Tuesday, May 11, 2010

Liquidity from Euro Rescue Pumps Up Stock Market

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

As I have said many times, liquidity is ultimately the driver of stock prices. A perfect illustration of that took place on Monday when a trillion dollar rescue package was announced for the euro before the market opened. After finding out about the latest big liquidity injection into the global financial system, traders went wild and the Nasdaq gapped up 100 points. Huge volatility though is rarely a good sign for the stock prices going forward.

The extreme move up could be seen as a positive event, if the problems in the eurozone will actually be solved by the recently announced euro rescue package. This is unlikely. First the need for a large-scale regional bailout indicates that we are still suffering from conditions that arose during the Credit Crisis. These have been papered over by previous massive bailouts that have paused the problems the world faces, but have not created long-term solutions for them.  Spending more money on bailouts means printing more money and this will ultimately have unpleasant consequences down the road.

Investors need to realize that the euro rescue effort is a bailout for the big banks, the ultimate beneficiaries of the many trillions spent previously by government  and central bank Credit Crisis programs. The debt crisis in Greece could have been solved instantly and without spending one penny on a bailout, if dollarization had been used to deal with the problem. Under this approach, Greece would have been allowed to continue to use the euro, but been kicked out of the currency union. This would have prevented contagion to the entire eurozone and markets worldwide. It would have cost nothing. Instead, we now have another trillion-dollar bailout to rescue the global financial system.

The euro rescue package consists of three parts. The biggest part is $560 billion in new loans from the 16 countries that are part of the eurozone. Of those 16 however, five - Greece, Portugal, Ireland, Spain and Italy (the so called PIIGS) are troubled. So it might be more accurate to say that these loans are really from the 11 more solvent countries in the currency union. The second part of the package is $318 billion from the IMF. The IMF is controlled by the United States from which it gets around 40% of its funding (if not more). So American taxpayers are participating in bailing out Europe for its misdeeds and incompetence. The third and smallest part of the rescue program is a $76 billion lending facility from the European Commission.

The huge gaps up in stock prices on Monday morning came after a short-lived market meltdown in U.S. stocks the previous Thursday. In a span of 16 minutes, the Dow Jones Industrial Average dropped 700 points and then rose 700 points. The Dow essentially opened up 400 points higher on Monday morning. Healthy markets don't have multiple big moves up and down, especially within a short period of time. Sudden big drops in the spring can frequently lead to much bigger drops in the fall. Recovery in the middle, usually lulls investors into a false sense of security. You may want to think about that while you're relaxing at the beach this summer.

Disclosure: None relevant.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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