Posts Tagged ‘correction’

On The June/August Market ‘Correction’, Obama And QE2

August 5, 2011

There was all kinds of questions and all kinds of answers regarding why the market has been crashing since July 21:

Dow falls 512 in steepest decline since 2008 crisis

NEW YORK (AP) — Gripped by fear of another recession, the financial markets suffered their worst day Thursday since the crisis of 2008. The Dow Jones industrial average fell more than 500 points, its ninth-steepest decline ever.

The sell-off wiped out the Dow’s gains for 2011. It put the Dow and broader stock indexes into what investors call a correction — down 10 percent from the highs of this spring.

The day was reminiscent of the wild swings that defined the markets during the crisis three years ago. Gold prices briefly hit a record high, oil fell an extraordinary $5 a barrel, and frightened investors were so desperate to get into some government bonds that they were willing to accept almost no return on their money.

It was the most alarming day yet in the almost uninterrupted selling that has swept Wall Street for two weeks. Since July 21, the Dow has lost more than 1,300 points, or 10.5 percent of its value. It has closed lower nine of the 10 trading days since then.

For the day, the Dow closed down 512.76 points, at 11,383.68. It was the steepest point decline since Dec. 1, 2008.

The “10% decline” is the tipping point that defines a “market correction.”

But what is being “corrected”?  The term “correction” implies that something was wrong that needed to be corrected.

Most of what I heard yesterday had to do with the ongoing fiscal crisis in the European Union, with the P.I.I.G.S. – Portugal, Ireland, Italy, Greece and Spain –  just getting uglier and uglier.

Greece was bad enough.  But now Italy is going into the crapper, and Italy is just “too big to bail,” to play off the phrase “too big to fail” that “justified” so many of the recent unprecedented bailouts.

I don’t doubt that the deteriorating situation in Europe is part of the crisis that is causing the gigantic selloff in the United States that is imploding all of our market indexes.  And of course I could now get up on my soapbox and point out that, given that this failed socialist model is crashing down in Europe, WHY THE HELL IS OBAMA AND THE DEMOCRAT PARTY DOING THE SAME CRAP HERE?!?!?

And of course, that is still a valid question.

But I have a different theory as to what is going on.

I think this major market reversal is merely a delayed result of the completely artificial levels created by QE2.  And QE2, of course, was the result of our own Obama Federal Reserve machinations.

Take a look at this (and notice it was written in May prior to the end of QE2 in June):

* The QE2 Counter-Play:

The end of Quantitative Easing Two (QE2) will occur at the end of June 2011. This article is designed to provide an area for focused discussions about the design of counter-plays for a potential sharp reduction in equity valuations.

* Why would the end of QE2 cause a sharp reduction in equity valuation? In other words, how does QE2 work?

Quantitative easing is a monetary policy used by the Fed to stimulate the US economy. The Fed buys government bonds and other financial assets with new money that the Fed creates (out of thin air), thus increasing the money supply and reserves of the banking system. This action raises the prices of the financial assets bought, which lowers their yield.

As the Fed systematically purchases a substantial volume of long-term Treasury bonds and other financial assets (i.e., equities), large financial institutions (i.e., bondholders) shift their wealth into equities to achieve a higher return. In other words, the Fed’s actions reduce risk in the equities market which makes equities a more sensible investment than bonds. So, simply put, the Fed puts large quantities of money into the markets, inflating the price of equities. Money follows money, and up the market goes.

The resulting rise in equity prices increases household wealth, providing a boost to consumer spending. Figure One clearly demonstrates the effect of quantitative easing.

Figure One

click to enlarge

Of course, a few data points do not constitute absolute proof that quantitative easing is causal to a stock-market rise, or that stock-market increases cause increases in consumer spending.

However, the timing of the stock-market rise, and the lack of any other reason for a sharp rise in consumer spending, makes that chain of events look very plausible. Figure One shows us that shortly after QE1 was announced, the market free fall began to stabilize. After the QE1 program was expanded from 600b to 1.725 trillion, the market sharply reversed. When QE1 ended, the market once again reversed with about a 20% drop. That’s 200 S&P points (2,000 Dow points) over a two month time period.

QE2 was then suggested, and the market reversed. At the moment of decision, the market hesitated, then QE2 was announced, and once again, the market sharply increased. The time line of these events is perhaps more clearly demonstrated in Figure Two.

Figure Two

Note that as the Fed buys Treasures, the yield stabilizes at about 3.5%. Figure Three demonstrates a clear association between the Fed purchases and commodity prices.

Figure Three

* Consumer Spending and Increases in Share Prices:

Note – the source for this section is based on a published interview with Martin Feldstein, Professor at Harvard.

The magnitude of the relationship between the stock-market rise and increases in consumer spending also fit the data. Share ownership (including mutual funds) of American households totals approximately $17 trillion. So a 15% rise in share prices increased household wealth by about $2.5 trillion.

Relationship Between Wealth and Consumer Spending:
Historically, the association between wealth and consumer spending implies that each $100 of incremental wealth raises consumer spending by about four dollars, so $2.5 trillion of additional wealth would be expected to raise consumer spending by roughly $100 billion. That figure matches closely with a drop in household saving and the resulting increase in consumer spending.

Since US households’ after-tax income totals $11.4 trillion, an one-percentage-point fall in the saving rate means a decline of saving and a corresponding rise in consumer spending of $114 billion – very close to the rise in consumer spending implied by the increased wealth that resulted from the gain in share prices.

None of this appears to augur well for 2011. There is no reason to expect the stock market to keep rising at the rapid pace of 2010. Quantitative easing is scheduled to end in June 2011, and the Fed is not expected to continue its massive purchases of Treasury bonds after that.

Without increases in stock-market wealth, will the savings rate continue to decline and the pace of consumer spending continue to rise more rapidly than GDP?

Will the strong economic growth at the end of 2010 be enough to propel more spending by households and businesses in 2011, even though house prices continue to fall and the labor market remains weak? And does artificial support for the bond market and equities mean that we are looking at asset-price bubbles that may come to an end before the year is over?

* The Hedge Shack:

So what does the investor do? Based on what happened at the end of QE1, it appears we can anticipate a 15% to 20% drop in the overall market. Are their any market sectors that would provide safety?

I’ve discussed quantitative easing.  As an example, I said on May 9:

QE2 is the economic equivalent of sugar in nutrition. Will it provide quick energy? Sure it will. Will that quick energy come at the expense of future health? You bet it will.

Right now, as a result of the Obama Federal Reserve’s policy of increasing the monetary supply by buying debt from itself (literally creating money out of thin air), there is more economic activity. Right now, as a result of this policy, credit rates are lower. Fewer banks and corporations are going under because of the ready access to cheap money. Investors see the stability and invest.

We should all feed our children tons of sugar, so we can enjoy the short term bonanza of frenetic activity.

Unless you worry about all the cavities, the weight gains, the diabetes, and of course that huge depressing crash with all of those catastrophic health consequences that necessarily come later.

The first time we ended QE1, the stock market lost 16% of its value in two weeks. Which is to say it didn’t work the first time for the same reason it won’t work this second time. Or a necessary third time, etcetera.

Talking about this new Keynesian tactic of quantitative easing with a financial whiz is kind of like the opposite side of talking to a financial whiz about gold.  Gold is routinely pooh-poohed by financial whizzes because if people bought gold, they wouldn’t need all of the damned financial whizzes, now would they?

Now, let’s just say for the sake of argument that you were watching the Democratic National Convention in August of 2008 and came to the belief that the mainstream media coverage was so blatantly biased and dishonest that Barack Obama was going to win the election.  And you had a vision of the sheer smackdown that would happen in this “God damn America.”

So you made an appointment with your portfolio manager and told her you wanted to cash out all of your stock holdings so you could put your investment nest egg into silver and gold.

What do you expect your portfolio manager would say?  Do the words, “This is a big mistake.  Trust me, the stock market is not going to collapse.  The average gains of the stock market invariably outperform gold indices.  Blah blah blah.”  The bottom line is that if you pull your money out of the fund she manages, she’s not going to get any more of your money.

Well, the fool who did that would have bought all kinds of silver at about $13 an ounce and gold at about $825 an ounce.  And that fool would have more than doubled his money while everybody else lost their shirt, then got part of their shirt back if they played the game right, then lost their shirt again.

And, of course, if that fool happened to be watching CNBC yesterday, he would have listened and laughed as the same sort of experts pooh-poohed gold because it went up in value to an all-time high before taking something like a $30/ounce hit.  And the smart guys said, “See what happens when you put your money in gold and silver?”

And the fool was thinking, “Yeah.  I more than double my money and laugh like a drunk monkey while everybody else runs around screaming like a bunch of Chicken Littles.”

It’s pretty much the same sort of thing with quantitative easing.  Only it’s a lot more technical, and you’ve got to be a whole lot smarter and a whole lot more informed to make any money before the whole economy comes crashing down.  And in the age of quantitative easing, boy do you ever need your financial whiz kid to help you plot your course

QE1 and QE2 were abject disasters.  And I don’t doubt for a second that the “correction” that we saw yesterday – and from all accounts will see again today given the Asian market bloodbath – was in large part a delayed reaction to the end of the sugar high of QE2.  Particularly given that Fed Chairman Ben Bernanke said, “There will be no QE3 for the moment, but QE2 won’t come to an abrupt halt at the end of June either.”  Which is to say that nobody really knew when to start the selloff after the end of the last sugar high.

But what do I know (or the above fool, for that matter?)?

But here we are – all promises aside – at the door to QE3:

ROUBINI: QE3 Has Begun
Joe Weisenthal|Aug. 4, 2011, 7:05 AM

With markets tanking, and the economy weakening, buzz about the Fed doing QE3 has really heated up.

The FOMC meets next week, and the Jackson Hole conference (where QE2 was announce) happens soon thereafter.

But arguably, the next round of general easing has begun.

Yesterday at 3:00 AM the Swiss lowered interest rates to stem the rise of the Franc, and last night Japan intervened to make its currency weaker.

And then today, the ECB confirmed more bond buying, so however you slice it, the central banks are back into easing mode.

On Twitter, Nouriel Roubini declares that the latest currency interventions from Switzerland and Japan represent the start of QE3, ultimately ending in more Fed easing

Here’s a video that is just looking more and more likely to be history before the event: