.  They'll have to drain enormous amounts of liquidity and tolerate vastly higher interest rates to be able to do that, and I doubt they have the courage for such bold action.  I think they will hesitate, equivocate, and ultimately be late.

History suggests that inflation is best tamed early, but the Fed is already late and demonstrating a remarkable callousness by doing the exact opposite of fighting inflation.  While we cannot know what it is that the Fed sees, or which demons it is fighting that provide the internal rationalization for risking a hyperinflationary outcome, we can only conclude that these threats are more spectacular than the alternatives.  

Unfortunately, these events conform to the main themes that I have been writing and advising about for the past several years.  Sadly, they are not a surprise at all; the only mystery to me so far is how they have managed to carry on as long as they have.

Events of the past few weeks - unrest in Tunisa/Egypt/Jordan, skyrocketing food prices, Dow cracking a 2-year high, dropping dollar with rising bond yields - make me even more confident in the conclusions of my recent report on How This Will All End (published January 12) in which I derive a calculated estimate of when a final fiscal deterioration will overwhelm even the best of intentions. While the money-printing-induced high we're currently on may feel fun today, the unavoidable inflationary smackdown we'll experience tomorrow most certainly will not. 

Click here to read the report on How This Will All End (free executive summary, enrollment required for full access)

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23 Comments

Lemonyellowschwin's picture
Lemonyellowschwin
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Re: How long can the party in stocks last?

Thanks for the insight Chris.

On the one hand I see and get what you say about inflation already being here in one sense.  On the other hand, I don't get the sense that price inflation is really an issue in the public eye nor that it is anywhere remotely near the issue now that you expect it to be later.  Do you have a gut sense of when price inflation will really start to "hit home" in the sense that it becomes a front page issue and an immediate concern to the average person on the street?  I mean, are we talking 6 months or 5 years, or is it just unknowable?

I'd also like to comment on the fact that PMs seem to have been especially volatile in the last couple of weeks.  It seems like we are seeing daily price swings on the order of a couple of percent every day.  Does there seem to be a ready explanation for this?

Travlin's picture
Travlin
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Re: How long can the party in stocks last?

Chris Martenson wrote:

While we cannot know what it is that the Fed sees, or which demons it is fighting that provide the internal rationalization for risking a hyperinflationary outcome, we can only conclude that these threats are more spectacular than the alternatives.  

The only answer that makes sense to me is the Fed is still “fighting the last war” of deflation, as the US experienced it during the Great Depression.  Shadowstats.com has a graph of M1, M2, and M3 that supports this idea.  All three measures started trending up about the time the Fed released trial balloons in mid 2010 for QEII.  I can’t copy the graph so here is the link.  http://www.shadowstats.com/alternate_data/money-supply-charts  

Memories of hyperinflation in Europe have resulted in the opposite course of imposing austerity.

My knowledge of these matters is pretty limited, so I would appreciate anyone’s thoughts.  Good report Chris.

Travlin 

Rector's picture
Rector
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Re: How long can the party in stocks last?

Chris,

The one thing that strikes me most about your analysis is this part:

"The bottom line is that by the time the Fed becomes institutionally aware that inflation is raging across the globe - and I often wonder when they'll finally awake to the threat - it will be too late.  Inflation will have the momentum, and it will take a vast overreaction on the part of the Fed to restrain it.  They'll have to drain enormous amounts of liquidity and tolerate vastly higher interest rates to be able to do that, and I doubt they have the courage for such bold action.  I think they will hesitate, equivocate, and ultimately be late."

I just can no longer accept the idea that the Fed is unaware of the inflationary pressures they are creating.  I know what they say publicly (the caviar on the chin moment), but they HAVE to be smarter than this.  Somebody over there has to be watching everything that we are watching and letting the boss know.

THEREFORE, the Fed must be acting intentionally, and I do NOT want to hear from anyone about conspiracies.  So why?  I am guessing it has something to do with the following:

1.  They actually understand the fiscal debt trap, know the government can't change its ways, and are trying to eliminate the debt through inflation.

2.  They are trying to screw China over to fix the trade imbalance.

3.  They are purposely (and criminally) favoring the well-being of banks over the national good.

I need to think they are doing this on purpose because the idea that they are unaware is far more disturbing.  Does anyone know why they are destroying our currency?

Rector

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JAG
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Re: How long can the party in stocks last?

It looks like Machinehead's dreaded "mother-of-all head & shoulders pattern" may be forming here in the markets. If true, I guess that puts the downside target for the Dow under 1000-ish? And with retail investors now worried about "missing out" instead of losing everything, the time for such a reversal is approaching.

I miss Machinehead, and Davos too.

nickbert's picture
nickbert
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Re: How long can the party in stocks last?

Chris-

Just thought you might find this of interest regarding another 'party in stocks'.....

I was talking with my sister-in-law last weekend and she told me that the Mongolian Stock Exchange has been skyrocketing for the last year or so, and especially since the start of 2011.  It's a very small exchange, and as this article describes it's located in an amusing little pink building next to Sukhbaatar Square.  

http://blogs.ft.com/beyond-brics/2011/01/27/mongolia-the-pink-house-of-rising-equities/

This is the Mongolian Stock Exchange, where share prices climbed 121 per cent in local currency terms in 2010 – more than any other market tracked by beyondbrics – and have jumped another 50 per cent this year.

.........

Driving this growth has been an inflow of new capital, say investors, primarily from foreign funds that are looking to increase their exposure to the Mongolia story.

While my in-laws and other local investors are pleased with this turn of events, it's very unusual to see this much growth and it has them a little concerned.  When asked about it, I told them I'm just guessing but I SUSPECT much of it is due to the money printing happening in the US and elsewhere, and all that money is desperately looking for places to go.  And since the Mongolian exchange is small to begin with, even modest amounts of this printed money could have an overwhelming effect.  Your QE1 and QE2 charts above appear to support that suspicion, as the timeframe of the stock boom roughly correlates with the Fed's quantitative easing:

http://www.mse.mn/   

It's in Mongolian, but the chart is right on the main page (notice the huge jump just in the past month).  The fundamental prospects of the Mongolian economy are good, but fundamentals alone seem insufficient to explain the insane climb.  And on a side note, this is all in spite of the Mongolian currency appreciating by some 17% against the dollar in the past year.

- Nickbert

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Re: How long can the party in stocks last?

Chris Martenson wrote:

While we cannot know what it is that the Fed sees, or which demons it is fighting that provide the internal rationalization for risking a hyperinflationary outcome, we can only conclude that these threats are more spectacular than the alternatives.  

Here is my second explanation.  The US Government can’t find enough lenders, at artificially low interest rates, to fund it’s deficit and debt.  It can’t afford to pay real market rates without cutting other expenditures more than would be tolerated politically.  The US deficit, at 10% of GDP, is all that keeps us in a “disguised depression” instead of an open one.  So the Fed has to create money out of thin air, to buy the Treasuries, to keep the US Government afloat.  The Fed knows this will create massive inflation.  To them, it is still better than letting the US Government and GDP go down the tubes.  So we inflate our way out of the trap.  These are are all things Chris has been telling us all along.

The destruction of our individual wealth is just collateral damage.

Travlin 

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ReginaF's picture
ReginaF
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Re: How long can the party in stocks last?

Hi, LYS;

Inflation made it not on the front-page, but on a main page or more in Germanys Main Stream Press: There was a lot of coverage the last days. Especially fruit & vegetables (about 20-40 % more year over year) and other food (grains, wheat, milk, butter, cheese) as well as electricity, oil & shale gas (about 10-20 % was mentionend and a lot of people I spoke with saw and feel, how inflation is coming  - sometimes in stunning forms: New bought Jeans or cotton underwear seemed to be a shadow of their former selves, i.e. a lot less in weigh and quality, 1 roll of toilet paper weights 40-50 gr. less than the toilet paper which was bought at the end of 2009, household papier is now not anymore 29 cm long but only 24 cm and on and on it goes...

Best from Germany,

Regina

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Re: How long can the party in stocks last?

Chris had been saying that he expected a 30% chance of deflation and a 70% chance of inflation.

So has he definitely changed his mind  and now believes it is 100% chance of inflation?

The big question is what one does with one's financial assets. Advice?

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Re: How long can the party in stocks last?

JAG wrote:

It looks like Machinehead's dreaded "mother-of-all head & shoulders pattern" may be forming here in the markets. If true, I guess that puts the downside target for the Dow under 1000-ish? And with retail investors now worried about "missing out" instead of losing everything, the time for such a reversal is approaching.

I miss Machinehead, and Davos too.

Yeah, what happened to Davos and Machinehead?  I miss their onery-nesses, too!

thelorax's picture
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Re: How long can the party in stocks last?
Saw this article in the Financial Times.  Here's the headline and 2 clips:

Fed passes China in Treasury holdings

By Michael Mackenzie in New York

Published: February 2 2011 00:01 | Last updated: February 2 2011 00:01

The Federal Reserve has surpassed China as the leading holder of US Treasury securities even though it has yet to reach the halfway mark in its latest round of quantitative easing, according to official figures.....

...“By June [the Fed] will have accumulated some $1,600bn of Treasury securities, likely to be in the vicinity of China and Japan’s combined holdings,” said Richard Gilhooly, a strategist at TD Securities. “The New York Fed surpassed China in the past month as the largest holder of US Treasury securities,” he noted

http://www.ft.com/cms/s/0/120372fc-2e48-11e0-8733-00144feabdc0.html#axzz...

(registration req'd)

If what Richard Gilhooly says in the above quote is true, and by June the Fed has something in the vacinity of China and Japan's holdings COMBINED, and THEN they launch QE3....I just wonder when the bond market psychology will shift....but then if the alternative is a much more serious downturn, they (we) and between a rock and a hard place...a big rock and a very hard place.

thelorax

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Re: How long can the party in stocks last?

PastTense wrote:

The big question is what one does with one's financial assets. Advice?

One of the best investments I've made is subscribing to this site and supporting Dr M's work.

There is more financial advice over in the subscriber area.

SingleSpeak's picture
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Re: How long can the party in stocks last?

PastTense wrote:

Chris had been saying that he expected a 30% chance of deflation and a 70% chance of inflation.

So has he definitely changed his mind  and now believes it is 100% chance of inflation?

Here is the answer to your first question.

Chris said, "Although, to be fair, I have always hedged that view somewhat, with a 70/30 split held for nearly 5 years that was recently amended to 80/20 (in 2010 shortly after QE II was announced)."

But, IMO chances are pretty likely that the revision to 100% won't take another 5 years.

SS

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Re: How long can the party in stocks last?

PastTense wrote:

Chris had been saying that he expected a 30% chance of deflation and a 70% chance of inflation.

So has he definitely changed his mind  and now believes it is 100% chance of inflation?

The big question is what one does with one's financial assets. Advice?

My official stance is still 80/20.  

Unofficially, I am very likely to move that goal post again towards greater, but not complete, certainty in favor of inflation.  

Why don't I just go "all in?"  For the reasons I mentioned, the primary one being that I have no idea what the Fed is going to do next.   Should they decide (or be forced by Chinese bond buyers) to prematurely terminate the QE II program and renounce all future printing ideas, then I would have to move the goal posts back towards deflation.

But, for reasons that I have laid out in numerous reports (many, but not all, require enrollment), the pressures to err on the side of inflation over deflation are numerous and powerful.  I think it would take a forcing function to set US officials on a different path than the one we are currently on, which is decidedly inflationary.

This is exactly the sort of thing that we spend more than a few cycles on around here, because the implications to each of us are rather profound.  

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Re: How long can the party in stocks last?

cmartenson wrote:

I think it would take a forcing function to set US officials on a different path than the one we are currently on, which is decidedly inflationary.

Would blocking a raising of the debt ceiling qualify as a forcing function? It's coming soon...

SteveW's picture
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Re: How long can the party in stocks last?

cmartenson wrote wrote:

As an aside, I used to track the Fed's thin-air money programs very closely, and if you had told me as recently as three years ago that the Fed would have been running 11-figure POMO operations each and every month, I would have told you it was unthinkably impossible.But here we are, that is exactly what is happening, and I am largely numb to the process, which worries me somewhat, as it means that my baseline has shifted.

I know exactly how you feel. I used to think $1 billion was a lot of money but now it takes a trillion for me to take notice. I guess $1 billion just won't buy what it used to.

Rector wrote:

THEREFORE, the Fed must be acting intentionally, and I do NOT want to hear from anyone about conspiracies.  So why?  I am guessing it has something to do with the following:

1.  They actually understand the fiscal debt trap, know the government can't change its ways, and are trying to eliminate the debt through inflation.

2.  They are trying to screw China over to fix the trade imbalance.

3.  They are purposely (and criminally) favoring the well-being of banks over the national good.

I agree the Fed has to know precisely what they are doing. I would favour #1 or #3, although since the government is beholden to the monetary power they coalesce into a single explanation with #2 as collateral damage.

My reading of the history of the financial crisis is of a battle between government and bankers. In February 2008 Northern Rock was nationalised by the British with shareholders and debt holders being wiped out, which was supported by the courts. The September 2008 meltdown in the US and Europe, Lehman, RBS, Barclays etc. was met with bailouts. Somehow in the 6 months between February and September the free market principle, that failed companies should be dissolved and the share/debt holders suffer the loss with economically critical companies being nationalized, was destroyed. This is not comspiracy theory but a simple reading of historical events where the documentation is yet to become public. So what happened? The US bankers and their supporters won the battle. There is now no way to effect a resolution of the financial crisis by means of a reset, the Fed is locked into QE devaluation and whether the bankers were criminal or merely looking out for their own best interests is subjectivie opinion.

Arthur Robey's picture
Arthur Robey
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Re: How long can the party in stocks last?

The availability of commodities has been decreasing since the industrial revolution.

Under duress the high priests of wealth distribution begin handing symbols of wealth (Cowry shells, cattle or cash) to the chieftains. 

I am going to be strong on commodities like food. 

My next purchase is a miserly motor bike that will make my future litre of fuel go further.

Arthur

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dbworld
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Re: How long can the party in stocks last?

Chris, thanks for the analysis. It made my day to see me quoted on your site. 

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007
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Re: How long can the party in stocks last?

Very well articulated piece Chris.  Thank you for putting so clearly.

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Re: How long can the party in stocks last?

Rector,

I think you hit the nail on the head.  I was scratching my head over some puzzling data on the Baltic Dry Index (BDI), which is a global index of the price of shipping goods in freighters.  When the index drops down, that means that the price of shipping goes down and one can then infer that the demand for shipping goods is dropping, which in turn means that economic activity around the world is dropping. The index has lost 75% of its value since June 2010, but yet the stock and commodity markets are all going up.  Below you can see a chart of the ratio SP500/BDI.  It shows two distinct spikes. The first one happened during the October crash of 2008 when the BDI crashed faster than the SP500 and caused a high ratio.  Today, we are again seeing that another spike is forming with the SP500 rising while the BDI is crashing.  How could markets be going up while the demand for shipping goods around the world be going down.  I couldn't understand why this was happening until I read this article.

Ratio of SP500/Baltic Dry Index

And your comments put the whole story together.  Stock and commodity markets are rising because of QE. Speculation and manipulative trading by the big banks, flush with QE money are driving the prices up while the real economic demand for stocks and commodities is going down (based on the BDI).  The FED is doing this on purpose, because they are smart enough to see what you and I see.  As you say, the game plan is to use QE to drive markets up, create inflation, devalue the $US, increase the cost of Chinese goods, decrease the trade imbalance with China, devalue the US debt owned by China and the rest of the world. The monetary war on China is in full swing. As you said, they are devaluing debt through inflation.  And of course, they are favoring the banks, because the FED is composed entirely of banks. They aren't even a U.S. government agency, and the $US dollar is not a government issued dollar. It is a FEDERAL RESERVE note.  The FED controls more things in this world than most people can even dream of.

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Re: How long can the party in stocks last?

Clearly the FED knows that QE is an all-in gamble. What do they hope to accomplish?

1) Keeping the economy from freezing up into the mother of all ice ages

2) Fight back with China that stubbornly refuse to let the free market value their currency

3) Hope that the free money will jump start true economic growth in the US

We all know and talked about the risk of this strategy. My opinion is that this plan has a decent change of working if the government get out of the way and allow small business to become the incubators of the US economic recovery.

tara Holbrook's picture
tara Holbrook
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Re: How long can the party in stocks last?

the party in stocks bewildered me also.  i think the explanation is twofold.  investors are beginning to recognize that bonds particularly municipal bonds are risky.  commodities, gold and silver are not large asset classes exciting as they have been of late.  that leaves stocks as the major beneficiaries of QE2. don't forget corporations have lots of cash and small business are having trouble borrowing (greedy banks, new regs and increased taxes.)  maybe its this simple.

taraH

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One of the best "Marriages

One of the best "Marriages of Convenience" I have witnessed in a long time. It will not be long before the wedding cake paralyses the country from the neck down. The golden handcuff will be thrown across the room along with the cutlery and the bags will be packed and thrown out on the lawn.  The minors sitting on the cross benches will have their santa sack full of goodies to stuff down their collective electorates throats and the country will suffer under this melting pot of political idealism.

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