Wall of Worry gets slippery ahead of turbulent week

The U.S. capital markets were mixed yesterday ahead of what promises to be an interesting and turbulent week. Among the widely anticipated events will be today’s election, Wednesday’s QE II, er, FOMC announcement, Thursday’s ECB meeting, and Friday’s unemployment figures. Other central banks will also be weighing in, and the continuing Q3 earnings season will only add to the noise level. How Mr. Market sorts through this crowded calendar is anyone’s guess, but the higher prices for equities, Treasurys, and commodities since the July lows leaves room for disappointment once QE II becomes a reality. Then again, it rarely pays to fight a central bank determined to shred its own currency, so it is possible investment ideas that benefit from money-printing still have room to run. But no matter what happens during the balance of the week, perhaps the smartest thing we can all do is vote.

Stock futures were up early Monday morning after the release of a strong purchasing managers survey in China, and the major averages in the U.S. extended those gains when our own ISM survey surprised investors to the upside. When fresh credit concerns emanating from Europe started to hit the U.S. money-center banks, those gains could not be sustained and the averages were sporting losses entering Monday’s final hour. A late rally left the indexes mixed, though the Russell 2000 (-0.7%) was a notable laggard. Treasuries, which had been down earlier, also reversed to finished mixed. The same was true of the U.S. dollar as it went from soft to firm as the day progressed. Commodities made it unanimous, as an early rally withered to leave the CRB index with a gain of just 0.25%.

When I last wrote about the U.S. capital markets back in July, the air was thick with fear and the worries were piling up by the day. The U.S. economy was visibly slowing; the housing market was suffering a relapse; various PIIGS nations were facing slaughter by their creditors; China was stumbling; Japan was entering a third decade just as lost as it was during the previous two; and no one could predict what zany new policy might next come out of Washington, D.C. With “austerity” the new watchword for many governments, more than a few observers worried just how the world would grow enough to create jobs. Against this negative backdrop, stocks were slipping, bonds were climbing, currencies were gyrating, and commodities were falling. A couple of pundits even went so fas as to warn about the possibility of another stock market crash. With the VIX spiking toward 40, the press found it a fertile time to plant gloomy stories such as the two that follow:

5 Doomsday Scenarios for the U.S. Economy
Pimco Sells Black Swan Protection as Wall Street Markets Fear

Of course, you know by now what happened next: the markets recovered smartly from the 2010 nadir set in July. It’s been said that Wall Street “likes to climb a wall of worry”. If so, then market participants managed this summer to build one that threatened to block out the sun itself. Contrary sentiment alone, however, does not explain why the major averages are more than 15% above their lows in July, nor does it explain why bonds have generally risen even as the dollar has been drubbed. Climbing a “wall of worry” is also insufficient to explain why commodities have taken flight this fall, or why gold and silver have recently scaled new heights.

Giving Mr. Market a healthy boost up this wall in recent months has been Benjamin S. Bernanke and his colleagues at the FOMC. From the Chairman, Vice Chairman, and various others on the FOMC during August and September, we heard speech after speech preparing the markets for another round of Quantitative Easing. Once the first round of QE (dubbed QE I) was refused docking privileges this summer, the anticipated launch of QE II has only grown. Securities prices already reflect at least some increased debt monetization by our central bank, but the questions of how much and how long remain open. The anticipation has grown to the point where economists are now handicapping the outcome on Wednesday in the same way they offer guesses about jobless claims and durable goods orders. The following story is as good a guide as any to measuring just how much new QE is expected by market participants:

Fed Likely to Announce $500 Billion of Purchases, Survey Shows

It’s a sign of our times that the debate now centers on half a trillion dollars of money-printing, give or take a hundred billion. The numbers are so staggering that we all seem numb to the implications of what was previously considered a radical, if not heretical, monetary policy. If you had told someone exactly 4 years ago that the following words would be the lead two paragraphs in a story on Bloomberg in November, 2010 — and that the story would have raised very few eyebrows — then you would have been laughed at, scorned, or ridiculed. But what was deemed impossible in 2006 seems set to become a fact that will be swallowed with relatively little difficulty on Wednesday. Try to imagine reading the following sentences with a pre-crisis mindset :

“The Federal Reserve will probably begin a new round of unconventional monetary easing this week by announcing a plan to buy at least $500 billion of long-term securities, according to economists surveyed by Bloomberg News.
“Policy makers meeting tomorrow and Nov. 3 will restart a program of securities purchases to spur growth, reduce unemployment and increase inflation, said 53 of 56 economists surveyed last week. Twenty-nine estimated the Fed will pledge to buy $500 billion or more, while another seven predicted $50 billion to $100 billion in monthly purchases without a specified total. The remainder said the Fed would buy up to $500 billion or didn’t quantify their forecast”. (Source: Bloomberg News, 11/1/10)

Is four years too long ago to imagine? Well, if you had shown these same paragraphs and the date of the story to investors only 3 years ago, they still would have called you crazy. They would likely have told you, with a sneering reassurance, “the stock market just set a new all-time high, housing has bottomed, and the Fed is easing. They’ve got the situation under control”.

Even two years ago, during the dark days of autumn 2008, few would have imagined that TARP and the Fed’s alphabet soup of various rescue operations would be so insufficient as to cause our central bank to not only scoop up $1.5 trillion of fixed income assets in the months ahead but also to contemplate another $500 billion or so in late 2010.

And remember November of 2009? Exactly one year ago, the debate centered on how much and how fast the Fed would EXIT their 2009 bond purchases. On November 1, 2009, the number of forward-thinking people who predicted QE II could have been comfortably seated around Donald Trump’s Board Room table — right before he fired them all for being so stupid.

In addition to being a sad commentary about the current state of monetary affairs in this country, what’s interesting about this thought experiment is that it shows us all how hard it is to invest — even when one is told in advance about a major policy move like Quantitative Easing. It will get no easier on Wednesday afternoon, either, when market participants are forced to weigh what the FOMC actually does versus what has perhaps already been discounted by current asset prices. Bulls and bears alike will find it easy to second guess themselves while getting chopped up in the process of reacting to the “news”. My own strategy is to hold onto positions that benefit from money-printing and currency debasement (e.g. the precious metals and the companies that mine them) while putting in place some hedges against a general market decline. The need for risk management is greater with the S&P 500 closing in on 1200 today than it was in July when the index was approaching 1000.

But no matter how the markets react in the short run, we should also consider the long term implications of QE and whether operations will halt with the Roman numeral II. I’ve written many times that the end game of fiscal stimulus, massive deficits, and Quantitative Easing will some day be a much weaker dollar, much higher long term interest rates, or a toxic combination of the two that ends in a funding crisis. Below you will find articles and an interview that openly speculate about these outcomes from different angles.

PIMCO’s Bill Gross calls Quantitative Easing a “Ponzi scheme” and predicts the launch of QE II will mark the end of the 30 year rally in government bonds. Tocqueville Asset Management’s John Hathaway makes the case that gold is the only currency that will be left standing once the QE-inspired currency wars leave behind a battlefield littered with fiat casualties. And finally, Kyle Bass warns those watching his interview that the U.S. is on an unsustainable fiscal path. His calm, well-reasoned arguments for getting back to fiscal sanity almost belie the urgency of his message.

In closing, let me say that the arguments made by all three gentlemen are worthy to consider as we go to the polls tomorrow on election day. The right to vote in free elections is one our founding fathers always saw as the ultimate safeguard to sustain our nation. Please vote tomorrow.

Jack McHugh

Investment Outlook: “Run Turkey Run”, by Bill Gross, PIMCO
Gold Will Outlive Dollar Once Slaughter Comes: John Hathaway
Kyle Bass Interview on Sustainability of Global Debt Burdens

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