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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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The Invisible Bank Bailout

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August 23, 2010

By now, you are probably more than familiar with the “backdoor bailouts” of the Wall Street Banks – the most infamous of which, Maiden Lane III, included a $13 billion gift to Goldman Sachs as a counterparty to AIG’s bad paper.  Despite Goldman’s claims of having repaid the money it received from TARP, the $13 billion obtained via Maiden Lane III was never repaid.  Goldman needed it for bonuses.

On August 21, my favorite reporter for The New York Times, Gretchen Morgenson, discussed another “bank bailout”:  a “secret tax” that diverts money to banks at a cost of approximately $350 billion per year to investors and savers.  Here’s how it works:

Sharply cutting interest rates vastly increases banks’ profits by widening the spread between what they pay to depositors and what they receive from borrowers.  As such, the Fed’s zero-interest-rate policy is yet another government bailout for the very industry that drove the economy to the brink.

Todd E. Petzel, chief investment officer at Offit Capital Advisors, a private wealth management concern, characterizes the Fed’s interest rate policy as an invisible tax that costs savers and investors roughly $350 billion a year.  This tax is stifling consumption, Mr. Petzel argues, and is pushing investors to reach for yields in riskier securities that they wouldn’t otherwise go near.

*   *   *

“If we thought this zero-interest-rate policy was lowering people’s credit card bills it would be one thing but it doesn’t,” he said.  Neither does it seem to be resulting in increased lending by the banks.  “It’s a policy matter that people are not focusing on,” Mr. Petzel added.

One reason it’s not a priority is that savers and people living on fixed incomes have no voice in Washington.  The banks, meanwhile, waltz around town with megaphones.

Savers aren’t the only losers in this situation; underfunded pensions and crippled endowments are as well.

Many commentators have pointed out that zero-interest-rate-policy (often referred to as “ZIRP”) was responsible for the stock market rally that began in the Spring of 2009.  Bert Dohmen made this observation for Forbes back on October 30, 2009:

There is very little, if any, investment buying.  In my view, we are seeing a mini-bubble in the stock market, fueled by ZIRP, the “zero interest rate policy” of the Fed.

At this point, retail investors (the “mom and pop” customers of discount brokerage firms) are no longer impressed.  After the “flash crash” of May 6 and the revelations about stock market manipulation by high-frequency trading (HFT), retail investors are now avoiding mutual funds.  Graham Bowley’s recent report for The New York Times has been quoted and re-published by a number of news outlets.   Here is the ugly truth:

Investors withdrew a staggering $33.12 billion from domestic stock market mutual funds in the first seven months of this year, according to the Investment Company Institute, the mutual fund industry trade group.  Now many are choosing investments they deem safer, like bonds.

The pretext of providing “liquidity” to the stock markets is no longer viable.  The only remaining reasons for continuing ZIRP are to mitigate escalating deficits and stopping the spiral of deflation.  Whether or not that strategy works, one thing is for certain:  ZIRP is enriching the banks —  at the public’s expense.



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