How long can the party in stocks last?
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.
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.