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What Corrections Are All About

Dan Calandro - Sunday, November 03, 2013

What Corrections Are All About

Nov 03, 2013

I often find myself torn between two sides – the Obama I hoped for and the one I got. He consistently says one thing and does another, and sometimes I totally agree with him, am proud of him, and hold him in high regard. But those times are too rare and too short-lived. 

The assassination of Osama Bin Laden was an American victory, an incredible display of military expertise and precision in one of the world’s worst neighborhoods. It was a tough call (an operation in Pakistan can’t be considered anything less than a high risk proposition), and it was a good call. It was a proud day for all Americans.  

But the tragedy in Benghazi wiped all of that good feeling away. It was as great a failure as the Bin Laden hit was a success. Benghazi still sticks hard in the craw. And while a terrorist leader of that attack was recently abducted by a team of U.S. Special Forces in Libya (another brilliant display by them) a trial in a U.S. courtroom seems way too good for the massacre’s ringleader. Benghazi, even with this most recent capture, doesn’t make any American proud.  

And as reported just this week, a Taliban leader with a long rap sheet was killed by a U.S. drone strike in Pakistan. While the killing of madmen is always good news to a peace loving world, it seems like only yesterday that President Obama promised to dramatically restrain the use of U.S. predator drones. He made the statement while meeting with the new leader of Pakistan.

This, of course, is not to mention that one day the Obama administration is spying on its Allies and the next day they’re collecting data on the Pope – while all along collecting information on every single American. 

What ever happened to the Rights of Privacy? 

Like many Americans, the world can’t seem to figure out President Obama either. 

Markets feel the same way. When you talk to real people on the street nobody is feeling good about the economy or the actions and behavior of U.S. government. Even so, there are always some businesses doing well in bad markets. This is just as common as some companies doing poorly in economic booms. Both happen all the time, in every cycle. The good, bad, and the ugly will always be part of the American experience. 

The same is true for major market indexes like the DJIA, the S&P 500, and the 15-51 Indicator, where only a few companies (stocks) drive the majority of their total movement. Those companies are big, strong, and above-average performers. So it’s only natural for their collection to outperform the economy (Nominal GDP). But that doesn’t make a strong market. 

Today’s stock market is an opportunistic one blinded by the lust of QE greed with little regard to Market fundamentals. In other words, this is a QE driven stock market rally, a bubble if you will, that can only be sustained with consistent new Fed money. In fact, a stronger economy will actually deflate stock market valuations and cause a correction.  

Think about it. In order to keep the QE money flowing Wall Street applauds every time poor market fundamentals (like weak job numbers) present themselves. This a world where bad economic news sends stock prices higher. The reason for this is simple: this stock market rally is not driven by the economy; it’s driven by QE money, which is fueled by poor economic data.   

On more than one occasion the Federal Reserve has been clear: a significant improvement in the unemployment rate will bring about an end to QE. Remember, Wall Street banks are in the money business. It is when the money-spigot is turned off that they will finally realize that stocks are extremely over-valued in relation to economic output. When QE ends a correction will ensue, and once again, Wall Street will be "surprised" by the severity of the event.

Weak politicians and public governors like dovish Federal Reserve chairman, Ben Bernanke, have no stomach for higher yields, and in fact, are scared to death of them. Higher yields will throw Europe and bond markets into a tizzy. Yields will spike dramatically and cause world turmoil. There is little doubt.  

But higher interest rates and a stronger dollar are exactly what America needs right now. It will provide banks incentive to lend money to businesses for growth and expansion, something that’s not happening right now. That’d be good for the economy, and because the U.S. is the dominant market in world GDP, higher interest rates would ultimately be better for the world over the long-term. There would be some interim pain, no doubt, but it would be worth it. 

Easy money proponents have no guts to take the tough medicine – and Wall Street knows it. That’s the reason they send stock prices sharply lower and spike yields higher every time word of a QE taper is mentioned. This behavior is a penalty for the Fed turning off the money-spigot. The movement is intended to extort weak governors into continuing poor monetary and fiscal policies, which is bad for markets, investments, and economies.

The chart below shows a comparison of stock prices, gold and yields since January 2011. Some special notes have been added to highlight key Federal Reserve announcements.

The first note, signified by a green diamond in the below chart, was the Fed’s initial announcement of a third quantitative easing effort, called QE3, in September 2012. It was an open-ended commitment of bond purchases without a specific expiration date. 

The second note is almost a year later, in May 2013, when Fed Chairman Bernanke first announced a taper of QE3 could arrive soon (signified by the red diamond.) Look at what yields did since that time.


11-1-13


QE money gives Wall Street banks plenty of firepower to manipulate valuations for multiple asset classes of investments simultaneously, including stocks, bonds, and commodities like gold. Remember, trillions of QE money has flowed into banks fast and furiously since its inception several years ago. As a result, Wall Street banks have an arsenal of new money to manipulate markets.  

QE is like handing guns to drug cartels and then not expecting to be targeted by those very same guns -- an obvious outcome to most rationale people.

The moment QE is tapered, and ultimately terminated, yields will automatically rise because insufficient demand for new U.S. government debt already exists in the marketplace.

Poor fiscal policy is causing the Treasury to produce more government paper than there is natural demand. This excess supply of T-Notes causes yields to rise; a move that provides additional incentive for lenders to lend. 

To combat this dynamic (higher yields) the Federal Reserve prints new money via QE and then hands it to Wall Street investment banks under the mandate that a portion of the funds are used to purchase U.S. Treasury securities – to thus fill the demand gap left by free-market investors, and to keep yields low.

In other words, QE is a function of central government deficit, as new money must be printed to fill the demand gap of U.S. Treasury debt. If fiscal deficits widen (e.g. due to increased spending for Medicaid expansion as a result of the implementation of the Affordable Care Act) the demand gap in U.S. government bonds will also widen; so in order to keep rates low the Fed will have to increase the amount of QE – in other words to print more new money so Wall Street banks can buy more U.S. Treasury securities.

It’s a vicious cycle, and so reminiscent of the subprime mortgage debacle.  

This too shall end. But if you ask me only two conditions will slow QE momentum: 1) a significant advance in economic performance and/or unemployment, or 2) an inflationary condition that causes yields to rise beyond the Fed’s control.

Bernanke and his ilk simply don’t have the guts to cut QE before one of those two conditions force their hand. 

And when yields begin to rise, whether it is because of a QE taper or inflationary condition, bond and stock values will hit the skids (and it will be ugly) and gold will rebound. Such a movement will bring all asset classes back in-line with Market fundamentals. 

That is, of course, what corrections are all about.  

Stay tuned…

ShieldThe road to financial independence.™


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