Oct 5 Market Update

The S&P soared 2% today on the back of central bank chatter in addition to Japan embarking on yet another round of its own version of quantitative easing (QE or printing money out of thin air to buy worthless paper assets). Not to be undone, Charles Evans, Chicago Federal Reserve President, added his voice to the daily chorus of Federal Reserve members openly advocating a second round of quantitative easing. The market anticipates that the FOMC will formally announce QE2 following its November 3rd meeting. This drove the dollar down 2% against gold as the precious metal jumped $25 to settle at $1,340. So the S&P, denominated in dollars, rose 2% while the dollar dropped 2% against gold and 1% against a basket of equally deficient currencies. This equates to no real return for the day as the dollar’s continued debasement serves to nominally inflate a stock market totally dependent on the FED for life support. After all, equities immediately turned back down in April of this year following the conclusion of the FED’s first round of asset purchases.

To further solidify my point, let’s take September’s equity performance as the most recent example. The headlines read “Stocks post best September in 71 years” as the 7.7% run-up in the DOW supposedly confirmed that the economic recovery is intact and progressing as planned. The press conveniently glossed over gold’s 5% increase and the dollar’s 7% drop against the Euro alone during the month. In aggregate, the dollar index dropped 5.4% in September. So the DOW’s “real” return adjusted for the dollar’s decline was only 2.3% (7.7% DOW increase - 5.4% dollar decline). Again, chatter from the Federal Reserve walloped the dollar as it communicated that it would ease further if economic conditions warranted. The market interpreted the remarks that the Federal Reserve stood by to engage in a second round of QE, which was confirmed once again today.

If QE1 had worked as intended, why would the FED need to engage in a second round of easing? Zero interest rates are no longer enough to stimulate the economy given that the capital markets will perpetually decline each time stimulus is removed prompting the need for additional asset purchases. As a result of the FED’s continued treasury purchases, the yield on the 10-year has dropped below 2.5%. Historically, such low yields in treasuries would have implied an S&P 500 value below 800 as the bond market is pricing in a much lower growth rate than what stocks currently reflect.

Anyone following my thoughts over the past several years knows how bearish I am on the economy. In early May 2009, I called a nominal top on the DOW of around 8,400, completely underestimating the impact that the ocean of liquidity created by central banks would have on commodity, bond and equity markets alike. I did qualify my forecast by stating that currency fluctuations and a weak dollar could artificially inflate stock and commodity prices. It appears that this exact scenario has played itself out over the past 18 months as most asset classes continue to climb in tandem driven by cheap money flows into risky assets. However, upon closer examination, the DOW’s 30% run-up since I called “the top” was far surpassed by the gold price 49% increase over the same period. In other words, the DOW, priced in gold, has dropped 12% despite nominally rising 30%.

Date DOW Gold DOW/Gold Ratio
5/4/2009 8,400 900 9.33
10/5/2010 10,945 1,340 8.17
% Change 30% 49% -12%

Gold is an excellent indicator of true value. It filters out currency fluctuations and the corresponding debasement of the US Dollar. Once this same ratio is applied over the past decade, the results are, in a word, stunning:

Date DOW Gold DOW/Gold Ratio
5/4/2009 8,400 900 9.33
10/5/2010 10,945 1,340 8.17
% Change 30% 49% -12%

The DOW, currently hovering at just under 11,000, has dropped 80% since Y2K once priced in gold. The dollar index has dropped from 103 to just 78 over the same period, representing a 32% decline. Now this number may seem farfetched, but let’s take a simple real world example to illustrate. In early 2000, gas prices were $1/gallon and have now climbed to roughly $3/gallon, representing a threefold increase in just over 10 years. This run up is not limited to gold and oil as many key commodities have experienced triple digit percentage increases as highlighted below. All the while, wages in the U.S. have remained stagnant, barely keeping up with the cost of living. Commodity prices refuse to decline despite the official unemployment rate doubling. However, at the height of the credit crisis in early 2009, commodity prices collapsed as liquidity evaporated from the system. The sharp decline in commodities during that period proves that it is cheap money and the weak dollar driving prices, not underlying demand. Refer to the commodity data below for a summary of pricing by key commodity. Note that current wheat prices may be exaggerated as droughts in Russia have led to a suspension of wheat exports, driving global wheat prices up sharply over the past several months.

Commodity 10/5/2010 Avg. 1999 price % Change
Oil $82.72 $16.56 400%
Copper $3.73 $0.71 425%
Corn $4.91 $2.14 129%
Soybeans $10.72 $4.69 129%
Wheat $6.63 $3.17 109%

Although China’s explosive growth over the past 10 years explains a percentage of this increase, it does not come close to accounting for the magnitude of these price increases. Bulls will argue that robust demand from emerging markets is the primary driver underlying today’s prices. However, any sane market participant would conclude that it is liquidity, leverage and speculation aided by the weak dollar and artificially low interest rates supporting prices.

Commodity and equity markets are in a bubble. The average person does not care to understand the detail behind the financial headlines they see on TV or read in the paper. They only know two colors, green and red. The massive trillion dollar bailouts only served to pile on more debt to an already overleveraged system. The collapse of ‘08/’09, leading to oil in the $30 range and an S&P of 666 was the market’s way of trying to cleanse itself of the excess leverage. The FED’s actions continue to interfere with the free market by artificially inflating paper assets through the issuance of debt that only serves to debase the dollar. Make no mistake about this, with asset correlations at all time highs, and all assets rising in tandem, a breaking point will soon be reached.

Investors must recognize that traditional cyclical responses will not address the deep rooted structural issues currently plaguing the global economy. From the earnings conference calls that I have listened to over the past twelve months, most CEOs still falsely believe that the economy is near the trough of the business cycle. In reality, the economy is only 3 innings into what will be the greatest deleveraging structural correction ever experienced. Companies looking to make acquisitions during this period are basing their projections on revenue streams that will never materialize in a deflationary environment.

Despite all the statistics thrown around by the talking heads, there is only one fact that matters. Consumption has risen to 70% of the US economy, an unsustainable level by any rational metric as it historically comprised 65% of GDP. America had a robust manufacturing base that supported this 65% consumption rate. The disappearance of industry has made it impossible to even maintain 60% consumption without individuals incurring untenable debt levels. Structural imbalances have fueled this binge as taxpayers and governments alike continue to employ excessive amounts of leverage to finance this addiction.

I am not a market timer so I will keep my projections longer term:

1) Systemic risk will rise to all time highs as Central Banks have all but eliminated market risk. Greece was the first domino to fall, but by no means the last. Portugal, Ireland, Italy and Spain (the remaining PIIGS countries) have significant structural imbalances and the Euro will fail as the European banking system is more leveraged than America’s. I will be shocked if the Euro does not at least trade at parity with the dollar by the end of 2012.

2) California will be the first state requiring a bailout from the Federal government, but it will not be the last. The municipal bond market will start to crack by 2012 as states will be unable to address their deficits fast enough to account for much lower than anticipated tax revenues.

3) The FED’s efforts to inflate asset prices will fail as servicing debt is inherently deflationary. Any real improvement in the economy will be met by prohibitively high commodity prices that will shock the system back into a sharp decline, alas the summer of 2007. It is no accident that the $140/barrel oil directly preceded the onset of the great recession in December 2007. Oil settled near $82 today despite comfortable supply levels amidst a weak global back drop. The question has to be asked; what if the Western economies actually show sign of life? Oil will skyrocket and push the economy into an sharper contraction. Thank you FED for your endless supply of cheap dollars.

4) Emerging markets will not be the safe haven that many investors anticipate. Contrary to popular belief, the Chinese and Indian economies are primarily export based as austerity measures in Europe and declining U.S. based demand will hit China and India hard. Their respective populations will not make up for the lost purchasing power of the developed Western economies overnight. Given my outlook on greatly reduced global demand, I personally think that you would have to be a fool to invest in emerging markets at these levels.

5) The US equity market, priced in gold, will continue to decline. However, I think that all asset classes will sell off sharply as final demand continues to decrease and the real unemployment situation worsens. The U6 unemployment rate, which factors in discouraged and underemployed workers, equaled 16.7% in August. I expect this number to climb north of 20% by the end of 2012.

6) According to Bloomberg, current analyst consensus estimates is for S&P operating earnings of $95 in 2011, or a 15% projected increase over 2010. Why is the FED in pure panic mode if companies are in a position to grow annual earnings by 15%? Further, how is projected GDP growth of 2% in developed economies going to drive earnings 15% higher after companies have already cut expenses to the bone? Margin compression seems more probable.

The domestic equity markets are clearly outperforming the real economy in anticipation of a recovery that is yet to materialize. GDP growth in the prior quarter already slowed to 1.7%, well below what is needed to make any meaningful dent in the unemployment rate. My advice is simple; do not get caught holding risk assets when the herd realizes that the FED is the only buyer left in the market. Governments cannot cure debt with the issuance of more debt. It really is that simple.