This is one of the most bizarre markets I have ever seen. The worse the economic outlook gets, the higher the market goes. But it doesn’t breathe like a normal market, with plenty of corrections along the way giving traders a chance to get in. It has been a straight line up with nary a pullback, trapping many players on the sidelines. But it has been going up so slowly that call option buyers have been left out in the cold too. What is the market struggling to tell we deaf investors?
Let’s go to the videotape. GDP peaked in Q3, 2010 and fell to a 1.5% rate by Q2, 2011, hardly a pace to set off fireworks. It has been flat lining ever since. Personal income has been falling for five consecutive months. So has sales growth. Industrial production hit a 22 month low in January.
Add up all these numbers, and you get a recession that starts by this summer at the latest. A data stream like this has reliably produced a recession every time for the last 50 years. Except, it’s different this time.
Enter quantitative easing. Virtually every major central bank in the world has rushed to print money in the past year. They have behaved like tag team wrestlers, with the Federal Reserve doing the heavy lifting, followed by Europe, Japan, the United Kingdom, and China.
How long did it take Europe’s quantitative easing to flood into the US? I reckon about five minutes. Look at the chart of the adjusted monetary base below prepared by the St, Louis Fed, which took off like a bat out of hell the second the ECB’s LTRO was announced.
However, all this stimulus is not having the desired effect, as very little of it is ending up in the real economy. You can see this in the velocity of money, or the number of times a dollar gets turned over per year, which has plunged to record lows in virtually every country. This means that all this cash is going into asset prices, especially stocks, where it stops dead in its tracks.
The scary thing about this is what happens to markets when the sugar infusions stop. For a preview, take a look at the chart for the S&P 500 last summer. The Fed ended QE2 on June 30. Within three months, the closely watched large cap stock index fell by 25%.
Markets didn’t recover until Europe started talking up their own QE prospects in the fall. It turns out that even the most dovish members of the Federal Reserve only want to use quantitative easing sparingly, and in small doses, because of the inflationary risks it presents down the road.
Markets are made up of people. Understand the people and you will understand the markets. Anticipate them, and you will make a fortune. I think what is happening here is that those who relied only on economic data and missed the true message of QE1 and QE2 and got trapped on the sidelines, greatly underperforming more aggressive peers.
They are not going to make the same mistake a third time. Those are the people buying up here. On top of that, others are buying simply because the stock market has gone up. Every time I have seen this happen in my 40 plus years in the business, it has ended in tears.
I am not cherry picking the data here to support a hopeless permabear position. I will not sit in a throne and order the tide to stop rising, like King Canute. Let me tell you what remains on the program:
*A $525 billion fiscal drag promises to suck 3.5% out of GDP by year end. This includes $250 billion from the expiration of the Bush tax cuts, $100 billion in automatic sequestration budget cuts, and $100 billion from the end of the payroll tax holiday. These are not forecasts, they are certainties under current law.
*The great prop for the stock market, corporate earnings growing at red hot rates, have begun a noticeable slowdown.
*Budget cuts at the state and local level are moving ahead at a prodigious rate, sucking another 2% out of GDP. Some communities are now charging those pleading for emergency services $300 for 911 calls. Teacher layoffs continue unabated.
*Europe is going into recession on schedule. The EU commission just cut its 2012 prediction of GDP growth from 0.5% to -0.3%. Portugal will see a -3.3% shrinkage in GDP.
*The China slowdown continues, with the People’s Bank of China rushing to chop reserve bank requirements twice in three months.
*Oil? Has anyone looked at oil lately? Every oil company economist on the planet will tell you that when oil sticks over $110 a barrel, demand destruction explodes, guaranteeing a recession. It went out on Friday just short of this print. Oil truly sows the seeds of its own destruction.
The data are not all bleak. Car sales have made it back up to a 14 million unit annual rate, up from the 9 million units in 2008. The decline in jobless claims is indisputable. So the rally could continue for another month or two. But the jobs data can be highly fickle, volatile, and subject to scads of revisions. So I am keeping my core short position in the (SDS) and protecting it with short dated upside hedges.
When the fat lady sings for this market, I want to have a front row seat.