Tuesday, August 3, 2010

Sustainable Rally or a Bear Trap?

Summer is providing a welcomed distraction in my reading. It is a good time for me to write what my observations add up to. It is not surprising that the stock market has moved up since I decided to fully hedge equities at the beginning of July. At that time, there was no lack of clear heads describing the increased level of risk that has formed in the stock market. That risk has not diminished in my mind and it has not discouraged traders from bidding prices higher. But the question continues, what do I see?

Recently, I listened to a video clip of Dr Marc Faber (the Doom, Gloom & Boom Report) describing a market where traders are pricing in a possible new round of quantitative easing (QE) from the Fed. He says there is talk of one beginning to be heard from people in high places. Could these be trial balloons? In another video clip from a couple of weeks ago, he was predicting QE should be expected this fall, before the elections. He has several targets in this short clip...

So if the discussion of new QE is building, does this have the potential to drive another powerful bull rally? Yes, QE is what propelled stocks since 2008, along with other concessions to accounting rules and to allowing excessive risk taking without penalty. But hey...it's all good.

Danielle Park's blog is my next stop. She has this to say about the advancing market based on leading indicator levels. "It is important to note that the ECRI leading indicator index which most recently reported a -10.9% weekly growth rate typically leads the ISM PMI by 13 weeks and 13 weeks ago the ECRI WLI was still a positive 12.7. This trend suggests that we could see the ISM PMI data fall officially into contraction mode this fall." It has been pointed out by several bloggers that the ECRI WLI has never reached -10.% or lower and not preceded a recession. Park also makes a good point on her blog that trading volume in July was higher on down days. That leads her to conclude that the lack of consistent volume is creating big moves, typical of low volume, and these advances can unravel quickly.

St Louis Federal Reserve Bank President, James Bullard has been speaking about his paper, The Seven Faces of "The Peril" analyzing his concern about inflation remaining low for an extended period and naturally morphing into a Japan style deflation. His analysis concludes that deflation in the US is possible, even though he describes himself as an inflation hawk. His solution is for the Fed to initiate a new QE program of huge, targeted and managed release of money. Here is a section from an executive summary of his paper.
The regime switch required must be sharp and credible. Policymakers have to commit to the new policy and the private sector has to believe the policymaker. Unfortunately, in actual policy discussions, nothing of this sort seems to be happening. Both policymakers and private sector players continue to communicate in terms of interest rate adjustment as the main tool for the implementation of monetary policy. This is increasing the risk of a Japanese-style outcome for the U.S. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.

All this leads me to agree with Marc Faber. QE is on its way. The leading indicators Danielle Park wrote about are indicating that the economy is slowing and the liklihood of recession is growing. The Fed must be getting intense pressure from well placed political powers to do something that will keep the political balance they have now from shifting. The announcement of a new QE policy will create a frenzy of criticism from inflationists, but it will be much less intense than the firestorm from political losers and their national party. In the final analysis, to initiate more QE or not is resolved as a political question. It's is not about restoring the currency, or creating jobs or controlling inflation. In the end, its about a political party maintaining its influence on power.