HERITAGE CAPITAL PARTNERS, INC.
Monthly Tactical Commentary – November 8, 2010
CAVEAT EMPTOR: BERNANKE’S PUT
Last week, there were a number of key data points that investors had been waiting for
with high anticipation. These included the election, the Federal Reserve announcement
on quantitative easing and October’s employment report. The election and the
employment report came in pretty much as expected. The Fed report, however, was the
key event for financial markets. I spent much of last month’s commentary outlining why
the Federal Reserve was going to embark on a new round of money printing. It is
worthwhile to continue that discussion and then address the market reaction.
The thinking by most investors was that the Fed would print another $500 billion initially
over about a five month period. However, about a week or so prior to the announcement,
a number of Federal Reserve board members voiced their concern over this action. As a
result, I think the market started reducing their expectations to around $300 billion or so
and leave it open for more depending on the economic data. When Bernanke announced
he was going to do $600 billion over about an 8 month period, the market had a marginal
surprise to the upside. As a result, it had a greater impact on financial assets over the
following two days. Goldman Sachs now believes Bernanke will not stop his printing
press on this round until he reaches $2 trillion.
Bernanke wrote an Op-Ed piece in the Washington Post the following day, defending his
decision. John Hussman addresses this in his latest commentary. Bernanke wrote,
“Stock prices rose and long-term interest rates fell when investors began to anticipate the
most recent action. Easier financial conditions will promote economic growth. For
example, lower mortgage rates will make housing more affordable and allow more
homeowners to refinance. Lower corporate bond rates will encourage investment. And
higher stock prices will boost consumer wealth and help increase confidence, which can
also spur spending. Increased spending will lead to higher incomes and profits that, in a
virtuous circle, will further support economic expansion."
BERNANKE’S LOGIC, OR LACK THEREOF…
Hussman responds to Bernanke’s comments by writing, “Given that interest rates are
already quite depressed, Bernanke seems to be grasping at straws in justifying QE2 on
the basis further slight reductions in yields. As for Bernanke's case for creating wealth
effects via the stock market, one might look at this logic and conclude that while it may
or may not be valid, the argument is at least the subject of reasonable debate. But that
would not be true. Rather, these are undoubtedly among the most ignorant remarks ever
made by a central banker.
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Let's do the math.
Historically, a 1% increase in the S&P 500 has been associated with a corresponding
change in GDP of 0.042% in the same year, 0.035% the next year, and has negative
correlations with GDP growth thereafter (sufficient to eliminate any effect on the long-
run level of GDP). Now, even if one assumes - counter to reasonable analysis - that the
GDP changes are caused by the stock market changes (rather than stocks responding to
the economy), the potential benefit to the economy of even a 10% market advance would
be to increment GDP growth by less than half of one percent for a two year period.
Now, as of last week, the total capitalization of the U.S. stock market was at about the
same as the level as nominal GDP ($14.7 trillion). So a market advance of say, 10% -
again, even assuming that stock prices cause GDP - would result in $1.47 trillion of
market value, and a cumulative but temporary increment to GDP that works out to $11.3
billion dollars divided over two years. Moreover, even if profits as a share of GDP were
to hold at a record high of 8%, and these profits were entirely deliverable to shareholders,
the resulting one-time benefit to corporate shareholders would amount to a lump sum of
$904 million dollars. In effect, Ben Bernanke is arguing that investors should value a
one-time payout of $904 million dollars at $1.47 trillion. Virtuous circle indeed.”
BERNANKE’S BAZOOKA MAY BE SHOOTING BLANKS…
Hussman addresses Bernanke’s expectations on the virtuous circle from inflating stock
prices to the economy. Let’s now look at the expected impact on interest rates.
A Fed paper was released and highlighted on CNBC last week. It highlighted the
potential impact from another round of quantitative easing on 10-year Treasury bond
yields. To arrive at the impact on interest rates, you first take the amount of new money
printing and divide by 10 to arrive at the equivalent cut in the Fed Funds rate. If we take
the $600 billion then it comes to a 60 basis point effective cut in the Fed Funds rate.
Then you take that and divide it by 3 to arrive at the expected impact on 10-year treasury
yields. 60 basis points divided by 3 comes to a 20 basis point reduction in 10-year
Treasury yields. The main point is that it takes a very large amount of additional money
printing to have a modest expected impact on interest rates, $600 billion to push rates 20
basis points lower.
10-year Treasury bond yields have hovered around 2.5% recently and as low as 2.33%.
If we use the recent low yield and reduce it by another 20 basis points we get to 2.13%.
Interest rates and liquidity are not the problem. Whether 10-year bond yields are at 2.5%
or 2.33% or 2.13%, does Bernanke really think that is going to make a difference to the
economy? I can just see consumers and businesses saying, “Wow, now that rates are 20
basis points lower its time to go out and lever up again.” Bill Gross in his latest
commentary said, “We are in a ‘liquidity trap,’ where interest rates or trillions in asset
purchases may not stimulate borrowing or lending because consumer demand is just not
there.” There is also the possibility of a reverse effect on interest rates due to Bernanke’s
policy whereby we could see long-term rates go up instead of down as a result of
international investors’ concern that we are monetizing our debt.
THE REST OF THE WORLD ARE NOT DUMMIES…
Last month, I discussed how game theory applies to what Bernanke is doing and how we
will continue to see responses by other countries. Just since the announcement last week,
we are already seeing comments out by Germany, China, Brazil and others. Germany’s
finance minister, Wolfgang Schäuble, criticized Bernanke’s move as reported by the
Financial Times. He accused the U.S. of undermining its policymaking credibility,
increasing global economic uncertainty and of hypocrisy over exchange rates. On Friday,
Mr. Schäuble described US policy as “clueless”. Germany’s export success, he argued,
was not based on “exchange rate tricks” but on increased competitiveness. “In contrast,
the American growth model is in a deep crisis. The Americans have lived for too long on
credit, overblown their financial sector and neglected their industrial base. There are lots
of reasons for the US problems – German export surpluses are not part of them.”
The Associated Press reported comments from China this morning. “The U.S. Federal
Reserve's move to pump hundreds of billions of dollars into the financial system will
bring greater volatility to markets worldwide,” a Chinese official said Monday.
“The step will create new waves of cash sloshing in and out of countries in search of
short-term profits,” vice finance minister Zhu Guangyao told reporters at a news
conference to discuss the Group of 20 meeting of major advanced and developing nations
in Seoul, South Korea later this week.
The U.S. decision "does not recognize, as a country that issues one of the world's major
reserve currencies, its obligation to stabilize capital markets," Zhu said, referring to the
global use of the dollar as the currency in which nations store the bulk of their foreign
reserves. "Nor does it take into consideration the impact of this excessive fluidity on the
financial markets of emerging countries," he said.
Reading these remarks, you can start to get a sense of the thinking by various
international countries as to what Bernanke is doing. It will be important to watch for
more deliberate actions taken by other countries over the coming months.
Bernanke’s comments were focused on his beliefs about the stimulative effects from
inflating asset prices and pushing rates marginally lower. However, the bigger effect
comes from the impact on the currency market. You will rarely find the Federal Reserve
Chairmen discuss the currency since that is the “responsibility” of the Treasury
Department, as evidence by no mention of the currency in his Op-Ed article. That is
ridiculous because Bernanke’s actions are having the greatest influence on the currency.
Drawing the line on the currency enables the Treasury Department to go around saying,
“We have a strong dollar policy,” while Bernanke cranks up his printing press and can
deflect questions on the impact to the dollar. Talk about discrediting the credibility of the
Treasury and Federal Reserve.
VIRTUOUS OR VICIOUS CYCLE…
The Federal Reserve has a dual mandate of full employment and price stability. In
Bernanke’s article, he writes, “Unfortunately, the job market remains quite weak; the
national unemployment rate is nearly 10 percent, a large number of people can find only
part-time work, and a substantial fraction of the unemployed have been out of work six
months or longer. The heavy costs of unemployment include intense strains on family
finances, more foreclosures and the loss of job skills. Today, most measures of
underlying inflation are running somewhat below 2 percent, or a bit lower than the rate
most Fed policymakers see as being most consistent with healthy economic growth in the
Since Bernanke feels he is falling short on both mandates, he thinks that he must do
something. However, price stability and the “threat of deflation” is what caused
Greenspan to artificially stimulate the economy through 1% interest rates. That artificial
sense of security, the Greenspan Put, encouraged excessive debt-based consumption and
investment into inflated risky assets. As asset prices reverted back to fundamentals, the
economy imploded and the effects of the increased leverage magnified the downturn.
That led to the current situation of high unemployment and debt-deleveraging which put
more pressure on the deflationary threat over the last year than was evident in 2002
during Greenspan’s era. Now, Bernanke’s solution is the same; artificially inflate asset
prices. The virtuous cycle both Greenspan and Bernanke were/are counting on from their
monetary policy begins to look more like a vicious cycle of Bubble, Crash, Bubble,
Crash, Bubble… [Hussman’s title of his latest commentary.]
If you have ever taken the helm of a large boat for the first time, you know that one
problem novices often experience is that they tend to over steer whereas less movement is
much more effective moving through longer cruises. By over-steering, the boat continues
to move in a zig zag fashion rather than a smooth consistent course. The U.S. economy is
a very large ship and Greenspan and Bernanke, at the helm, have been very ineffective by
over-steering dramatically. Just look at the course of the Fed Funds rate in the last
Fed Funds Rate
Now, Bernanke is not only over-steering, but turning on the turbo props. As I have
mentioned many times before, the government and the Fed need to understand that a
desire to manipulate the economy in such a way to avoid any effects of a normal business
cycle ultimately leads to much more harm than good and plays out in the form of bubble
and bust dynamics. The normal business cycle serves to help clean out mal-investments
and encourages capital moving to its most productive use instead of bailing out failed
institutions and artificially inflating asset prices. What we need now is more saving to
rebuild our foundation, not a renewed spirit of over-consumption. By trying to avoid the
downturns of normal business cycles in past years, we now find ourselves in a structural
predicament where we are testing economic theories in unchartered waters.
Also, Bernanke is punishing the savers and rewarding the foolish speculators. He is
attempting to provide such a low return on safe assets that people will move back out into
risky assets again, just like Greenspan. And, the effects on the dollar are pushing up food
and energy costs. This is hitting the retirement community especially hard while he is
providing continued bailouts to debt-based speculators.
As you can see, I am not a fan of Bernanke’s actions and I think he is an academic with
too much power and is testing out his economic theories in a highly dangerous way.
While Greenspan went from being the “maestro” to receiving much of the blame for the
recent bust, I continue to think history will show Bernanke as the most ineffective central
banker of all. Remember, he is the one with the most economic data at his hands with
hundreds of analysts at his call and completely missed all the signs that the housing
market was in a free fall and the economy was rolling over toward the worst recession
since the Great Depression, even after the declines had already gained momentum. He
did not get it then and I think he is setting us up once again for significant unintended
FALSE SENSE OF SECURITY, AGAIN…
Now, let’s move on to the recent action in the markets. Investors are once again buying
into a new and much more pronounced “Bernanke Put.” A put option basically hedges
you against downside risk. Investors believe if any trouble comes along, Bernanke will
print more money and bail everyone out. As a result, investors believe it is time to
aggressively move out on the risk curve. It is amazing how quickly investors forget how
dangerous it was to heavily rely on the Greenspan Put back a number of years ago.
In spite of the dangers of Bernanke’s actions, my indicators shifted to the positive just
over two months ago as a result of an incremental change in buying power. This was
undoubtedly due to the anticipated short-term Pavlov’s dog reaction by investors to
Bernanke’s upcoming announcement. While I have seen hints of selling pressure into
this rally, it has not increased to a concerning level. This could change in a very short
period of time though.
It is important to note that my indicators are designed to identify shorter-term tactical
opportunities as well as longer-term strategic shifts. Bernanke’s actions most likely will
align with a tactical opportunity rather than a strategic one. While artificial stimulus
usually fosters short to intermediate-term changes in the trend, fundamentals such as
important valuation troughs fuel longer-term strategic investment opportunities.
Many leading indicators were suggesting renewed risks of a downturn in the economy
back to negative GDP a number of months ago, but it now appears that the economy may
move along but at a very sluggish pace. To reach earnings expectations for next year, the
market needs the economy to accelerate notably from here. Instead, we may have just
postponed the negative prints in GDP for a while rather than avoided them.
From the lows at the first of September to now, the market has moved into overbought
territory with very high bullish sentiment while insiders continue to sell. Valuations are
still very elevated but the momentum has been strong with Bernanke encouraging
increased speculation. We will likely get a correction soon of some degree. If the selling
pressure builds prior to or during the price correction, then we may get a downside
surprise. If, however, we get a minor pullback without increased selling pressure it will
be another short-term buying opportunity for year-end. We won’t know until we see the
character of the corrective action.
This corrective action may come from the normal process of digesting recent gains or
from a macro event such as a resurgence in fears over European sovereign debt. The
primary point for investors to consider is that there are an unusual number of artificial
cross-currents pushing asset prices around. For example, you can just look at the dollar
everyday and know what is going on with most all other asset prices since the
correlations have been running extremely high.
While short-term gains for the market are welcomed from a tactical perspective, investors
should not let their guard down and abandon their risk management practices. Market
gains during periods of elevated valuations and which are induced by irresponsible
monetary policies are often temporary in nature. Greenspan was successful in forcing
investors to move far out on the risk curve for short-term benefits. We all saw what
happened as a result of that. Investors should remain tactical in their thinking and
positioning as Bernanke attempts to do the same again but with a lot more force. Buyer
Beware of the perceived “Put” sponsored by our wonderful Central Bank Chairman.
Joseph R. Gregory, Jr.