Let’s Talk Monetary Theory
January 17, 2012
Good morning. The market continued its move to the upside last week, with the SPY up 1.13 (.9%) to close at 128.84. That close represents a move of 2.7% (3.84) since the start of the year and an impressive 7.3% (8.81) since the recent low on Dec. 19 of last year. Even the S&P downgrade of several European countries late last Friday, including France losing the coveted AAA rating, has not seemed to stop the market advance. Plainly put, the market looks like it wants to go higher and, maybe most telling, is that recently the US market does not seem to reflexively drop down every time the news from Europe is less than ideal. Having said that, the market has had quite a move since Dec. 19 and you have to wonder if it might be getting a little tired. My concern remains the same as it has for really the last 10-12 years. The market has had little to virtually no total advance going back to January of 1999, but there have been some solid rallies, notably late 1999 through April of 2000 and from June 2002 all the way through September 2007. Both seemed to coincide with “unusual” Federal Reserve activity in the sense that money supply growth was accelerated, during 1999 partially in response to widespread fears of banking issues potentially due to Y2K fears and later an outgrowth of Alan Greenspan’s keeping of rates at 1% for an extended period of time. Now we are right at the “apex” of the historically amazing money supply surge of last summer (blow off end of so-called QE2) that saw full year 2010 M2 grow at 9.8% (economy growing at roughly 2%) showcased by a 2.2% monthly growth in June 2010 itself. In fact, the months April 30-July 31 saw an increase of 3.8% in just that three-month period, which would correspond to a 15.2% annual rate. In just that three months the Fed saw fit to increase the money supply roughly twice what the full year growth number would be for the total economy. I think the remains in Milton Friedman’s grave have to be spinning.
Conventional monetary theory would normally put a six-month lag on the effects of changes in monetary growth rates on the economy, which would put the last month or so right in the middle of the expansive “effect” of last summer. Fortifying that monetary push would be the coordinated recent injection of close to $600B into the European Banking system, probably blunting the effects of the US Fed recently slowing the US M2 growth rates to the more normal 4-5% range. In other words, it can be argued that the significant “rallies” of certainly the last ten years have been little more than manifestations of excessive Federal Reserve policy moves, and maybe we are just seeing one more manifestation. It should be noted that on the last few occasions of this phenomena when the artificial stimulus was removed the market lost (sometimes violently) most gains, or worse. The question on the table right now is whether the current rally, which is becoming impressive as to numbers, is just another of these passing “blips” brought on by our “challenged” Federal Reserve or the start of maybe a real bull market. My suspicion is that the answer is the former, and that this rally will also end badly. That does not mean, however, that we do not want to participate while it continues. It does mean, just like the skier who thinks a cliff might be lurking ahead, that we have to be careful and use strategies that are “cliff safe.”
The other question might be “Maybe we should bleep-can all this Monetary Theory anyway, Milton Friedman is dead and so are the ideas he championed.” If he was so right, how come all this “excessive” money isn’t causing the inflation it should be causing if it is so “excessive.” Remember, the basis of all Monetary Theory is the formula MV = PQ, where M is the money supply, V is the velocity of money (how many times the money is spent), P is the price level, and Q is the quantity of all good and services. What it basically does is describe a relationship that theorizes that if the quantity of money grows faster or slower than the quantity of goods and services the price level will adjust accordingly. Too much money entering the system relative to “real” growth causes inflation, too little deflation. For short periods of time the V, or the velocity of money, could be affected, but the V number is considered fairly constant over long periods of time. No matter how you consider the Velocity number monetary theory would say that a year like 2010, with almost 10% increase in M2 and 2% growth in real goods and services should have some inflationary beginnings. Why isn’t it, or why isn’t it showing in the numbers we are given?
The question is an interesting one, and I would not want to be the person that says that maybe my old teacher Dr. Friedman (let’s not get carried away, one class and a few open lectures) was wrong, especially since I think he was, and is, right. The problem, I think, stems from the bluntness of the Monetary Policy instrument. When you throw money at the “problem” you may hope that it goes to solve housing issues or whatever you really want it to solve but there is surely no assurance that the money can be “targeted.” So why no inflation, and why is that serving to embolden the Fed even more, making them even more aggressive and talking about a possible QE3? I will submit several possible reasons why these large increases are not having the “predicted” effect on inflation. One, it could be that the Velocity variable has actually had a short-term decrease, partially offsetting the increase in M2. I think that actually is true, the reason being that a lot of the money being injected into the economy by the Fed is not being used by the Banks, other than to lower their borrowing costs to near zero. In fact, it appears that the Banks are depositing their excess cash back at the Fed, and were (for a time at least) getting paid interest by the Fed to do so. The insanity of that sort of a system (jamming money for free at a slimy Banking system with no requirement as to how to use it for the greater good, and then “paying” interest to the same people on what was your own money) could be a whole article on its own, but let’s just say it is a reason why the full effect of the monetary expansion may not be being felt. Maybe an almost 10% growth in M2 is really 7% or something given how it is being administered.
The second, and one the conspiracy people love, is that it really is causing inflation. It certainly has caused inflation in gold (or shall we say that there have been corresponding price increases) in the last few years (almost double), the stock market has recovered dramatically, health care has probably averaged ten percent increases per year, college tuition, certainly state and local taxes, gasoline, etc. So should we say that maybe there has been inflation that the Fed refuses to acknowledge? The truth is that in areas with pricing power, areas that have been allowed to concentrate, you could probably find pockets of almost virulent inflation. I would say the CPI number put out probably applies to no one in the sense that it would represent “their” basket of goods and services.
The third “reason” for the uneven effects of the monetary stimulus might be the whole housing situation. While it is true that there has been a dramatic decrease in the costs of home ownership, both in mortgage rates and prices, that relative “good” only affects first time buyers. The majority of Americans are homeowners, and the dramatic effect on their personal wealth due to the precipitous declines in home prices far exceeds any “positive” effect on others of lowered prices. Even the positive effects on mortgage rates act as a negative of sorts for people caught in this trap, as the decrease in home value usually does not allow the current homeowner to refinance. You would think that the Fed, maybe not initially, but certainly after seeing the effects of some strong policy moves would see the very uneven and even detrimental effects of those moves, but this group appears blind. Or maybe not blind, maybe they do really want to put a dagger into the relatively unique and possibly short-lived notion of a middle class. The last thing you would want to pile on a populace with dramatic decreases in household wealth and slack wage growth is some sort of general inflation, denied or otherwise. Talk about salt in the wound, but good for the scavengers that will end up owning all this wealth at rock bottom prices, probably with actual help from the government. It is almost eerie how the Fed (and Treasury) has acted to help virtually everyone affected by the housing fiasco other than the individual homeowner, but this group remains mortally wounded. It is not a question of whether or not to bail out those that have signed contracts and, in effect, made their own bed, but whether everyone else involved should be helped but them.
I do have to ask myself why my views of our policy makers is so negative, as I actually do think the economy is slowly on the mend. In some ways I think the apparent resiliency of many in the population (in the face of huge impediments courtesy of various governmental agencies) is nothing short of spectacular. For some reason, however, the policy makers will only let the recovery happen through terms that favor those that have bought them off (I mean those that have contributed and have access). Don’t even think about a new entrepreneurial enterprise in Illinois getting a fair contract with the city or state, the barriers to doing what Americans are very good at, even today, are large. I am really starting to wonder if the economy can begin to really fix itself if the massive political corruption and barriers are not dealt with first, and I am at a loss about how that could even happen.
Notice how I talked about problems in the economy without even mentioning Europe, we don’t really have to look elsewhere for problems, they just add to ours.
So how do we make money in 2012? I think we want to be carefully long for at least a little while, using whatever volatility edge we can find to be long at good prices. The weekly options sometimes have had some edge that might allow us to use some shorter-term positions to our advantage, but the recent trending in the market (recently trending up) has made picking the strikes difficult. Clearly the market is still giving mixed signals, there has been good news and market recovery finally from some of the financials but there may be some long issues in that sector going forward. There also has been some huge percentage movement in some of the home sectors, but that seems a little stretched given the predicted very slow recovery. The steel/aluminum/coal sectors still are choppy, and should not be if a recovery was really a sure thing. The signals from developing countries are also mixed, and clearly a solid growth dynamic from China right now is very necessary for a robust worldwide recovery. Like I said, cautiously bullish but with eyes open. We have put some money to work in the Protected Index Program in the last few weeks, and will look to do more if the volatility in the long-term puts were to move down. I like to initiate positions with the put limiting the risk in the position to under 12%, but it seems like the number is going to continue to exceed that in an election year. I think we can ratchet up the call premium using the weeklies so I am getting more comfortable risking a little more, but still am looking to keep some cash in reserve. The dividend basket of stocks hedged by the SPY has continued to show promise, and if it continues to perform well we will be thinking of a combined PIP/dividend seminar within the next month to keep everyone up to date. There may also be some opportunity in some weekly calendar spreads in earnings stocks this week and next, we will be looking for sure. I think this year will be a good one for trading, and I wish everyone health and happiness outside of the market as well as in for 2012.