… but it stands on a weak foundation.
The expected rebound in stocks and commodities has continued on Monday, but there are a number of signs that this is not much more than a short covering rally that is unlikely to last. Although yields on euro area government bonds and CDS on them have continued to decline (we will update the euro area charts tomorrow), the fact remains that the economy is under pressure, so bounces in stocks have to be approached with great caution – they are more likely to represent selling opportunities than a reason to buy at this stage. Notably the recent rally has inter alia been triggered by a short selling ban in several European countries. Short selling bans have historically always been medium term bearish events – they can trigger a bounce lasting for a few days, but in the long run they are extremely counterproductive, as they lower liquidity and hinder the price discovery process. By taking away the opportunity to hedge, they ultimately create even more selling pressure than would have appeared otherwise. This latest short selling ban is thus likely destined to fail as well – one wonders why the authorities even bother.
Consider the chart of the S&P 500 Index below, where we have penciled in the currently relevant fibonacci retracement levels.
The S&P 500 Index with the broken neckline (dark blue dotted line) with fibonacci retracement levels. Yesterday's rally ended at the 38.2% retracement level. Note that volume on rallies is declining sharply – a sign of weakness – click for higher resolution.
Among the things we find worrisome for stocks is the fact that several other markets have been very reluctant to 'confirm' the rebound. For instance, the 10 year t-note yield has hardly budged so far and gold has actually reversed and once again closed in positive territory on Monday. Given the recent negative correlation between stocks and gold, this represents a subtle warning sign.
The 10 year t-note yield – not much of a bounce yet – click for higher resolution.
Gold closes in positive territory on Monday, thereby producing a subtle non-confirmation signal for the stock market rally – click for higher resolution.
Crude oil with lateral resistance levels. Crude has followed the stock market higher, but here too we see a sharp decline in trading volume on the rebound – click for higher resolution.
In addition to the above, the complacency of market participants remains uncommonly high. Consider for instance the Investors Intelligence poll, which currently shows that 47% of financial advisors are bullish on stocks, while there are only 23% who are bearish. It is astonishing that people are not more worried about the stock market's likely future performance in view of the recent crash.
The Investors Intelligence poll of stock market advisors: bulls outnumber bears by more than 2:1. This is incredible complacency in view of the recent market crash – click for higher resolution.
The Stock Market and the Pool of Real Savings
We would nevertheless expect the rebound to continue for a little while (although not without interruptions – there is likely to be a fair amount of short term volatility in both directions). Eventually the market should either come back down for a retest of the crash low, or – and we think that is actually quite likely – should break below it and go even lower.
Readers may recall that we briefly talked on Friday about the recent surge in money supply in all the major currency blocs. Normally such a sharp rise in the money supply will tend to support asset prices, especially in the face of declining economic activity, as less money will be used in the real economy – so there will be 'excess liquidity' that is often spilling over into stocks.
However, a word of caution is advisable in this context. As we noted in our little missive on Paul Krugman's wish for an attack from outer space, the state of the pool of real funding is what ultimately funds and determines economic activity. We always believed that one of the symptoms that would show that monetary pumping is failing to revive economic activity would be weakness in the stock market in spite of the presence of excess liquidity. If the pool of real funding is stagnating or declining, then excess liquidity, instead of spilling over into the stock market, would flee into assets considered safer than stocks. This happened in fact in the early 1930's, as Frank Shostak reports here.
Indeed, Mr. Shostak confirms our idea that the stock market's reaction to monetary pumping represents circumstantial evidence regarding the state of the pool of real savings – an idea we first mentioned in late 2008. He writes:
“If the pool of real savings is in trouble, then various key economic data will have difficulty performing well. If the pool of real savings is falling, then an increase in liquidity is not likely to be employed in the stock market. The state of the pool of real savings dictates the economy's ability to generate wealth — that is, economic growth.
For instance, the yearly rate of growth of industrial production fell from 15.3 percent in January 1929 to negative 24.6 percent in October 1930. The growth momentum of the consumer-price index (CPI) also had a large fall during this period. The yearly rate of growth fell from negative 1.2 percent in January 1929 to negative 6.4 percent in December 1930.
In response to these large falls, the yearly rate of growth of surplus money increased from negative 16.6 percent in May 1929 to a positive figure of 25.5 percent by November 1930. Despite this strong increase in liquidity, the S&P 500 fell from 24.15 in October 1929 to 15.34 by December 1930 — a fall of 36.5 percent. The index in fact continued to slide falling to 4.4 by June 1932 — a fall of 81.8 percent from October 1929.
The inability of the increase in liquidity to affect the stock market from May 1929 to December 1930 was because of a fall in the pool of real savings. The ensuing depression and massive unemployment pushed people to stay out of any form of risky investment for safety reasons.”
This mirrors our thinking on the matter and is one of the reasons why we would caution that a sharp rise in the money supply and free liquidity is not a guarantee for a rising stock market. The Fed can create money, but it has no control over where this money ultimately goes.
Since we believe that the credit booms of the four decades old fiat money system have done grave damage to the pool of real funding and consumed untold amounts of scarce capital, we are not at all certain that the stock market will keep rising if the pace of monetary pumping is increased. This is something one should keep in mind when considering what to expect – normally, the strong rise in free liquidity should lift stock prices, but if it fails to do so, then that would be a very bad sign indeed. It would likely indicate that a severe economic depression was in train.
The Great Default's sad 40th Anniversary
Yesterday it was exactly 40 years since president Nixon severed the dollar's last remaining link to gold – effectively defaulting on the Bretton Woods agreement in the process - and introduced price controls in a vain attempt to keep inflation at bay.
Ever since, the world has been on a pure fiat money standard of free-floating currencies and not surprisingly, the biggest credit bubble in all of history has ensued. The incredible inflation of the credit and money supply since 1971 has ultimately brought us to the current juncture, where the system finds itself on the brink of catastrophic failure.
A good overview over the disastrous economic policies pursued by Nixon and his partner-in-crime Arthur Burns, then chairman of the Federal Reserve, can be found in an article at Bloomberg that chronicles the events that culminated in the decision to throw gold overboard – 'The Nixon Shock'.
Incredibly, in spite of the fact that the evidence of what a terrible policy decision this was continues to pile up all around us, some people think that Nixon's failures should serve as an 'example for Obama' – one 'worth emulating'. No, we're not kidding. Bruce Bartless writes: 'Nixon's Radical Economics: A Lesson For Obama'. At first we thought that Bartlett meant Nixon's escapades should serve as a warning, but no:
“As Barack Obama struggles to find his Presidential footing in the face of a weakening economy, tinderbox stock market, and hard-headed opposition, it is instructive to consider this: On August 15, 1971, Richard Nixon implemented the most radical economic program in American history. And it was all done over a single weekend in secrecy worthy of the atomic bomb project during World War II.
While ultimately unsuccessful, the Nixon program showed what a forceful president can do to completely change the nation’s course if he is willing to push the limit of his power.”
Yeah, right – never mind whether an economic policy is a complete and utter disaster – the most important thing is that the president is willing to 'push the limits of his power' to show us how radical he can be! Let's advocate boldness for the sake of boldness, even if it means an economic debacle of unimaginable proportions.
Sometimes we wonder where they find the people coming up with such garbage. There must be a nest somewhere.
Christina Romer Continues to Push Her Flawed Depression History
For some reason interventionist inflationist theories continue to flourish like never before, in spite of the fact that we have just seen another such experiment end in failure. We have previously commented on the statism of Christina Romer, who these days snipes at the allegedly not 'bold enough' policymakers from her redoubt in Berkeley.
She has once again penned an editorial for the New York Times, pushing her faulty depression history and using it as a misguided argument supporting her demands for more inflation and more deficit spending. Once again she revives the old canard that 'World War II ended the depression' and argues that the 1930's give us 'reason for hope, if only our policymakers decide to employ their tools'. The image of policymakers who like car mechanics can somehow 'fix' the 'stalled engine' of the economy just won't go away. We would be inclined to ask, if it's so easy, why haven't they done it yet?
“Look more closely at history and you’ll see that the truth is much more complicated — and less gloomy. While the war helped the recovery from the Depression, the economy was improving long before military spending increased. More fundamentally, the wrenching wartime experience provides a message of hope for our troubled economy today: we have the tools to deal with our problems, if only policy makers will use them.
As I showed in an academic paper years ago, the war first affected the economy through monetary developments. Starting in the mid-1930s, Hitler’s aggression caused capital flight from Europe. People wanted to invest somewhere safer — particularly in the United States. Under the gold standard of that time, the flight to safety caused large gold flows to America. The Treasury Department under President Franklin D. Roosevelt used that inflow to increase the money supply.
The result was an aggressive monetary expansion that effectively ended . Real borrowing costs decreased and interest-sensitive spending rose rapidly. The economy responded strongly. From 1933 to 1937, real gross domestic product grew at an annual rate of almost 10 percent, and unemployment fell from 25 percent to 14. To put that in perspective, G.D.P. growth has averaged just 2.5 percent in the current recovery, and unemployment has barely budged.
There is clearly a lesson for modern policy makers. Monetary expansion was very effective in the mid-1930s, even though nominal interest rates were near zero, as they are today. The Federal Reserve’s policy statement last week provided tantalizing hints that it may be taking this lesson to heart and using its available tools more aggressively in coming months.
One reason the Depression dragged on so long was that the rapid recovery of the mid-1930s was interrupted by a second severe recession in late 1937. Though many factors had a role in the “recession within a recession,” monetary and fiscal policy retrenchment were central. In monetary policy, the Fed doubled bank reserve requirements and the Treasury stopped monetizing the gold inflow. In fiscal policy, the federal budget swung sharply, from a stimulative deficit of 3.8 percent of G.D.P. in 1936 to a small surplus in 1937.
The lesson here is to beware of withdrawing policy support too soon. A switch to contractionary policy before the economy is fully recovered can cause the economy to decline again. Such a downturn may be particularly large when an economy is still traumatized from an earlier crisis.”
Well, as we noted in our previous comments on Romer's interpretation, if you look even more closely at these alleged 'good times' within the depression and the subsequent retrenchment, you find that things were not exactly as 'hopeful' as she paints them. In fact, you soon realize why the period is nowadays known as the 'Great Depression' and not the 'two little recessions book-ending the great state-financed boom of the 1930's'.
There were, as Romer rightly notes, a great many reasons why things happened the way they did. All her story shows is that 'historical data' can be used to 'prove' just about anything – they are however no replacement for good economic theory. Unfortunately it remains impossible to 'buy' a genuine sustainable economic recovery with deficit spending and money printing. What Romer forgets is that the necessary liquidation of malinvested capital can only be delayed, but never averted by such interventions. If anything, they will make the eventual retrenchment all the worse – which is precisely what happened in 1937-38. It was not a 'mistake' to stop the deficit spending and money printing orgy in 1937 – it was a mistake to start with it in the first place and then stopping it so late. Had the authorities waited even longer, the subsequent recession would have been even worse. Had they simply continued along the path they were on, they would eventually have invited a complete conflagration of the currency system. That is the only lesson worth learning from 1937
Euro Area Chart Update
Below is our usual collection of charts of CDS spreads and bond yields in the euro area, plus a few other charts – prices in basis points, color-coded where applicable. We have added a few new charts that may be of interest, such as UoM consumer sentiment and a long term view of French and Spanish CDS spreads.
5 year CDS on Portugal, Italy, Greece and Spain – still in pullback mode (see also a few of the individual CDS charts further below for a longer term view) – click for higher resolution.
5 year CDS on Ireland, France, Belgium and Japan – the move in Japanese CDS is beginning to look suspicious – a left of field problem apporaching? Japan is a 'gray swan' – click for higher resolution.
5 year CDS on Bulgaria, Croatia, Hungary and Austria – all pulling back now as the euro area crisis temporarily calms down again – click for higher resolution.
5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – click for higher resolution.
5 year CDS on Romania, Poland, Slovakia and Estonia – we should keep an eye on Poland (we will have more to say on CEE nations tomorrow) – click for higher resolution.
5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – following their European counterparts – click for higher resolution.
10 year government bond yields of Ireland, Greece, Portugal and Spain – some are beginning to bounce once again – click for higher resolution.
10 year government bond yields of Italy and Austria, UK gilts and the Greek 2 year note – not much change, except that Greek debt is once again selling off – click for higher resolution.
5 year CDS on BAC (Bank of America) – a slight pullback, but not much has changed really. Still close to a 10 year high – click for higher resolution.
3 month euro basis swap – a small bounce, but nothing earth-shattering. This remains at a worrisome level – click for higher resolution.
5 year CDS on France – a small pullback as well, but this long term chart shows how precarious the situation remains – click for higher resolution.
5 year CDS on Germany – also a tiny pullback – click for higher resolution.
5 year CDS on Spain, a long term view. This shows that in spite of the recent pullback, the current level remains rather concerning – click for higher resolution.
5 year CDS on the 'Big Four' Australian banks - also a tiny pullback, but nothing that threatens the uptrend yet – click for higher resolution.
University of Michigan consumer sentiment, a long term chart – this is the lowest level since 1980 – click for higher resolution.
University of Michigan consumer sentiment, expecations index – good grief! – click for higher resolution.
Charts by: StockCharts.com, Decisionpoint.com, Bloomberg
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