September 27, 2010
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Good morning. It was another positive week for the market last week, or actually was a very strong Friday after a lackluster first four days. The SPY closed up 2.33 (2.1%) on the week to finish at 114.82, all but one cent of that advance coming on Friday. The economic numbers had been generally positive for the week, and when the Durable Goods number on Friday came in less than forecast in total, but better with the Transportation orders out, the market ran to the upside. It still seems to be somewhat concentrated in a few areas, those companies that benefit by a lower dollar, like CAT and IBM, and the NASD names, like AAPL, PCLN, and AMZN that for some reason people will buy without regard to earnings, dividends, or whatever. Having said that, Friday was more broad based than we have seen in a while, and may well be the upside break-out that many have been waiting for. Friday’s closing price is the highest we have seen since May 13 of this year.
One of the things that has me believing that the market may continue to run up for a time is the recent behavior in the money supply. Even though the talking heads, and really people in general conversation, routinely have spouted the statement “All they are doing is printing money” it has not been confirmed in excessive growth in the monetary base. The economic problems we encountered in the last few years (virtually none of which has been effectively fixed) in and of themselves would have dramatically lowered the monetary base, or the supply of money available. If you lost all your wealth in LEH or BS or FRE, and had to draw down cash deposits you saw first hand how the money supply can drop, the money is just plain gone. The Federal Reserve needs to offset that decline in an effort to stop what happened in the Great Depression, when the money supply dropped 20-25% in a very short period of time. To their credit (and because they had things like deposit insurance this time) the Fed did not let the same thing happen in this latest crisis. However, it still does not make people whole. John Doe lost his life’s savings in C or GM, and the Fed has offset that money in the economy by printing money, so the money supply is now even, but John Doe is still broke. So even though the Fed this time has done the right thing, it is no cure all. The excess money the government is spending each month (almost $100B per month on average) is actually being borrowed more than printed, which will bring up, maybe sooner rather than later, its own set of problems.
Anyway, back to the money supply. The growth in M2 (M3 numbers have been shown to be declining in some publications, but are not readily found) has been around 2.8% in the last 12 months, and 1.2% in the last six months, hardly expansionary in normal circumstances. [Note: M1 is a measure of total money supply. The M1 money supply includes only checkable demand deposits. M2 is M1 plus net time deposits (other than large certificates of deposit).] However, there is a school of thought that says if you expand the money supply when the economy has structural barriers to growth (think late 1970’s) all that happens is that you create inflation. Anyway, I do not believe the 2.8% growth level will cause that. Very recently, however, we have seen an increase in this M2 growth, and the growth rate in the last three months has been over .9% (or 3.6% annually). Combine this with the growth rate in the overall economy of less than 2% we are seeing and the money supply growth can be becoming excessive. Two other news items last week seem to confirm my view. One was that a significant portion of the surprise jump in Thursday’s Leading Economic Indicators was due to the increase in the money supply, and the other was the Fed statement on Tuesday alluding to increased stimulus “if needed.” I think they have already started.]
So why is this a concern? Monetary Theory says that the amount of money in the economy times the number of times it turns (velocity) is going to be equal to the amount of goods produced times the price of the goods. Increase the money supply and either production goes up or prices go up, or some of both (velocity is thought to be a relative constant). Recently, however, in the last ten or so years, it seems like when the Fed increases the money supply (maybe for the wrong reasons or at the wrong time) it seems to just create asset pricing bubbles that end up as disasters. Remember in the early part of the last decade, with the Y2K scare, the amount of money poured into the economy by the Fed in case some of the dire predictions of Y2K came to pass. I have always felt that all that money did was help create the dot bomb bubble that exploded about a year or so later. Similarly, when Greenspan flooded the economy with money to keep the discount rate at 1-2% in 2003-2004 (with a massive increase in M2 in 2003 of 5%, 5.6% in 2004, and 4.1% in 2005) it was instrumental in both the unsustainable market rally from 2003 to mid-2007 and in the housing bubble that we still have not effectively dealt with. These mistakes, throwing too much money at an economy incapable of rapid growth due to issues other than restrictive money supply, have had devastating consequences. Yet it is still a popular policy tool. Every country is fighting now, sort of like the old Mercantilist Days of centuries past, to devalue their currency to gain an export advantage. They also all would love to pay back (if they can get away with it) the enormous debt with inflated currency. Wouldn’t it be nice to pay back China someday the billions we owe them with dollars worth half as much? Also, if in the short term the market were to run up and make people feel wealthier for a time, especially election time, that is not so bad either.
The problem is, it always seem to eventually backfire somehow, the fools growth, not based on increased wealth creation of real things and real wages, always seems to blow up. More ominously, those closer to the political power always seem to gain in the mess that follows. We are almost getting like Mexico, where the wealthy people have historically kept their wealth in dollars offshore. Whenever there was a crisis in the peso, and everyone here was concerned with people down there and their decreased buying power, we need not have worried about those on top. The ten or twenty percent drop in the value of the peso just meant that they just became 10 or 20% richer in pesos than all those not in dollars. Although everyone here, I think, agrees that things are better economically that at this time 18 months ago, very few would say that the recovery has been balanced. Banks are more powerful, less competitive, and charge way more than two years ago, despite some useless legislation aimed at putting some limits on the thievery. Large companies, like Sony in Japan, are actually comfortable threatening elected officials publically that if they do not drop yen prices jobs will move out of Japan. If the Fed pours money into the economy we will see a market rally that no one can figure out by earnings, dividends, or regular fundamentals, and we will see bonds continue to stay at or even rise from levels that are absurd historically. Then someday it will end, and the same group of people will be hurt and those close will magically gain. I for one am sort of tired of watching it, we are not Mexico, but I have yet to invent a phrase or word I can use to describe what I am seeing. We may not be Mexico, yet, but we are not my vision of the U.S. either, really making me nervous.
For those looking for a political solution, or someone to blame, I do not know where you turn. There is not a politician out there who does not want the market to advance, even if they think it might not be sustainable. How many times have you heard this President take credit for an up market, the market being up for no other reason than his policies (of course down days are not his)? It sure makes campaigning easier to retired people if the 401k or IRA is doing better. The short term thinking of all these people is just prop stuff up, get me elected, and somehow the economy will continue to grow like it always has. I just think that long term growth is off track, and that this time the little games will not only not work, but may be a disaster. Also, anyone who believes that the Fed is not worried about politics in an election year is someone I would love to invite next time I play poker.
So how do we trade it? I see a possible rally on the horizon that I feel will ultimately fail like those before it, but for me and my clients I want to participate in any rally for as long as it goes, then hopefully be gone, protected, or even short when it blows up. Right now we are placed pretty well in the PIP in the IWM, XLE, and XLF positions, and are a little deep in the money on call positions in the SPY. We will have to be a little more aggressive in getting a little longer in the SPY, either by paying a little to jump up a few strikes on a roll or in a complimentary position. I suppose the market could come back our way for a few days and we could get a nice price on a more routine roll, but I think a lot of people want this rally into the election and the supposedly politically neutral Fed will be happy to oblige. Having said that, we will continue to play the short side in the weeklies if it seems like we might have a short term excess to the upside (like maybe last Friday?). In any case, we will be quick to take profits in those short-term positions. I also think we need to be long term short in the bonds here, although we appear to have been a little early