LunaticTrader

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Posts Tagged ‘Quantitative easing’

Why QE fails to start the economic engine

Posted by Danny on November 20, 2013

I get occasional questions about the quantitative easing (QE) programs that are being perpetuated by the world’s central bankers. Will it work? When?

The idea of QE is to add some extra money-fuel to start the economic motor. This is really no different from priming an engine before you start it in cold weather. If you own a classic car or an airplane, then you may still know the art of priming the motor before starting it. But with modern cars it isn’t needed, so most people, including our central bankers, have probably forgotten how to prime an engine.

I used to sell motorized vehicles in my early 20s, so I have explained the problem of over-priming countless times. But to keep this piece short you can read all about it in this well-written article: http://www.premierflightct.com/newsletters/TrainingArticles/ColdWeatherStarting.html
The dynamics of an economic motor are really very similar. So where the article correctly states: “Engines will fail to start for 2 reasons: too much fuel and too little fuel!“, we could as well say:

Economic engines will fail to start for 2 reasons: too much money and too little money!

When the economic weather turned unusually cold, and they tried to prime the economic engine with QE1 and QE2, it made sense. But since QE3 they are basically saying: we will continue to prime this engine until it starts. And that makes no sense. Then the engine fails to start because of over-priming. Then all you get is black smoke coming out. The motor stutters along but doesn’t really catch on properly. Black economic smoke has been belching out of Europe, Japan and the USA for years, but these central bankers fail to make the proper diagnosis: they have flooded the engine. It would have been better to put a car mechanic at the head of the Fed, because it looks like universities fail to teach such basic principles in their economy classes.
The mentioned article also correctly describes the dangers of continued priming. The extra fuel-money will accumulate in certain places and risk causing an engine fire. So the stock market could catch fire (speculative mania) or commodity prices could go crazy (hyper-inflation), both very damaging for an economy. At the moment it looks like we are coming close to the first possibility.

Now, for the sake of this little exploration, let’s assume that despite repeated over-priming the economic motor catches on somehow. Some more black smoke is seen and suddenly we hear the promising noise of an engine coming up to speed. Then our grounded economic plane is still not up in the air. There are still a few other problems to tackle.
Given the weather conditions and the amount of horsepower, an economic plane can only take a certain maximum load. Three things are typically weighing down an economic engine: interest rates, taxes and regulations. The burden of interest rates has been reduced to near zero. But governments in Brussels and Washington have not stopped inventing new taxes and adding more regulations on top of the old ones. Even with zero interest rates this plane may not realistically be able to take off anymore, it is overloaded.

And to make matters even worse, what we have is that the cockpits have gradually become bigger than the rest of the plane. Champagne is being served in those cockpits, quarrels are being heard from them,… but the plane doesn’t fly, it always stalls as soon as it gains a little bit of altitude. And the mechanics are getting the blame.
That is an ugly situation.

In a second part we can explore how to unburden this plane so it can fly again.

Be well,
Danny

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QE is like free beer

Posted by Danny on June 17, 2013

We have recorded the first negative lunar green period of the year. The Nasdaq lost 59 points. Is this the start of a prolonged downturn in the stock markets?
The current lunar red period will probably give us good clues going forward.

Let’s take a look at the S&P 500 chart (click for larger image):

S&P 500

The S&P remains within a beautiful trend channel since late last year. The lower trend line got touched twice in the recent weeks, and each time we got a swift recovery.
To put this period of weakness behind us the S&P now needs to climb above 1650 and show some follow through.

But I wouldn’t bury this correction just yet.
A third test of the lower trendline would be a bad omen, and probably see the S&P drop to 1550 fast.
This means market is likely to show its hand this week or next.
I hold some 1600 put options, just in case.

If the support at 1600 holds, then we can set sights on 1750 in July.

***

As chart of the week I have chosen the long term bonds (TLT):

TLT

A short term buy signal is setting up here, as my Earl2 indicator is turning up from oversold level. So, look for an upward bounce in bonds, no matter what Ben Bernanke comes out to tell us this week.
But that will only set up for another long term shorting opportunity imo. Because we are approaching the point where more QE will turn against itself. The problem is that after a while the QE itself becomes seen as a risk factor in the market. Investors start wondering when the QE rug will be pulled from under them, and start getting out while they still can.
That’s why QE is like free beer. When it is first announced it lifts the mood of all participants, and soon you have dance and party. But then you reach the point where more free beer only leads to bigger headaches (if not upset stomachs).
That’s what is seen in Japan already. Their latest batch of record QE has driven up interest rates rather than down, because Japanese banks have used the opportunity to sell 10% of their bonds. (see: http://www.reuters.com/article/2013/06/16/us-japan-economy-bonds-analysis-idUSBRE95F0H720130616)

Good luck,
Danny

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What parabolic peak?

Posted by Danny on June 2, 2013

The recent advances in the stock market have led to an explosion in articles contending that we are in a new stock market bubble or mania. Some analysts are seeing a parabolic peak already. Almost everyone seems to agree that some market decline should come any day now. The number of references to “bubble” on Twitter has also gone up significantly, as was pointed out in this article.
So, let’s have a look.

We all know how a parabolic peak, typical for speculative manias, looks like. The chart just shows a faster and faster appreciation, until it goes almost vertical.
The stock market in the 1980s and 90s shows a classic example (click for larger image):

S&P monthly

It’s easy to see how the rate of change accelerated twice, until it became unsustainable, and then the inevitable collapse after the year 2000.

Is that the kind of picture we see in the current S&P 500 chart? Here it is (click for larger image):

S$P 500 weekly

This is not a parabolic peak at all. If anything the rate of change has decelerated noticeably since 2011. In fact the S&P is still near the bottom of the trend channel it has occupied since 2009. That doesn’t mean it has to keep rising within this channel forever, but unless we get a drop below the support line (currently ~1500) it can keep going for quite a while. If it does so, then I would look for the market to reach the mid line by summer, which would be around 1800. The mid line is likely to put up serious resistance, so look for a meaningful correction if the S&P gets there.

Is there any precedent for this kind of scenario? Well yes, it’s the one scenario you never see mentioned anywhere in comparison with the current times: the roaring 1920s.
Some will consider that crazy, but there are more than a few parallels with now:
1) The market bottomed out in 1921, at the end of a sharp deflationary depression, not unlike 2009
2) Investors had suffered 50% losses twice within a decade, just like investors have burned their fingers twice in the 2000 – 2010 period. When investors have recent memory of painful losses they become very skeptical of any new market advance, and this sets the stage for a long bull market.
3) By 1923, two years after the bottom, the Dow Jones had recovered most of the depression losses, and by 1925, four years after the bottom, it was pushing into new highs. The current market playbook happens to be very similar, markets have pushed into new highs four years after the bottom.
4) What fueled the market? Well, besides ongoing innovation, the Fed also increased the money supply by 60% in the mid 1920s, with the aim of keeping interest rates low, not unlike the current QE programs. That money had to go somewhere, and apparently started flowing into stocks at some point.
5) We know what happened next. Most investors had probably remained scared, scarred and skeptical, even when the market was setting new highs every day. Then they started buying stocks in 1928 and 1929, and that made for the parabolic peak, almost eight years after the bottom. A similar scenario now would point to a peak in 2016/2017.

Here is the chart Dow Jones 1920-1940. (click for larger image):

Dow Jones 1920-1940

I have added the current years to line up the historic comparison. Notice how once the market moved into new record highs, there was only a brief correction and then the market kept grinding higher for almost a year without any serious pullback. Is the same happening again now? We will know by the end of the year.

Here is a chart comparing the current recovery with the post-1921 depression recovery, based on monthly Dow Jones index (click for larger image):

Dow Jones 2010vs1920

Up to now there has been a 0.81 correlation between them. We will see how it continues.

I think the current high levels of ongoing skepticism, and all the talk about bubbles, are actually lending credibility to this scenario. And the ongoing QE programs around the world are known to come with a high risk of igniting another stock bubble.
Bear in mind: history does not repeat, but it tends to rhyme.
The market action in the early 1920s rhymes well with what we see currently. The question becomes: when and where will the rhyming stop? Are we setting up for a great depression in the 2020s, or will the rhyming stop well before then?

Danny

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