Recent corporate results show that even if you can accurately predict a company’s earnings, the market’s reaction is still much harder to get right.
As the most-recent "earnings season" winds down, it's worth looking at the overall message from the stock market so far.
Heading in to this earnings season, I was not expecting a lot of positive reports from the companies I follow, due to weak gross domestic product worldwide and the strong dollar. But I was especially interested to see if poor results and/or lowered guidance could take the overall stock market lower, or whether bad news would be ignored.
Thus, I was paying particular attention to some of the larger names in the technology sector as a litmus test for real economic strength.
History teaches us that the Federal Reserve has been the root cause of our biggest, most harrowing financial problems
I have not really delved in depth into the subject of the Federal Reserve for some time, but this week I decided to revisit some of my history books on the 1920s and ‘30s. Once again, I was struck by the length of time it took for the Fed's inappropriate policies to wreak havoc, the damage done, and, in between, how wonderful everyone thought everything was.
Of course, that creates a bit of déjà vu.
But it is instructive to consider the modest actual amount of monetary injections, as a percentage of gross domestic product, in the mid-1920s that led to the stock bubble and, ultimately, to the bust. That stimulus was small compared with the easy money of the late 1990s that culminated with the $30 billion to $50 billion the Fed injected to protect the world from "Y2K."
Yet the sums involved in previous periods of irresponsibility are mere rounding errors nowadays.
Thus, when I contemplate the damage that will be done by four years (and counting) of quantitative easing, I just shudder at how big the disaster might be -- and there is no doubt this experiment will be a disaster.
The Fed has expanded its balance sheet to $3.5 trillion, and it now owns more than 20% of outstanding U.S. debt. Either it is going to continue buying bonds forever, which is impossible, or there is going to be a massive dislocation at some moment, because someone else is going to have to buy that debt when the Fed ultimately stops, even if it doesn't choose to sell anything (and just lets the debt run off).
There will be no painless extrication from QE and, as I have said, I don't believe the Fed will be able to leave ZIRP (zero-percent interest rate policy) willingly.
My best guess is that inflation will rise high enough to matter and people will question the Fed's policies, but it will not have achieved its objectives on the employment front and will continue to try to suppress interest rates, which will result in a funding crisis.
(On the inflation front, the July 16 Consumer Price Index of 0.5% was higher than expected and annualizes to a rate that is closer to the real world than to the 1.5% or so the Fed pretends is the case. Nonetheless, it is mind-boggling to think that so many people in the financial world are actually rooting for the inflation rate to go higher.)
More money, more problems
Printing money has never worked. The only questions are how big the consequences are going to be and when they are going to hit. This is as true today as it was 80-plus years ago, when our young central bank made its first forays into monetary mismanagement.
While the current mainstream view, with Chairman Ben Bernanke its leading proponent, holds that it is the Fed's response to the Crash of 1929 that helped worsen and prolong the Great Depression, the fact is that the Fed deserves the blame much earlier. The Fed (even on the gold-bullion standard) actually had a very large role in causing the boom, which got out of control (Bernanke, please note).
In Benjamin Anderson's fabulous book "Economics and the Public Welfare" (mandatory reading for any serious student of the Depression), he states, on page 156:
"(T)he Federal Reserve System used (open market operations) deliberately for the purpose of relaxing the money market and stimulating bank expansion in 1924 and 1927. At a time when unusual circumstances called for extra caution, they abandoned old standards and became daring innovators in the effort to play God.
“ . . . The process of the creation of excess reserves with the resultant great expansion of bank credit did not move slowly and gradually from early 1922 to early 1928. It was concentrated, rather, in three great moves.
“ . . . Then again in the latter part of 1927 there came a third great move in the purchase of government securities, with a new great burst of expansion in bank credit.
“ . . . (This) touched the match to the powder keg and set the uncontrollable forces working which blew us up late in 1929."
Anderson continues, on page 192: "With the renewal of the Federal Reserve cheap-money policy late in the summer of 1927 a sharp acceleration of the upward movement of stock prices began. "
And on page 193: "(Finally) alarmed, the Federal Reserve authorities reversed their policy in the winter of 1927-28. They sold government securities. They raised rediscount rates.
“ . . . But the boom went on. There was a new factor in the situation. The public had taken the bit in its teeth. The rise in stock-market prices and the lure of stock-market profits had caught the public imagination."
In short, then-New York Fed Chairman Ben Strong decided to boost the economy in the mid-1920s, one thing led to another and, eventually, we had a mania and then a bust.
The Federal Reserve was the root cause of creating the problem. Bernanke thinks the Fed had no role to play in this phase, and that it erred by not doing enough later. But that is nonsense.
When whiskey sours
Those passages by Anderson led me to this from "Modern Times: The World from the Twenties to the Eighties" by Paul Johnson, who wrote:
"Domestically and internationally they constantly pumped more credit into the system, and whenever the economy showed signs of flagging they increased the dose. The most notorious occasion was in July 1927, when Strong and (Bank of England Gov. Montagu) Norman held a secret meeting of bankers at the Long Island estates of Ogden Mills, the U.S. Treasury Under-Secretary, and Mrs. Ruth Pratt, the Standard Oil heiress. Strong kept Washington in the dark and refused to let even his most senior colleagues attend. He and Norman decided on another burst of inflation and the protests of (German banker Hjalmar) Schacht and of Charles Rist, Deputy-Governor of the Bank of France, were brushed aside."
Johnson continues: "The New York Fed reduced its rate by a further half per cent to 3-1/2; as Strong put it to Rist, 'I will give a little coup de whiskey to the stock-market' -- and as a result set in motion the last culminating wave of speculation. Adolph Miller, a member of the Federal Reserve Board, subsequently described this decision in Senate testimony as 'the greatest and boldest operation ever undertaken by the Federal Reserve System (which) resulted in one of the most costly errors committed by it or any other banking system in the last seventy-five years."
The policy appeared to be succeeding, Johnson wrote.
"In the second half of the decade, the cheap credit Strong-Normal policy pumped into the world economy perked up trade. . . . This was genuine economic management at last! Keynes described ‘the successful management of the dollar by the Federal Reserve Board from 1923-8’ as a ‘triumph.’ (British economist and Keynes ally Ralph George) Hawtrey's verdict was: 'The American experiment in stabilization from 1922 to 1928 showed that early treatment could check a tendency either to inflation or to depression. . . . The American experiment was a great advance upon the practice of the nineteenth century.’
“ . . . Strong's last push, in fact, did little to help the 'real' economy. It fed speculation. Very little of the new credit went through to the mass-consumer. . . . Strong's coup de whiskey benefited almost solely the non-wage earners: the last phase of the boom was largely speculative. . . . The 1929 crash exposed in addition the naivety and ignorance of bankers, businessmen, Wall Street experts and academic economists high and low; it showed they did not understand the system they had been so confidently manipulating. They had tried to substitute their own well-meaning policies for what Adam Smith called 'the invisible hand' of the market and they had wrought disaster. Far from demonstrating, as Keynes and his school later argued -- at the time Keynes failed to predict either the crash or the extent and duration of the Depression -- the dangers of a self-regulating economy, the dégringolad indicated quite the opposite: the risks of ill-informed meddling."
The main point to understand is that the "ill-informed meddling" on the part of the Fed in the mid-1920s was infinitesimally small compared with what it has done in the past five years, and the ultimate damage will be correspondingly horrendous.
The Fed chief reinforces the notion that, in the wake of the central bank's zero-percent interest rate policy, the 'verbiage standard' is all that remains.
I'm sure that everyone reading this knows that Federal Reserve Chairman Ben Bernanke's speech July 10 moved markets. The Wall Street Journal's headline -- "Fed affirms easy-money tilt" -- says it all.
When you are on the "verbiage standard," as we now are, the noise level can be quite high.
However, I think the fact that all markets responded (and all accounts I have read regarding Bernanke's comments interpreted them as the remarks of someone very reluctant to taper) means that was the message he wanted to deliver.
From bond markets to Chinese stocks to the Fed to gold, Wall Street is dialing up the chaos in a big way.
As regular readers may know, I closed my short fund in the wake of the collapse of the housing/real estate bubble, which culminated in the financial collapse that ended in early 2009, as I was certain that central banks would print money in response to the crisis.
I never dreamed they would print anywhere near as much as they have, but I knew what was coming and that it would be difficult to make money on the short side.
I felt that the outcome we would experience in that environment would most likely be stagflation, with feeble gross domestic product growth and decent-sized inflation, or, if we were lucky, strong growth but even higher inflation. The possibility I never considered was an outcome that could be described as "Goldilocks."
Bond investors still have the power to stifle the Fed, although they may do it much more quietly than had been expected.
This week brought another installment of "As the QE-driven world turns," starring Federal Reserve Chairman Ben Bernanke, who held a news conference June 19 following the Federal Open Market Committee’s latest policy meeting.
First of all, regarding the presser, let me be clear that there was nothing in what Bernanke said that could have led anyone to think that the Fed is inclined to take actions that could remotely be considered tightening.
Bernanke went out of his way to say that even when Fed officials got around to reducing the amount of Treasurys they were purchasing, they would, to use his metaphor, still be stepping on the accelerator, just at a reduced rate.
As Japan's problems continue, investors worldwide are still largely convinced central bankers are in control. They're not. The market is.
As I noted last week, I am focusing much more than usual on Japanese markets, since I believe there may be important information to be gleaned from the action there in stocks and, particularly, in Japanese government bonds (JGBs).
The Nikkei 225-stock index was hit hard on Monday and Wednesday, making the cumulative pullback in Japanese stocks about 20% from their recent high. Yet the bond market has rallied only about six basis points from its worst level. Obviously, the Bank of Japan has its work cut out for it as it tries to create negative interest rates and a bond market that doesn't collapse.
As my friend the Lord of the Dark Matter summed up in a recent email: "We all get that (Bank of Japan Governor Haruhiko) Kuroda wants Japanese real interest rates to be negative, but achieving that without implied yen-rate volatility trending higher and Tokyo banks realizing losses on JGBs is going to be tricky."
Bond market to introduce 'start loss' orders
I would go one step further and say it's going to be impossible.
Basically, bondholders have to be willing to accept a negative real rate of return, and although that has been the case worldwide for quite a while, the bond market at some point is going to believe central bankers when they say they want more inflation, because they will get it (in fact, they have already).
Once the perception changes to inflation being the only outcome, life for central bankers is going to become incredibly complicated.
One reason markets have become so ebullient, particularly here in the United States: They have concluded that money-printing has created a Goldilocks environment instead of the stagflation or inflation I have long expected. Obviously, Goldilocks is a state of mind and can only last so long, but when you are in the money-printing "sweet spot," anything is possible.
I never would have dreamed it could last this long, nor gone to the extremes that it has, but, then again, we have never had the world's central banks printing this much money.
When you consider that the BOJ and the Fed together are printing $170 billion a month, and that only about $50 billion of liquidity provided by the Fed in the winter of 1999 blew the top off the stock market then, it is easy to see why insanity rules.
However, minds may be changing. David Rosenberg, of Gluskin Sheff, to cite one example, is now expecting stagflation. When the bond markets of the world collectively have the same opinion, the funding crisis will be upon us. (That is not yet today's problem, even though -- as I noted recently -- the very early stages may be occurring in Japan.)
Heading into negative knowledge territory
As a bit of an aside, I would like to make a point about the media and the 20% decline in the Nikkei. Most media talking heads know nothing about investing, yet love to talk about a 20% decline as the definition of a bear market, and other assorted nonsense.
The fact of the matter is that 20% doesn't mean anything. It is just a decent-size decline. It could be a correction or the early stages of a bear market (although that is quite unlikely at this early juncture for Japan). Nonetheless, a bear market is a bear market, but it doesn't become one when you cross 20%. You've quite likely been in one, and it might be over, or it might have been just a correction. In any case, thinking about things from that perspective is totally useless.
We have room only for the big picture
Speaking of wrong-headed, large numbers of investors still believe it is possible that the Federal Reserve will stop its quantitative easing efforts, let alone "taper" them. I continue to believe it is very unlikely that Fed Chairman Ben Bernanke will ever willingly taper.
After all, we've had five years of 0% interest rates, and the Fed can't even talk about an exit strategy that allows it to sell bonds, only buy fewer of them. The same sort of discussion has been held every year, but the masses fail to comprehend that, and get more excited with each QE-inspired rally -- with the latest goosed by the BOJ actions.
Once it is clear that tapering is not likely to occur, it will be interesting to see where the stock market is. It is quite likely to have a failing rally and, in the interim, stock market weakness might give us some insight into where the bond market might fail.
As I have noted, there are plenty of crosscurrents, and in this era, they can be incredibly violent. Unfortunately, when there is so much money printing going on around the planet, virtually all trades are macro.
On the air
In my latest interview with Eric King on King World News I talk about one of the most exciting investment opportunities I have ever seen in my career. Eric called it my "most powerful interview ever." Interested readers can listen to it here.
Cracks have appeared in the Japanese bond market, and potentially ours as well, as the world's finances may be reaching critical stress-points.
Buckle up because we have a lot to cover. The past 10 days have seen some very important action in several markets that is worth delving into in detail.
First, I want to talk about the crack in the Japanese bond market that occurred on May 23. I believe that was a very important moment in recent and longer-term financial history. In the near-term, I believe it marked the end of the "sweet spot," a term I have used to describe the environment we've been in where people believe that central banks could create an easy-money nirvana at the push of a button.
You can check out anytime you like
In a recent column, I mused about which bond market -- Japan's, Britain's or ours – would crack first. Now we know: Japan's. The reason I say the sweet spot has ended is because on May 23, the very early stages of a funding crisis hit Japan.
This is demonstrated by the fact that Japanese government bonds traded through 1.00%, which is two-and-a-half times their rate when the Bank of Japan's huge quantitative easing efforts began. One can imagine the carnage that would occur here if our 10-year rates leaped higher in a similar fashion.
It was also a mini-demonstration of a point I made last week: Once you have entered ZIRP (a zero-interest-rate policy) you can never leave, unless you have a funding crisis and the market drives rates higher, despite central bank commands/demands.
In terms of a timeline, I believe the action in Japan is analogous to first-payment defaults during the mortgage meltdown, which began in early 2007 and were a sign that the subprime market had cracked. However, it wasn't declared "contained" until six to nine months later. During that period, fallout from the bursting of the housing bubble was not only not contained, it was spreading.
The storm after the calm
The Federal Reserve is trapped and -- as May 23 demonstrated -- so is Japan. The choice central bankers are facing is the same one that has confronted them since the money printing inspired by former Fed Chairman Alan Greenspan began. Once trouble starts, they have to decide if they are going to allow their economies to fall into a depression or go down a path that seems painless but leads to inflation.
My belief has been that central bankers -- as they have already demonstrated -- will always choose the path that leads to inflation because they think they can easily stop it. And for a long time (most especially recently), people have believed that the money-printing path was essentially painless. I believe that view peaked on May 23 (even though no real inflection point can ever pinned down to one day, or even one week).
In other words, the macroeconomic and financial environment cannot get any better than people already thought it was. It was not as good as people thought, but "the best has been seen/imagined." From here, warts will begin to appear, and we will start to go from all news being good to all news being bad. But that is a continuum and will take some time.
Turning to this week, worldwide volatility continued, this time centered -- for once -- in the U.S. bond market. That may or may not be meaningful, but in this case, and in light of Japan's bond market, I think it is.
The $64 trillion question, however, is: "Why are bond markets sinking?" Is it (1) just noise; (2) too much liquidity; (3) not enough liquidity; (4) too much leverage/too many people short volatility; or, most importantly, (5) the beginning of a funding crisis?
The recent declines in U.S. and Japanese bonds (I will restrict my comments to those two, since what happens elsewhere will be an extension of what happened with those) are most likely due to a combination of factors, primarily some noise, but also too much leverage/too many who are short volatility.
When rates are held artificially low, with the promise that they will be kept there for an even longer period of time, it is easy for careless, greedy and/or naïve investors to get in over their heads trying to turn what is available from the bond market -- i.e., nothing -- into something that might actually be called "yield." As the saying goes, more money has been lost reaching for yield than at the point of a gun.
As for the underlying root cause, is there insufficient money printing (which could easily be solved by central banks), or is there too much (which would be the early days of a funding crisis)? I believe that for Japan the answer is a combination of points 1, 2 and 4 above, which lead to point No. 5.
Though it isn't articulated as such, the combination of leverage and monetization promises have precipitated a selloff and a gigantic increase in volatility, which will be very hard to get under control. Even if this is ultimately going to create a funding crisis (which is quite likely), nobody would be able to articulate exactly how and why right now. Just as it would have been almost impossible in late 2006 to extrapolate the final collapse of the economy, stock market and financial system at the end of 2008 from the initial first-payment defaults, even though they were all part of the same process.
Such is the case today in Japan, though I believe there are going to be many vicious crosscurrents along the way.
As for the U.S. bond market, which was really roughed up on May 28, the blame has been laid at the feet of Fed chief Ben Bernanke (i.e., point 3 above) and the other Fed heads trying to talk out of both sides of their mouths. It is understandable that Bernanke & Co. would want to prepare the markets for the eventual end to quantitative easing. They have never understood that they are the problem, and they continually think that money printing will solve everything, so every now and then, when the stock market gets frisky and the economic data get better, they contemplate that they will be able to stop someday. I don't believe that, as when the end comes for QE, it will be because the bond market has forced it to stop.
It can happen here
But whereas Ben's threat to someday print less money has been blamed for the backup in U.S. yields (and I'm sure that had some role in it), part of what is at work, in my opinion, is the same process that is occurring in Japan. And since the fact that the Fed may someday buy fewer bonds doesn't impact Japan, it is clear its problem is a case of "too much." (That said, teasing out the precise reasons for why markets move on any given day is usually close to impossible, and when you are trying figure out what might be causing a massive inflection point, it can be even more difficult.)
The bottom line, I believe, is that Japanese authorities have "lost the bond market" (i.e., rates are much higher than authorities want, despite their best efforts) and the Fed has as well, but, perversely, Japan may be further along in the process, even though its powers that be started much later to really get serious about QE-powered monetary debasement.
As far as markets go, the crosscurrents emanating from the macro consequences of money printing (and associated socialistic government policies) are going to be treacherous, and that is unavoidable. One needs to understand that essentially the macroeconomic environment has been all that has mattered for the last decade.
Money printing precipitated the stock bubble, which led to a bust, and nothing mattered but the macro, in both directions. Ditto during the housing bubble: Nothing mattered on the upside or downside except money printing or its consequences. (Reckless policies caused the bubble, but as it unwound, nothing mattered until enough money was printed to turn it around again.)
One-lane road ahead
In the last four years, nothing has mattered except how much money was printed. When the consequences of that are felt, that is all that will matter. That doesn't mean individual security research is meaningless, because you have to know what you are involved with, but if I were to pick one motto, it would be: "All macro, all the time; it's all one trade."
As for our stock market, folks are still concluding that Goldilocks was not a fairy tale and is, in fact, exactly what the Fed has engineered -- i.e., economic activity that is not too hot, nor too cold, with interest rates rising ever so gently. The same delusions that allow one to think that also indicate that rising interest rates are actually bullish because they theoretically mean the economy is getting better. Historically, pre-Greenspan, that was the case most of the time. But now, since we live in a world with make-believe interest rates picked by the Fed, assets are much more likely to be mispriced -- something stock bulls fail to comprehend.
Thus, our stock market feels bulletproof, as we are the leaders in the Goldilocks propaganda. The recent carnage in fixed incomes in Japan, the violent equity selloff there and the bond market decline here have done almost nothing to dent the enthusiasm of that camp in America.
Save the last dance for QE
However, following the crack in Japanese bonds, my friend the Lord of the Dark Matter said, "I would expect in the coming days (and given the violence of this selloff, it is days, not weeks) that central bankers will reaffirm their commitment to liquidity and that they are 'all in.' They will make their intentions both clear and unambiguous. If the markets don't stabilize after that, then it is '1987 time' for equities."
I totally agree. Eventually, even the really slow learners should be able to understand that the central banks are trapped and that their only choice is between depression and easy money.
When it comes to monetary policy, our Federal Reserve is hoping words speak just as loud as actions.
It's time once again to check in on our fearless leaders at the Federal Reserve, as Wednesday was the scene of Chairman Ben Bernanke's most recent congressional testimony (as well as the release of the latest FOMC minutes).
But we already knew -- regardless of what Bernanke or the minutes said -- what the Fed is going to do, namely what it has always done since former Chairman Alan Greenspan manned the helm. This is not debatable: The central bank is going to print money -- too much money, it as it will turn out, and the central bankers won't understand that -- leading to a collapse in the economy and financial markets, and so the Fed will come back and do the same thing on an even bigger scale.
For five years now, there has been steady talk of exit strategies, yet none has occurred. Nor is exiting described as a binary on-off switch any longer, but rather as a dial whereby the flow of money can be scaled up or down, depending on the data.
Thus, the very concept of an exit strategy, where the Fed might suddenly stop buying or actually sell bonds and reduce its balance sheet, has been abandoned and is never going to happen.
This makes it rather annoying and maddening to deal with financial markets that move on every speech given by every Fed head as they work their jawbone standard. But that is where we are.
Fed won't hit the brakes until it's sure we've hit something
No one should be shocked to learn that Bernanke opened Wednesday's testimony by saying that a premature tightening risks slowing or ending the recovery.
That is all you need to know: There will be no premature tightening. Bernanke is not going to pre-empt anything, certainly not inflation.
In fact, he said, ". . . inflation, if anything, is a little too low."
All of the tough talk, I believe, is because the powers that be at the Fed have some inkling somewhere in the back of their minds that maybe if they "overdo it," financial markets might get a little (in Fed terminology) overheated.
Other than that, they have no interest in ending their massively stimulative policies in any time frame that could remotely be called early.
In any case, when the Bernanke headline hit the tape, everything vaulted to the upside. Then, during the question-and-answer period with lawmakers, Bernanke said he could raise or lower the purchase pace of Fed bond buying (gee, what a shock), depending on the data (ditto).
But then he dropped a supposed bombshell, noting that the Fed could cut the pace of bond purchases at one of its next few meetings (yes, slowly, or maybe not at all). That comment caused a great deal of selling in the bond, currency and metals markets, but it initially had only a modest impact on the stock market, which eventually sank with everything else.
Hanging ourselves on every word
The bottom line is that this is a whole lot of hot air, but we are forced to deal with it on a daily basis because we live in a world where central bankers think they know the future and the only standard that exists anymore is the jawbone standard.
(And, most importantly, the damage from money printing has already been done, the consequences just haven't yet fully manifested themselves.)
Are bonds u-ZIRP-ing control?
Bonds were deservedly smoked on Wednesday, and yields are approaching their highs of the year. If they keep sliding, stocks will get hit (though they could tank for any reason now, given how frothy the market is) and then the economic data will be seen for what it is: weak.
Of course, "taper talk" would then cease and folks would realize that the Fed is (and has been) trapped. You can't abandon zero-interest-rate-policy (aka ZIRP) until the market forces you to via a funding crisis. Period!
At the time of publication, Bill Fleckenstein owned gold.
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ABOUT BILL FLECKENSTEIN
This column is a synopsis of Bill Fleckenstein's daily column on his website, FleckensteinCapital.com, which he's been writing on the Internet since 1996. Click here to find Fleckenstein's most recent articles.
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As the devil-may-care bravado of Wall Street marches on, history warns that -- in the end -- there will be the devil to pay.
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