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Running Out of Pixie Dust

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On September 18 of 2008, I pointed out that exactly one year earlier, Jon Markman of MSN.com noted that the Federal Reserve had been using “duct tape and pixie dust” to hold the economy together.  In fact, there were plenty of people who knew that our Titanic financial system was headed for an iceberg at full speed – long before September of 2008.  In October of 2006, Ambrose Evans-Pritchard of the Telegraph wrote an article describing how Treasury Secretary Hank Paulson had re-activated the Plunge Protection Team (PPT):

Mr Paulson has asked the team to examine “systemic risk posed by hedge funds and derivatives, and the government’s ability to respond to a financial crisis”.

“We need to be vigilant and make sure we are thinking through all of the various risks and that we are being very careful here. Do we have enough liquidity in the system?” he said, fretting about the secrecy of the world’s 8,000 unregulated hedge funds with $1.3 trillion at their disposal.

Among the massive programs implemented in response to the financial crisis was the Federal Reserve’s quantitative easing program, which began in November of 2008.  A second quantitative easing program (QE 2) was initiated in November of 2010.  The next program was “operation twist”.  Last week, Jon Hilsenrath of the Wall Street Journal discussed the Fed’s plan for another bit of magic, described by economist James Hamilton as “sterilized quantitative easing”.  All of these efforts by the Fed have served no other purpose than to inflate stock prices.  This process was first exposed in an August, 2009 report by Precision Capital Management entitled, A Grand Unified Theory of Market ManipulationMore recently, on March 9, Charles Biderman of TrimTabs posted this (video) rant about the ongoing efforts by the Federal Reserve to manipulate the stock market.

At this point, many economists are beginning to pose the question of whether the Federal Reserve has finally run out of “pixie dust”.  On February 23, I mentioned the outlook presented by economist Nouriel Roubini (a/k/a Dr. Doom) who provided a sobering counterpoint to the recent stock market enthusiasm in a piece he wrote for the Project Syndicate website entitled, “The Uptick’s Downside”.  I included a discussion of economist John Hussman’s stock market prognosis.  Dr. Hussman admitted that there might still be an opportunity to make some gains, although the risks weigh heavily toward a more cautious strategy:

The bottom line is that near-term market direction is largely a throw of the dice, though with dice that are modestly biased to the downside.  Indeed, the present overvalued, overbought, overbullish syndrome tends to be associated with a tendency for the market to repeatedly establish slight new highs, with shallow pullbacks giving way to further marginal new highs over a period of weeks.  This instance has been no different.  As we extend the outlook horizon beyond several weeks, however, the risks we observe become far more pointed.  The most severe risk we measure is not the projected return over any particular window such as 4 weeks or 6 months, but is instead the likelihood of a particularly deep drawdown at some point within the coming 18-month period.

In December of 2010, Dr. Hussman wrote a piece, providing “An Updated Who’s Who of Awful Times to Invest ”, in which he provided us with five warning signs:

The following set of conditions is one way to capture the basic “overvalued, overbought, overbullish, rising-yields” syndrome:

1) S&P 500 more than 8% above its 52 week (exponential) average
2) S&P 500 more than 50% above its 4-year low
3) Shiller P/E greater than 18
4) 10-year Treasury yield higher than 6 months earlier
5) Advisory bullishness > 47%, with bearishness < 27%

On March 10, Randall Forsyth wrote an article for Barron’s, in which he basically concurred with Dr. Hussman’s stock market prognosis.  In his most recent Weekly Market Comment, Dr. Hussman expressed a bit of umbrage about Randall Forsyth’s remark that Hussman “missed out” on the stock market rally which began in March of 2009:

As of last week, the market continued to reflect a set of conditions that have characterized a wicked subset of historical instances, comprising a Who’s Who of Awful Times to Invest .  Barron’s ran a piece over the weekend that reviewed our case.  It’s interesting to me that among the predictable objections (mostly related to our flat post-2009 performance, but overlooking the 2000-2009 record), none addressed the simple fact that the prior instances of this condition have invariably turned out terribly.  It seems to me that before entirely disregarding evidence that is as rare as it is ominous, you have to ask yourself one question.  Do I feel lucky?

*   *   *

Investors Intelligence notes that corporate insiders are now selling shares at levels associated with “near panic action.”  Since corporate insiders typically receive stock as part of their compensation, it is normal for insiders to sell about 2 shares on the open market for every share they purchase outright.  Recently, however, insider sales have been running at a pace of more than 8-to-1.

*   *   *

While investors and the economic consensus has largely abandoned any concern about a fresh economic downturn, we remain uncomfortable with the divergence between reliable leading measures – which are still actually deteriorating – and more upbeat coincident/lagging measures on which public optimism appears to be based.

Nevertheless, Randall Forsyth’s article was actually supportive of Hussman’s opinion that, given the current economic conditions, discretion should mandate a more risk-averse investment strategy.  The concluding statement from the Barron’s piece exemplified such support:

With the Standard & Poor’s 500 up 24% from the October lows, it may be a good time to take some chips off the table.

Beyond that, Mr. Forsyth explained how the outlook expressed by Walter J. Zimmermann concurred with John Hussman’s expectations for a stock market swoon:

Walter J. Zimmermann Jr., who heads technical analysis for United-ICAP, a technical advisory firm, puts it more succinctly:  “A perfect financial storm is looming.”

*   *   *

THERE ARE AMPLE FUNDAMENTALS to knock the market down, including the well-advertised surge in gasoline prices, which Zimmermann calculates absorbed the discretionary spending power for half of America.  And the escalating tensions over Iran’s nuclear program “is the gift that keeps on giving…if you like fear-inflated energy prices,” he wrote in the client letter.

At the same time, “the euro-zone response to their deflationary debt trap continues to be further loans to the hopelessly indebted, in return for crushing austerity programs.

So, evidently, not content with another mere recession, euro-zone leaders are inadvertently shooting for another depression.  They may well succeed.”

The euro zone is (or was, he stresses) the world’s largest economy, and a buyer of 22% of U.S. exports, which puts the domestic economy at risk, he adds.

Given the fact that the Federal Reserve has already expended the “heavy artillery” in its arsenal, it seems unlikely that the remaining bit of pixie dust in Ben Bernanke’s pocket – “sterilized quantitative easing” – will be of any use in the Fed’s never-ending efforts to inflate stock prices.


 

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Where The Money Is

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June 1, 2009

For the past few months we have been hearing TV “experts” tell us that “it’s almost over” when discussing the Great Recession.  Beyond that, many of the TV news-readers insist that the “bear market” is over and that we are now in a “bull market”.  In his new column for The Atlantic (named after his book A Failure of Capitalism) Judge Richard A. Posner is using the term “depression” rather than “recession” to describe the current state of the economy.  In other words, he’s being a little more blunt about the situation than most commentators would care to be.  Meanwhile, the “happy talk” people, who want everyone to throw what is left of their life savings back into the stock market, are saying that the recession is over.  If you look beyond the “good news” coming from the TV and pay attention to who the “financial experts” quoted in those stories are … you will find that they are salaried employees of such companies as Barclay’s Capital and Charles Schwab  … in other words:  the brokerages and asset managers who want your money.   A more sober report on the subject, prepared by the National Association for Business Economics (NABE) revealed that 74 percent of the economists it surveyed were of the opinion that the recession would end in the third quarter of this year.  Nineteen percent of the economists surveyed by the NABE predicted that the recession would end during the fourth quarter of 2009 and the remaining 7 percent opined that the recession would end during the first quarter of 2010.

Some investors, who would rather not wait for our recession to end before jumping back into the stock market, are rapidly flocking to what are called “emerging markets”.  To get a better understanding of what emerging markets are all about, read Chuan Li’s (mercifully short) paper on the subject for the University of Iowa Center for International Finance and Development.  The rising popularity of investing in emerging markets was evident in Fareed Zakaria’s article from the June 8 issue of Newsweek:

It is becoming increasingly clear that the story of the global economy is a tale of two worlds.  In one, there is only gloom and doom, and in the other there is light and hope.  In the traditional bastions of wealth and power — America, Europe and Japan — it is difficult to find much good news.  But there is a new world out there — China, India, Indonesia, Brazil — in which economic growth continues to power ahead, in which governments are not buried under a mountain of debt and in which citizens remain remarkably optimistic about their future.  This divergence, between the once rich and the once poor, might mark a turn in history.

*    *    *

Compare the two worlds.  On the one side is the West (plus Japan), with banks that are overleveraged and thus dysfunctional, governments groaning under debt, and consumers who are rebuilding their broken balance sheets. America is having trouble selling its IOUs at attractive prices (the last three Treasury auctions have gone badly); its largest state, California, is veering toward total fiscal collapse; and its budget deficit is going to surpass 13 percent of GDP —  a level last seen during World War II.  With all these burdens, even if there is a recovery, the United States might not return to fast-paced growth for a while.  And it’s probably more dynamic than Europe or Japan.

Meanwhile, emerging-market banks are largely healthy and profitable.  (Every Indian bank, government-owned and private, posted profits in the last quarter of 2008!)  The governments are in good fiscal shape.  China’s strengths are well known — $2 trillion in reserves, a budget deficit that is less than 3 percent of GDP — but consider Brazil, which is now posting a current account surplus.

On May 31, The Economic Times reported similarly good news for emerging markets:

Growth potential and a long-term outlook for emerging markets remain structurally intact despite cyclically declining exports and capital outflows, a research report released on Sunday said.

According to Credit Suisse Research’s latest edition of Global Investor, looking forward to an eventual recovery from the current crisis, growth led by domestic factors in emerging markets is set to succeed debt-fuelled US private consumption as the most important driver of global economic growth over coming years.

The Seeking Alpha website featured an article by David Hunkar, following a similar theme:

Emerging markets have easily outperformed the developed world markets since stocks rebounded from March this year. Emerging countries such as Brazil, India, China, etc. continue to attract capital and show strength relative to developed markets.

On May 29, The Wall Street Journal‘s Smart Money magazine ran a piece by Elizabeth O’Brien, featuring investment bargains in “re-emerging” markets:

As the U.S. struggles to reverse the economic slide, some emerging markets are ahead of the game.  The International Monetary Fund projects that while the world’s advanced economies will contract this year, emerging economies will expand by as much as 2.5 percent, and some countries will grow a lot faster.  Even better news:  Some pros are finding they don’t have to pay a lot to own profitable “foreign” stocks.  The valuations on foreign stocks have become “very, very attractive,” says Uri Landesman, chief equity strategist for asset manager ING Investment Management Americas.

As for The Wall Street Journal itself, the paper ran a June 1 article entitled: “New Driver for Stocks”, explaining that China and other emerging markets are responsible the rebound in the demand for oil:

International stock markets have long taken their cues from the U.S., but as it became clear that emerging-market economies would hold up best and rebound first from the downturn, the U.S. has in some ways moved over to the passenger seat.

Jim Lowell of MarketWatch wrote a June 1 commentary discussing some emerging market exchange-traded funds (ETFs), wherein he made note of his concern about the “socio-politico volatility” in some emerging market regions:

Daring to drink the water of the above funds could prove to be little more than a way to tap into Montezuma’s revenge.  But history tells us that investors who discount the rewards are as prone to disappointment as those who dismiss the risks.

On May 29, ETF Guide discussed some of the exchange-traded funds focused on emerging markets:

Don’t look now, but emerging markets have re-discovered their mojo.  After declining more than 50 percent last year and leading global stocks into a freefall, emerging markets stocks now find themselves with a 35 percent year-to-date gain on average.

A website focused solely on this area of investments is Emerging Index.

So if you have become too risk-averse to allow yourself to get hosed when this “bear market rally” ends, you may want to consider the advantages and disadvantages of investing in emerging markets.  Nevertheless, “emerging market” investments might seem problematic as a way of dodging whatever bullets come by, when American stock market indices sink.  The fact that the ETFs discussed in the above articles are traded on American exchanges raises a question in my mind as to whether they could be vulnerable to broad-market declines as they happen in this country.  That situation could be compounded by the fact that many of the underlying stocks for such funds are, themselves, traded on American exchanges, even though the stocks are for foreign corporations.  By way of disclosure, as of the time of writing this entry, I have no such investments myself, although by the time you read this  . . .   I just might.

Update: I subsequently “stuck my foot in the water” by investing in the iShares MSCI Brazil Index ETF (ticker symbol: EWZ).  Any guesses as to how long I stick with it?

June 3 Update: Today the S&P 500 dropped 1.37 percent and EWZ dropped 5.37 percent — similar to the losses posted by many American companies.   Suffice it to say:  I am not a happy camper!  I plan on unloading it.

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