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Tuesday, August 10, 2010 5:03 AM

Quantitative Easing Take II; Uncharted Territory

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In response to Will Quantitative Easing Spur Inflation? Job Creation? Credit Expansion? Do Anything? (a point-by-point discussion of thoughts from Chris Ciovacco at Ciovacco Capital Management regarding quantitative easing), I received a nice reply from Chris.

Chris writes ...

Hello Mish:

I agree with your comments today. We could have done a better job properly framing our comments on quantitative easing. We added the following to the top of our review to clarify our remarks:

Our interpretation below relates to the asset markets and asset prices. We believe quantitative easing can impact asset prices in the short-to-intermediate term. We do not believe quantitative easing is the solution to the global economy’s problems, nor do we believe it will create long-term prosperity or job growth.

As money managers, our job is to understand the possible impact of Fed policy on the value of our clients’ investments. The short-to-intermediate-term driver of asset prices would be the perception of market participants, right or wrong, that the Fed can create positive inflation.

We firmly believe quantitative easing can impact the prices of stocks, commodities, and currencies in the short-to-intermediate term. In that light, we believe quantitative easing, or even the potential for the Fed to buy Treasury bonds, is an important factor in determining investment outcomes in the next six to twelve months. Financial market performance and the long-term economic impacts of quantitative easing are two separate issues.

Have a great weekend,

Ciovacco Capital Management
Chris Ciovacco
My Reply ...

Thanks Chris.

That is much better expressed. It is possible we are seeing some up-front effects now. If so, we could see a spike and a sell the news event, if and when the Fed does start QE2.

Moreover, this could be another "bazooka" ploy. So far all such ploys have failed. However, it is conceivable one of these bazooka plays "works" (rather appears to work), temporarily. One must balance that with the possibility QE2 blows up in the Fed's face if they try it.

This is a very difficult market to judge. I see absolutely no reason to be long here. However, that is not an endorsement to short.


Chris Responds - Deflationary Outcomes Possible:
Hi Mish:

Appreciate the feedback. These are difficult times for investors and professional asset managers. We agree QE2 could result in another speculative leg higher in the markets or it could backfire.

Your comment "this is a very difficult market to judge" is right on the money. In our view, investors must understand and respect that short-term, primarily speculatively-based, gains are possible in asset prices. However, deflationary outcomes are also possible.

Asset price deflation (stocks & commodities) could take hold near current levels or could occur after another leg higher. We see the threat of a deflationary spiral accelerating if the S&P 500 again revisits the 1,010 to 945 level.

Any sustained break of 945 could open the door to very unpleasant outcomes. I think posting the email (and your thoughts) is a good idea. As I am sure you agree, our objective is to help people understand possible outcomes, over different time horizons.

Ciovacco Capital Management
Chris Ciovacco
Inflation Threat is Congress Not the Fed

The real inflation threat in the US is not the Fed. I think the Fed is pretty much powerless here. If quantitative easing seems to work, it will be temporary, just as happened in Japan.

Many people have emailed me stating that the Fed will give away money. No the Fed won't.
The Fed cannot throw money out of helicopters or give money away. Such talk is nonsense. However, Congress can give money away.

Here are the pertinent questions:

1. How likely is that?
2. Enough to cause a serious bout of inflation?

The answer to #1 is straightforward enough: It is certain. Indeed, Congress has reluctantly agreed to toss another $26 billion at states to "save jobs". The idea is foolhardy of course. One of the big problems cities and states face is public unions and public union salaries.

Those problems wrecked Greece and in my opinion have virtually bankrupted many major cities and states. Yet, here we are making another policy error, attempting to keep union wages intact and a defined benefit pension scheme alive, both of which desperately needs to be tossed in the gutter permanently.

The more important question is #2. Most think yes. I think no.

For starters the next Congress is going to be a lot more conservative than this one. Already we have seen unemployment benefits delayed for week. Money for the states came out of another pocket so the deficit did not go up.

However, a major reason a massive helicopter drop is not coming in spite of what everyone seems to think, is neither the Fed nor banks wants one! The Fed does not want hyperinflation as it will end the game. Banks do not want hyperinflation for the same reason.

What Do Banks Want?

Leaving aside the issue of hyperinflation, a complete loss of faith in the value of currency (an idea I believe is extremely remote), does anyone benefit from strong inflation?

I do not believe banks want serious inflation for the simple reason they do not want to be paid back with inflation cheapened dollars. Banks who were bailed out by taxpayers, already got what they want. They have nothing but scorn for the average Joe on the street his problems.

Besides, rising prices is no guarantee there will be job growth.

If banks don't want it, and the Fed doesn't want it, and Congress is likely to be far more conservative, then how is it going to happen? It is possible of course, but how likely?

That was a hidden theme in Fooled by Stimulus - Structural Problems Still Intact.
Problems Many, Solutions Nonexistent

  • Tide of Debt: Consumers are swimming against a tide of debt with no way to pay it back.
  • Demographics: Boomers are heading into retirement scared half to death because they did not save enough.
  • Jobs: There is no source of jobs
  • Wages: Global wage arbitrage
  • Attitude Changes: a secular shift in the attitudes of consumers towards housing and risk taking is underway.
  • The Fed is powerless to change attitudes.
It is going to be extremely difficult to counteract all of the structural problems in place.

As long as those structural problems are in place, the most likely outcome by far is a long drawn out Japanese style malaise. Whether or not prices as measured by the CPI stay above the zero line or dip below is actually a fairly insignificant point.

Bank lending and job creation are what matters most. The Fed is powerless on both of those scores, and barring massive efforts by Congress (and probably even with massive efforts by Congress), job creation is not around the corner.

Here is the essential question: If $1 trillion in fiscal stimulus did next to nothing, pray tell why would another trillion do anything?

Is another $trillion in fiscal stimulus coming? I highly doubt that.

Might a $trillion in QE2 come? Sure, perhaps even double that. But would it accomplish anything?

Long-term Chris Ciovacco agrees that it will not spur growth or fix any structural problems.

Short-term is more debatable, but perhaps the only response is a move in treasuries or gold.

Shorting Treasuries

Many have gotten their heads blown off again shorting treasuries. With all the above-mentioned structural issues, and with the Fed threatening QE2 on top of it, why would one want to be short treasuries here?

Fed Cannot Change the Trend

Let's return to the revised thesis, that QE2 may cause a bounce in the markets. Chris believes "quantitative easing can impact the prices of stocks, commodities, and currencies in the short-to-intermediate term."

While possible, please remember ...

The Fed can speed up or delay, but not change the primary trend.

Quantitative easing might give a boost to that downward trend in 10-year treasuries, but Fed purchases of treasuries is certainly is not the cause of plunge in 10-year treasury yields. The slumping economy and deflation are the cause.

Fundamentally, yields ought to be falling, and they are. If and when yields are poised to rise, the Fed will not be able to do much to stop it.

Perhaps QE2 causes a bounce in the equity markets, but it will quickly fade unless the market was ready to head in that direction permanently.

Uncharted Territory

To be sure, we are in uncharted territory, not only in treasuries, but in the Fed's response to the crisis. I called for the Fed's power grab and willingness to break rules in advance on April 3, 2008 in the Fed Uncertainty Principle.

Nonetheless, I do not know for sure what is coming up next. No one else does either. Yet I see statements every day on the internet such as "I know gold is headed to $2000", "The bottom is in", etc.

Well gold may (or may not) hit $2000 but certainly no one knows. It may also fall to $500. The Bottom in the stock market may be in, but there is a very good chance it isn't.

The Known

1. Structural problems (tide of debt, demographics, etc - as noted above) are numerous.

2. Stocks are not cheap if you factor in quality of earnings, dividends, historical PEs, etc. Stocks only "appear" cheap if you believe forward earnings estimates in the face of those structural problems.

3. Buying stocks in the face of such structural issues, at a time when they are not cheap is highly likely to yield poor results.

4. It is difficult if not impossible to time the effect (if any) of quantitative easing. In fact, we may have already seen it in advance.

5. Gold is in a long-term bull market with its monthly trendlines intact. Other than treasuries, not much if anything else is.

Some may debate point number two, but I am willing to state that is what I know. However, knowing stocks are not cheap, and knowing where they are headed are two entirely different things.

The Unknown

We do not know what Congress will do, what the Fed will do, or what foreign central banks will do if the economy heads south again in a major way. We have ideas, but we cannot say we know.

Moreover, it is not what the Fed or Congress does in isolation that will matter most, rather what they do in relation to what other countries is what matters, and we certainly do not know that.

China is a wildcard and its response to the next global slowdown will greatly impact commodities. Does anyone know for sure what China will do? I think not.

The Mideast is another wildcard. Certainly we might see a startling reaction if Israel were to attack Iran or vice versa.

The Odds

While stocks may rise in this environment, the odds are they don't. While treasury yields may shoot to the moon, the odds are they won't. While gold may collapse, the odds are it won't.
While quantitative easing (assuming it happens) may temporarily effect stock prices favorably, the odds are against someone timing it correctly.

This is is not a call for anyone to short this market as most of those structural problems are reasonably well understood. However, this is quite a good time to be thinking about risk-reward setups, because the odds of a sustained rally sure do not look favorable.

Bear in mind unfavorable and impossible are not the same thing. While one might throw sevens, four times in a row at craps, I would not advise betting on it.

Mike "Mish" Shedlock
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