No Direction Home
Featured in Market Shadows Newsletter: No Direction Home, April 11 2013
This issue took us too long to put together, and if you've been following the Market Shadows blog, you've probably seen some of the featured articles before, because we post them before creating the newsletter. To get newsletter articles immediately, visit us here.
As discussed in Whether Stocks are Cheap is Besides the Point, the stock market is not "low" according to metrics commonly used to determine whether the market is underpriced or overpriced - such as P/Es. However, the context in which valuations are measured has changed dramatically since the 2008 meltdown and subsequent succession of quantitative easings, courtesy of the Federal Reserve. The Fed and other Central Banks are creating a tsunami of liquidity in a race to devalue their own currencies. This is not a minor detail; it's a game-changer in the pricing of assets.
Discussing the Bank of Japan's monetary experiment, Chris Martenson wrote:
By now, we are all familiar with the details. Japan has initiated a program of monetary expansion that goes by the shorthand of 2-2-2. In two years, the Bank of Japan (BoJ) will fully double the monetary base as it seeks a minimum of 2% inflation.
In the aftermath of this announcement, the yen weakened by a whopping 8% against the dollar, the Nikkei stock average vaulted up by roughly 10%, and the $10 trillion Japanese government bond market had to be frozen twice because of intense volatility.
In truth, what Japan is running is as much a massive social experiment as it is a monetary experiment...
The basic formula for creating inflation involves more money and credit chasing too few goods. Whether this is more goods (just not enough to match the growth in money and credit), the same amount of goods, or even fewer goods is not important. What matters is that there is more money and credit than goods.
On this front, so far, so good. Japan is going to fully double (!) the monetary base in just two years. In any tidy, mathematical world where economics is governed by linear, rational processes, this doubling of the monetary base would result in inflation.
Unfortunately, the real world is not very tidy.
The monetary base is really an abstraction that refers to the amount of money that the banking system has available to pyramid into a greater number of loans. As I am sure you have figured out by now, simply having more money in the system will not automatically result in more money chasing goods.
In fact, without a good reason to borrow and then spend that money, those new funds may well just sit in the banking system chasing nothing related to real goods and services in the real economy. Instead, that money will simply chase financial assets such as stocks and bonds.
The BoJ knows this, and yet their plan revolves around the idea that they can create inflation by simply doubling the monetary base. Does this mean they are confident that there is pent-up consumer demand that was stymied by a lack of cheap funds from the banking system?
The very short answer is ‘no.’ The BoJ knows perfectly well that more base money will do nothing to stimulate additional inflation via consumer demand, and they know this because Japan has had rock-bottom borrowing costs for a very long time.
The Real Target – Trust...
The form of inflation that Japan hopes to stoke involves the kind where money currently stored in Japanese bank accounts comes roaring out into the Japanese economy. The BoJ is willing to harness the import/export losses* as a useful means of convincing the local businesses and populace that the yen is just not a safe store of value.
So the basic plan that the BoJ has put into motion is to ruin local faith in the yen...
Trust is an essential component in every economy and for every currency. The BoJ has just upped the ante by explicitly and specifically targeting trust in the yen. Perhaps they know what they are doing, and we certainly hope so, but I happen to think it is playing with fire. (Japan vs. Newton (and Certain to Lose))
[*When the BOJ prints money, it devalues the Yen versus other currencies. That makes exports cheaper for foreigners, who pay with dollars, euros etc. Companies such as Toyota, Honda and Canon benefit greatly. Japanese consumers take a big hit to their cost of living as everything imported to Japan will cost much, much more. Oil, food and other things might double in price. It is a zero sum game. Exporters win while ordinary citizens get slammed by higher prices.]
The Japanese stock market has gone wildly higher since the November election not because people are especially bullish on Japanese companies - they are not bullish on real growth, earnings or the economy. No, people are buying Japanese equities because they are bearish on the value of Yen.
(Chart source: Yahoo)
Last week, Mish Shedlock referred to the Bank of Japan's plans as madness: "Central bankers have gone totally mad. The stunning news of toady is a new pledge by Japan to double its monetary base in two years as the Bank of Japan Unveils Aggressive Easing... As one might expect on such a surprise announcement, the Yen had a spectacular plunge."
(Chart source: Mish)
"Don't expect the Fed [central banks in general] to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.
"Japan is eventually going to achieve "escape velocity" on deflation, and I assure you Japanese citizens will not like the results when it happens.
"When the Japanese bond market finally reacts to this inane policy, there is going to be a global currency crisis. (Competitive Easing Madness; Japan to Double Monetary Base; Draghi Signals More Easing; Yen Plunges)"
In the U.S., as in Japan, the economy and the stock market have detached. It's because people know that the value of cash is being eroded as the Fed "prints" new money to flood into the financial system and devalue the dollar. With a Zero Interest Rate Policy (ZIRP), there simply aren't practical alternatives for holding cash, investing, or earning decent interest.
As we have just seen occur very acutely in Japan, in the U.S., people are buying stocks as a defense against the U.S. dollar's slow and painful demise.
Given this landscape - with a vehement currency war brewing - equities prices are going higher, even after their terrible performance in 2008/2009 meltdown which chased many people out of the stock market.
Not only should an analysis of stocks consider the background in which stocks are priced, it should also consider investor psychology. Has the public fled for good? Probably not.
In Mom and pop: The world’s worst investors (MarketWatch), Brett Arends wrote:
"Stock prices were wrong in 2007 because they were too high, and they were wrong in late 2008 and early 2009 because they were too low.
"Second, as they [investors] now know, they sold out somewhere near the lows. They were not alone. According to the Investment Company Institute, the trade body of the mutual fund industry, U.S. investors flooded the market with stocks in the fall of 2008 and the winter of 2009. From September, 2008 through March, 2009, ordinary U.S. investors dumped $114 billion worth of stock funds. They sold at absolutely the worst time.
"This is not a coincidence. The stock market is 'us.'”
Currently, even after four strong years of stock market gains, the ordinary U.S. investor has not quit his job, invested all his money, and joined the party. As Joshua M Brown observed:
"To be clear, I don't see the renewed interest in stocks from the Mom & Pop investor class as a negative or a sign of a massive top - it's when they start quitting their jobs to daytrade or offering me tips at dinner parties that I get more circumspect about the meeting of Main Street and Wall Street.
"But, we're not there yet, these people are buying index funds at this point and they are anything but giddy and care-free at the moment.
"I nicked the below chart from Barry, it's hard to say the folks are truly "running with the bulls" just now. My best guess is we're somewhere hovering between Media Attention - "new highs!" - and Enthusiasm. Could be wrong, just a hunch."
Where do we think the public is on this chart?
Typically the public enters the market only after a large run up, just in time to buy at the top. Investors might get luckier in today's situation if American stocks start behaving more like the Nikkei 225 index. US equities have plenty of room to run simply as hedges against massive money-printing by Chairman Bernanke.
Read the full Market Shadows Newsletter: MarketShadows: No Direction Home, April 11 2013.