There is something wrong with the Dow's all time high last week.

  March 12, 2013

Something is Wrong

Dow Sets Record On Fed’s QE

by MIKE WHITNEY

The Dow Jones Industrial Average (DJIA) roared to an all-time high on Friday wrapping up a 4-day winning streak and shrugging off grim reports of government budget cuts that are expected to slow growth. The Dow rose 67 points on the day to close at 14,397 passing the previous record set in October 2007. While Wall Street’s bulls claim that stocks are still underpriced and have further to go, wary traders are watching for any sign that the Fed is planning to end its easing operations (QE) which have flooded financial markets with $2 trillion of extra liquidity triggering an unprecedented 4-year stock rally. The markets are so addicted to the Fed’s $85 billion per month liquidity injections, that even grumbling from dissenting members of the FOMC could spark a panic and send stocks into freefall. Here’s more background from an article in the Wall Street Journal:

“Many give the Federal Reserve, and its latest asset-purchase program, much of the credit for the Dow Jones Industrial Average’s rally to record highs. But some strategists feel that, as long as the economy continues to improve, the Dow’s upward trend will continue, even if the Fed starts taking its foot off the liquidity pedal. 

The Fed has been creating liquidity via outright purchases of longer-term Treasury and mortgage-backed securities since the end of 2012. These purchases, known as quantitative easing, are aimed at stimulating economic activity by lowering longer-term Treasury yields and borrowing costs. Treasury yields move inversely to Treasury note prices…
Stock-price valuation is unlikely to be derailed by changes in Fed policy despite fears,” said Tobias Levkovich, chief U.S. equity strategist at Citigroup…
The unemployment rate was at 9.9% in March 2010 … versus 7.9% as of January 2013. …In addition, new home sales were at seasonally adjusted annualized rates of 381,000 and 305,000 in March 2011 and June 2011, respectively, but have climbed to a 4 1/2-year high of 437,000 as of January 2013. Meanwhile, data released Thursday showed that the four-week average of initial claims for jobless benefits fell to a five-year low.” (“More to Dow’s Rally Than Just the Fed”, WSJ)

Levkovich knows that what he’s saying is nonsense. As soon as Bernanke removes the punchbowl, stocks will start circling the plughole. There’s no doubt about it. $85 billion per month is serious money, and withdrawal of that support is enough to send markets into a nosedive. That’s why Bernanke is so hesitant to explain his exit strategy or whether he plans to slow his purchases of US Treasuries (USTs) and mortgage backed securities (MBS) when the recovery finally strengthens. He knows he’s backed himself into a corner where even the slightest pause in stimulus will roil the markets. Here’s a clip from Trimtabs explaining “Why Stocks are Rising Even as Economy Slumps”:

“Stocks are approaching all-time highs. At the same wages and salaries, after taxes and inflation, are declining year over year. How can stocks keep going up without the economy leading the way or even following behind? Simple. It is a case of supply and demand in the stock market. 

Ever since July 2011 when QE 2 ended, companies have been using some of the record amounts of cash on their balance sheets to reduce the total number of shares outstanding by about $1 billion each and every day. Why? All that cash was earning virtually nothing because of low interest rates…
Then there’s the fact that this year, the Fed for the first time since the end of QE2, has resumed directly adding $4 billion each and every trading day into the bond and stock markets. 

Therefore, we have more money chasing fewer shares. That is the only reason stocks are going up. So what if the economy is on its ass? What difference does that make in a drugged stock market? Isn’t it obvious that stock prices most likely will keep going up as long as the narcotic of free money keeps the investing public all doped up?
But the real problem with a drugged market is what will happen when the drugs are either withdrawn or no longer work. Can you imagine what this stock market will look like on cold turkey?” (“Why Stocks are Rising Even as Economy Slumps”, Trimtabs)

So, when the Fed buys $85 billion of financial assets per month, stocks go up. And when the Fed stops buying $85 billion per month, stocks will go down. Only they’re going to go down considerably further then anyone expects because of the vast amount of money that has followed Bernanke into the market. For example, businesses with a lot of cash have been buying back their own shares to pump up the prices. Check out this out from Slate:

Cardiff Garcia offers this chart from Birinyi Associates showing that one reason stock markets are touching record highs this month is that share buybacks reached a record high back in February….. When stocks are cheap, firms buy shares. When stocks are expensive, they buy capital goods.” (“February Stock Buybacks Set a Record“, Slate)

And then there’s margin debt which has recently ballooned to record highs which means that investors are borrowing a lot of money to buy stocks because they think the Fed will keep printing. This is from Orcan Investment via Pragmatic Capitalism in a post titled “NYSE Margin Debt Stalks All-Time Highs“:

Then, of course, there’s a pick up in mergers and acquisitions which is back to 2008 levels. M&As are going great-guns because everyone thinks the zero rates and free funny money will go on forever. And, now, there are bubbles popping up everywhere. For example, the yields on junk bonds are at historic lows. Why? Because there’s so much liquidity floating around that people are piling into junk to nab a few extra farthings on their investment. It’s called “chasing yield” and it explains why leveraged loans, CLOs and even residential real estate are headed for the moon, because Bernanke has opened the liquidity floodgates pushing money into every corner of the system except the one place where it would do some good, in the pockets of working people who would spend it at the grocery store, the malls, the dry cleaners, the department store, the daycare or the gas station. Any consumer spending would help to boost the recovery and strengthen growth. But while there’s plenty of money for bankers, fund managers and the other chiselers who blew up the financial system, there’s nary a dime for the people who work for a living.

It’s also worth noting that Bernanke’s monetary monkey business poses serious risks for the financial system and thus the broader economy. Check this out from Washington’s Blog:

“An influential group of leading world banks warned Thursday that central banks are pumping out too much easy money and markets risk becoming dangerously addicted to ultra-low interest rates.

The Institute of International Finance, which groups 450 banks, said that if central banks continue to flood money into the global economy, then any future bid to get it under control could itself destabilize the financial system.
“These conditions — quantitative easing, very low interest rates — cannot last forever, but the risk is that financial markets have become addicted to them,” it warned.
“The longer central bank liquidity is relied on to hold things together, the more excesses and distortions are being accumulated in the financial system. An eventual unwinding of these excesses will become a destabilizing risk event.” (“Top Bankers: Too Much Central Bank Easing Is Becoming Dangerous,” Washingtons Blog)

The risks of QE have been pointed out by Bernanke’s own lieutenants like Fed governor Jeremy Stein who was thrust into the national spotlight when he voiced his concerns about emerging bubbles in certain kinds of securities, including junk bonds and REITs (real estate investment trusts) Stein argued that these bubbles could endanger the economy if they get big enough, leaving the Fed with no choice except to raise rates and wait for the fallout. Here’s more on Stein from economist Brad Delong:

“It is Stein’s judgment that right now whatever benefits are being provided to employment and production by the Federal Reserve’s super-sub-normal interest rate policy and aggressive quantitative easing are outweighed by the risks being run by banks that are reaching for yield… Stein’s arguments are one more reason that we ought to have a much more aggressive and expansionary fiscal policy…”(“Jeremy Stein, The risks of QE and zirp” Bradford DeLong, Grasping Reality with Both Hands)

Bernanke’s response to Stein: “Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading to an even longer period of low long-term rates”. In other words, “Damn the torpedoes. Full speed ahead!”

Four years after the Fed launched its first round of QE, unemployment is still above 7 percent, GDP is under 2 percent, wages are either stagnant or dropping, 47 million people are on food stamps, another milion and a half homeowners will face foreclosure this year, median household income has dropped 7.2 percent in the last 6 years, while–according to a report from the Fed which was released in June— middle class families have seen a 40 percent decline in their net worth between 2007 to 2010. Working class America has been walloped by the policies of the Central Bank and the Obama administration. Still, stocks are at record highs, profits are bigger than ever, and more of the nation’s wealth is being transferred to the 1 percent than any time since the Gilded Age.

There’s something very wrong with this picture.

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at fergiewhitney@msn.com.