Should Stocks be Rallying on Hopes of QE3?

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.  


Stocks have rallied significantly since August 10th on the hopes that the Federal Reserve will engage in a third round of quantitative easing (QE) -- a form of money printing. While QE1 and QE2 were successful in juicing stock prices, this is not what the Fed is supposed to be doing.

The Fed's current mandate was established by the U.S. Congress in 1977 in the Federal Reserve Reform Act. This legislation requires the Fed to establish a monetary policy that "promotes maximum employment, stable prices and moderate long-term interest rates". Manipulating stock prices is not supposed to be on the Fed's agenda. Quantitative Easing was unknown in 1977 and was therefore not specifically addressed by Congress.

If anything,the Fed has significantly overshot in its goal to keep long-term rates moderate. The Fed Funds rate has been kept at around zero percent since December 2008. The Fed has stated it will maintain this rate until 2013. The interest rate on the 10-year treasury fell below 2.00% at one point this August -- a record low. Two-year rates fell below 0.20%, also record lows and well below the bottom rate during the Credit Crisis. Low interest rates indicate an economy in recession and not deflation as is commonly claimed in the mainstream press. Maintaining interest rates at a low level for too long is inflationary however.

The Fed announced its first quantitative easing program in November 2008 (according to an analysis of its balance sheet, it was begun somewhat earlier). The second round ended this June. How has the employment situation changed during the two rounds of QE?  When QE1 started in November 2008, the official U.S. unemployment rate was 6.8%. When it ended in June 2011, it was 9.2%. The high was 10.1% in October 2009. The post-World War II average has been 5.7% and unemployment has fallen to the 3% range when the economy is strong. With respect to employment, quantitative easing seems to have been a failure.

So what about price stability, the Fed's other mandate? While the inflationary effects of quantitative easing are most evident in commodity prices, the typical American consumer has seen them in gasoline, food and clothing prices. The average price of gasoline was as low as $1.60 a gallon when the Fed started QE1 and it almost reached $4.00 a gallon during QE2. A number of commodities, including cotton and copper, hit all-time record-high prices during QE2. Gold, the ultimate measure of inflation,rose to one new price high after another. Silver went from under $10 an ounce to over $48 an ounce. Quantitative easing obviously hasn't led to price stability. In fact, it has resulted in much higher prices and is therefore counterproductive to the Fed's goal of limiting inflation.

There is no question that quantitative easing has helped the stock market and resulted in higher stock prices. This is not exactly a secret however and all Wall Street traders are well aware of it. They will therefore push stock prices higher if they think more quantitative easing is on the way and much of any rally that results will occur before it even takes place. Quantitative easing is also no panacea for stock prices. It doesn't insulate the market from external shocks. While it doesn't make crashes more likely, it will make them worse when they occur. A default on Greek, Spanish or Italian debt and any number of other crises will have greater impact than they would have ordinarily because the market has been pumped up to artificially high levels. The market has also become dependent on quantitative easing and has not been able to rally since late 2008 without it. Almost as soon as it stops, the market drops and those drops will become more serious after each succeeding round.

Disclosure: None

Daryl Montgomery
Author: "Inflation Investing - A Guide for the 2010s"
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

Will Fed Meeting Be a Turning Point for Stocks?

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.


The Fed has its August meeting today and stocks sold off in the morning despite media attempts to put a positive spin on the outcome. The latest phase of the rally that started in early July took place after Ben Bernanke admitted to congress that the U.S. economy was troubled. Stocks shouldn't have rallied on this news, but they did.

The stock market is supposed to be a leading indicator of the economy and should react to changes approximately six months in advance. This only works in a free market however. The more the authorities are fiddling with the financial system behind the scenes, the less stock prices will act as an early warning system. The bull market peaked in October 2007 for instance, but a recession began only two months later.

This time, U.S. stocks peaked on April 26th. May and June were bad months for the market. While stocks have not gotten back to their highs, they have been rallying since the beginning of July, when problems in the eurozone calmed down (thanks to a commitment of an almost trillion dollar bailout for the currency). The rally entered a second phase after Ben Bernanke testified before congress about the bleak prospects for the U.S. economy. The market sold off that day, but then mounted a rally on the bad news, which was supported by numerous economic reports showing the economy was turning down.

Why would anyone buy stocks when the economy was facing a possible recession? While this behavior doesn't make sense, a better question is: Who was buying stocks after this news came out? Based on the trading volume, not many market participants were entusiastic. With the exception of a few days of selling, the entire rally since early July has taken place on below average volume - a technical negative.

The 50-day moving average for volume has also been declining as well since early July. This is part of a greater trend that started in March 2009, when the bigger rally began. Volume peaked on the Dow Industrials when the market hit bottom and back then there were days when over 600 million shares were traded. More than a year later, a day when over 200 million shares traded would be considered good volume.

The market seems to be rallying on the hopes of Fed easing. With fed funds rates at zero, the traditional forms of easing are obviously no longer available. The Fed would have to engage in quantitative easing (a form of money printing), which would involve the purchase of treasury bonds and this would lower their interest rates. According to mainstream media reports, consumers and businesses would supposedly borrow and spend more money as a result. This is wishful thinking at best.

Even though the Fed has lowered interest rates to nothing and has effectively provided the big banks with free money, this has not been passed on to the consumer. Interest rates on credit cards were 14.55% in 2005 and in May 2010 they were 14.48% (see: http://www.federalreserve.gov/releases/g19/Current). Banks have not lowered their interest rates in response to the Fed's recent actions, but have pocketed the difference. This has been the major reason that they have been reporting such huge profits. It is naive to think that they are going to change their behavior.

Disconnects between markets and the underlying economy have happened many times. They don't last forever however. The two eventually have to meet. Either the economy improves to justify market pricing or market prices decline to meet the economy. The tech bubble at the end of the 1990s and the more recent real estate bubble were good excellent examples of this. Pricing that is too high will come back down to earth and the correction can last for years. Government attempts to try to hold up the market, as has happened with real estate prices, don't prevent the inevitable, they merely delay it. The current disconnect with stock prices and the economy will also self-correct and may do so suddenly. The only question is when it will occur.


Disclosure: No Positions.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

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.

Fed Sends a Message With Discount Rate Hike

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.


The U.S. Fed raised its discount rate after the market close on Thursday, February 18th. The rise in rates from 0.50% to 0.75% was characterized by the central bank as further normalization of the Fed's lending facilities. While the Fed's discount rate action is mostly symbolic, it raises the question of when the historically ultra-low fed funds rate will be normalized. As would be expected, the U.S. dollar rallied and gold sold down on the news.

The discount rate is not an important factor in control of money supply, but is the Fed's mechanism for getting money to banks when they are in crisis, either individually or because of a systemic shock. During the Credit Crisis the Fed created a number of new programs to temporarily accomplish this goal. Five of those programs were ended on February 1st. Another one, the TAF (Term Auction Facility), will have its final auction on March 8th. Prior to the Credit Crisis, the discount rate was usually a full percentage point above the fed funds rate. Even with the recent rise, it is only half to three-quarters point higher. We are still not yet back to the way things were pre-Credit Crisis. Fed Chair Bernanke has been saying the U.S. banking system was fixed for many months now. If that is the case, why has he waited so long to get the Fed's operations back to the way they have been historically when there is no crisis?

The last time the Fed began a major policy change was with a move in the discount rate. The Fed first cut this rate by 50 basis points in August 2007. One month later, it started lowering the fed funds rate and continued doing so until instituting its current zero to 0.25% rate policy in December 2008. While Bernanke's signature approach is to change the discount rate first, the time lag is likely to be longer than one month this time. Members of the Open Market Committe may already be losing their patience for ultra-low rates however. The Kansas City Fed Governor dissented at the January meeting on the fed's message of "exceptionally low levels of fed funds rates for an extended period". He wanted language that indicated something briefer.

Higher U.S. interest rates are of course bullish for the dollar. Although the U.S. will have to raise rates by 0.50% to be higher than Great Britain's rates, by 1.00% to outdo the euro zone, and by 3.75% to challenge Australian rates. The U.S. trade-weighted dollar continued its rally on the Fed news and is flirting with nine-month highs. The euro on the other hand fell as low as 1.3443 on the news. Technically, the dollar confirmed its rally with the 50-day moving average moving above the 200-day - a classic buy signal.  The euro has the opposite chart pattern and the 50-day average having dropped below the 200-day earlier this month. Gold held up better than expected. February is a month of strong seasonal buying for the metal and this has provided enough buying pressure to prevent significant drops for now.

Disclosure: No positions.

NEXT: Greece's Statistical Lies - Are the Numbers Any Better in the U.S.?

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

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.

When Stimulus Ceases to be Stimulating

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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Apparently Pavlov was right - and a better economist than anyone ever imagined. More than 100 years ago he noted that a stimulus has its greatest effect in the beginning and loses it impact if continually applied. Contemporary central bankers have apparently failed to appreciate the significance of this finding and its application to their field.

Early this morning New York time, the Bank of England cut interest rates 1.5%. While this may not be the biggest rate cut ever in nominal terms, it is enormous by any measure. The old rate was 4.75 and the new one is 3.25. Before the credit crisis began last year, a rate cut of this magnitude would have been enough to rally the market 10%, 15% or maybe even 20% in as little as a few days. However, as the credit crisis has proceeded, central banks rate cuts have lost their efficacy. The rallies that have resulted have become smaller and briefer. Today the FTSE 100 closed down 5.7%. Instead of the expected big rally, the London market crashed.

The Bank of England's grand rate cut gesture was a follow-up to the U.S. Fed's 50 basis point pre-election rate cut last week. While the Fed's cut helped prop up the American stock market into the voting, it could have done even more and there were rumors that it was considering 75 or even a 100 point cut (the remaining 25 or 50 basis point cut will probably be done at the next meeting). The ECB and the Swiss central bank decided to follow this more conservative approach today when they both cut 50 basis points also. Euro zone rates are now at 3.25%, above Britain's new 3.00% and well above the 1.00% in U.S. Counterintuitively, the trade weighted dollar rallied. This pattern has been seen since late July when funds have been flowing from high interest rate currencies to low interest rate currencies - something which seems to defy all logic.

Bourses on the continent suffered even more today than the British market, since they only had a big rate cut, instead of a truly huge rate cut to support stock prices. The German DAX was down 6.8% and the CAC-40 dropped 6.4%. The U.S. markets started selling as soon as they opened and hit a temporary bottom around 1:30, when the Dow was down more than 400 points and Nasdaq down over 70. Oil prices was hit even worse than stocks, with light sweet crude falling to $60.16 at one point. Don't be surprised if oil falls even further to 50 or even 40 in the future, although this may take awhile. In the shorter term, current levels are likely to be broken for stocks.

NEXT: Employment Losses Revealed After the Election

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

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.

Stock Market Enters Bermuda Triangle

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.


Our Video Related to this Blog:

In technical analysis, a symmetrical triangle pattern usually indicates a continuation of a trend. The U.S. market indices look like they are making such a pattern on the charts. Triangles aren't the most reliable of chart patterns however and a break on both to the upside and downside is possible. If a downside break occurs, and this has not happened yet, then look for a test of the intraday lows of of around 7850 on the Dow, 840 on the S&P 500 and 1542 on Nasdaq. If successful, this could put in a double bottom and make a rally possible. A break of these levels would indicate a test of the 2002 lows on the Dow and S&P, at 7200 and 775, would likely take place.

While Monday was a good rally day in the U.S. markets, the action took place on below average volume indicating a lack of conviction in the buying. On Tuesday, the Dow was up an hour before the close and then experienced approximately a 250 point drop to end down 232 or 2.5% (It's volatility like this that is preventing the the market from getting anywhere on the upside). The Nasdaq was the hardest hit of all the indices because of bad tech earnings. It dropped 73 points or 4.1% to close below 1700 at 1696. The selling continued overnight in Asia, with Japan, Hong Kong and Korea experiencing another crash day. The Nikkei was down 6.8% or 632 points, but was still well above its 2003 low. Financials bore the brunt of the selling in Japan. The Hang Seng and KOSPI were down 5.2% and 5.1% respectively. Oil fell below $70 a barrel in Asian trading.

Things were a little better in European trading this morning, but not much. The 3 major indices, the FTSE, DAX and CAC-40 managed to hold their losses at the 4% level, just below the criteria for a crash. In a surprise move, Hungary raised interest rates 3% to protect the collapsing Forint. Surprisingly, despite all the global negativity, U.S. stock futures were up early on in pre-market trade. Wachovia's announcement of a $24 billion quarterly loss, the biggest for any U.S. financial company ever, seemed to have turned sentiment highly negative.

By a number of technical criteria, the U.S. markets should have bottomed by now. There has of course been a short-term rally, but the market is having trouble holding it. Not that the monetary and fiscal authorities haven't been trying to assist it, with one new program after another - and you can expect another 50 basis point rate cut from the Fed next week as well, with Fed funds returning to the 1.0% rate that caused the credit crisis in the first place. Right now bad earnings and negative outlooks are causing stocks to sell off. None of the major problems with the financial system have been permanently solved however. Expect them to continue showing up again and again, just when you least expect it.

NEXT: The House of Cards Economy

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

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.

Bailout to Bailout - The Collapse and Rescue of Bear Stearns

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

Our video for this posting can be found at: http://www.youtube.com/watch?v=G8Mn67rNCFQ

By March 10, 2008, rumors were flying everywhere on Wall Street that Bear Stearns was in trouble. In an attempt to counter these rumors, Bear's CEO released a statement to the press that the company had a sufficient liquidity cushion to weather the credit crisis. When a company is going under, it has no choice except to make such claims. Instead of being reassuring, this type of statement is an indication of serious trouble. After all, a sound company has no need to assure the public that its financial position is strong - and Bear Stearns was no exception. Insiders, of course, are not fooled by these proclamations, which are meant for the average investor. Indeed examination of options activity during Bear's last days shows heavy put buying that quickly turned into huge profits for those in the know.

According to an SEC report released the following week, Bear Stearns had a cash shortfall starting on March 11th, only one day after the CEO assured the public that Bear had sufficient liquidity. By the evening of March 13th, Bear was no longer a viable business and behind the scenes it was already working out the details of a bailout plan with the Fed. Ironically, if indeed it was a coincidence, earlier that day, S&P released a cheer-leading report heralding the end to subprime crisis write offs, which in turn led to a strong rally in U.S. financial stocks.

On Friday the 14th, Bear Stearns stock went into free fall. It closed at $30 a share, down from a high of over $171 at its peak in January 2007. Depending on the source, the book value for the company's stock was somewhere between $84 and $97 a share. The market obviously didn't agree and it would turn out the Fed's judgment was even more pessimistic. Nevertheless, after the close, the CEO stated in a conference call with investors that the book value was fundamentally unchanged. He also claimed that Bear's 'liquidity position had markedly deteriorated because of market rumors' indicating that management incompetence, the reporting of misleading financial figures, or that Bear actually being insolvent had nothing to do with the loss of faith in the company.

The CEO also announced an emergency 28-day loan from the U.S. Federal Reserve. The Fed had no real legal authority to assist Bear Stearns, so it funnelled the loan through JP Morgan, one of its member institutions. It justified its actions based on an obscure 1930s law that gives the Fed broad ability to grant loans to corporations in crisis conditions. During the weekend, the Fed would became even more proactive and Bear Stearns was no longer be an independent company when the markets opened again on Monday morning.

NEXT: Bailout to Bailout - The Bear Bailout and Its Aftermath

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

The Fed's (long) Term Auction Facility

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

On November 28, 2007 the Federal Reserve started a massive year end injection of liquidity into the financial system. On December 11th, the Fed once again lowered the funds rate a quarter of a point (for a total of 100 basis point drop since the half point cut on September 18th). While neither of these events were extraordinary, what happened the next day was.

On December 12th, the Fed announced the creation of its Term Auction Facility . The TAF program was open to any bank or depository institution, which would be allowed to bid for one-month loans up to the total amount of funds being auctioned off. The winners had a wide-choice of what they could pledge as collateral, including mortgage-backed securities that could not be traded and had no market price. In exchange for their possibly worthless securities, banks and brokers could get cash from the Fed. This new program represented a sea change in Fed operations.

First, the Fed would be offering up sums of money in auctions to banks and depository institutions instead of having them come to the Fed to get a loan. Using the Fed's discount window was usually only done by institutions teetering on insolvency and was carefully avoided by any institution that wanted to preserve its reputation. The Fed finally found a way around this impediment to getting money to struggling banks by offering the money at auction, guaranteeing an injection of liquidity into the system at the amount auctioned off and removing the stigma for those who got the money.

The second major change the TAF introduced was that the Fed was willing to take even worthless paper as collateral for a loan. During its history the Fed usually only accepted treasuries as collateral. With the TAF, it effectively began engaging in subprime lending itself . By doing so, it was bailing out the banks that had foolishly engaged in this practice - and who might have become insolvent if they couldn't get rid of their subprime paper.

When the TAF was announced in December, the original auctions were for $20 billion each. By January 2008, this amount was raised to $30 billion. By March each auction was for $50 billion and two additional Fed lending facilities would be introduced (the TSAF and the PDCF) - breaking even newer ground for Fed operations.

Next: Economic Predictions for 2008

Daryl Montgomery
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21