October 29, 2010

The Fed & the Markets: A House of Cards?

Ignorance keeps the house of cards alive, but for how long?

Call me a hopeless “free market” romantic, but I believe that the natural forces of supply and demand (and cause and effect) will eventually trump the Federal Reserve’s underhanded, yet obvious, efforts to pump up the market.

If you are curious to know how the Fed massages the stock and commodity markets in an effort to keep the economy from collapsing, keep reading. But before we get there, let’s take a look at a problem that is as obvious as it is ignored.

Ignorance keeps the house of cards alive, but for how long?

Bad News Is Good News; Good News Is Good News

If you’ve ever been asked: “Honey, does this skirt look too tight?” you know there’s only one response that won’t have negative consequences. Right now, the market – at least according to Wall Street and the media – is in a win-win position. Any commentary to the contrary is met with disdain.

Good news means the economy is improving. Bad news means more quantitative easing is on the way. Any news is good news.

The media has put a blanket of silence over the foreclosure debacle or mortgage bust 2.0. It's obvious that investors have not even begun to price in the eventual ramifications.

Without going into too much detail, courtesy of faulty foreclosure procedures, many mortgage payers may have the legal right to walk away from their debt.

Banks (KBE) and other financial institutions (XLF) on the other hand have no recourse of getting their money back. The plot for the financial sector continues to thicken … and continues to be ignored.

Obvious and Ignored

Simultaneously, Bloomberg featured the following two headlines on Oct. 18: “Citigroup profits exceeds estimates on decline in provision for bad loans;” “Mortgage buybacks may cost lenders $120 billion, JPMorgan says.”

In case the irony of the headlines isn’t obvious, here it is again: Citigroup rallied over 5%, because profit increased due to a reduction of bad loan provisions, while a fellow banking giant sees a $120 billion future liability caused by bad loans.

Is this a problem that can be hidden via another round of accounting rule changes?

As I look at the performance of stocks, I wonder how long it will take for investors to realize the magnitude of the problem. Stocks don’t care, which means investors don’t care – at least not yet.

Overall, the market reminds me a lot of April 2010. For a period of weeks, stocks kept inching higher, making incremental new recovery highs and thereby pushing sentiment readings to an extreme.

It seemed like the rally would never end, but it did. On April 16, the ETF Profit Strategy Newsletter took note of this unhealthy behavior and stated that: “The message conveyed by the composite bullishness is unmistakable bearish.”

Note the reason for investors’ bullishness in April and compare it to today. The newsletter continued: “Most bulls have no clue why they are bullish except for the fact that they feel the need to play the momentum game. It doesn’t take an economist to see how fragile the economy really is.”

Have things improved since April? Let’s see; unemployment has gone up, GDP has been revised down, banks are struggling, real estate continues to slide, Europe has been patched although hit with more downgrades and the foreclosure landslide has hit the fan.

Things have gotten worse, yet stocks have come back to revisit the April highs. How come? There’s an explanation with an 89% accuracy ratio.

Rising Prices, How and Why?

Since the Fed has been unable to create consumer inflation (why else would we need QE2?) it has shifted its focus to another type of inflation – asset inflation.

As the administrations attempts to propel the economy have failed, it realizes that the stock markets role as a nation’s mood barometer is crucial to the economy’s survival. A declining stock market would surely deliver a depression.

Monetizing Debt

Monetizing debt was the buzzword in early 2009, when the Federal Reserve agreed to buy $1.2 trillion of government and government agency debt (such as Fannie Mae and Freddie Mac). By so doing, the Federal Reserve exchanged crisp new dollar bills against toxic debt.

This also meant that the U.S. dollar was not only backed by U.S. Treasuries, it was also backed by toxic mortgages. Quite a departure from the gold standard. The chart below shows the soaring balance sheet of the Federal Reserve.

In POMO They Trust

Who are “they?” POMO is the Federal Reserve’s Permanent Market Operations. Via POMO, the Fed buys back T-Bonds from banks and financial institutions. “They” are banks. Banks sell the T-Bonds at a profit and invest the additional funds in stocks and commodities.

A rising stock market – even if devoid of any fundament reason – is what the government wants. It doesn’t matter that the same banks that started the financial wreckage now make money with the clean up.

Entire books have been written to explain the unethical role of the Federal Reserve. The November issue of the ETF Profit Strategy Newsletter explains the process concisely and understandably in a few pages.          

POMO vs. Free Market

As mentioned above, I am a free stock market romantic and believe that normal market forces will drag the market down as swiftly as it’s come up.

But, POMO should not be underestimated. It’s success rate in lifting the market is in some instances higher than 80% and the Fed is holding a lot of POMO purchases before the November 2nd elections, probably in an attempt to keep prices up (a detailed analysis of the POMO effects on the S&P and schedule of future POMO purchases is available in the November ETF Profit Strategy Newsletter).

Whether you are bullish, bearish or confused, the coming days/weeks seem to be pivotal in determining whether POMO will drive prices up, or market forces will push prices down. The market is to drop below recent support in order to gather downside momentum. A drop below support may trigger a bigger decline.

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The ETF Profit Strategy Newsletter includes a forecast for the days, week, and month ahead, along with safety, trigger and target levels that help navigate the market and stay on the right side of the trade.

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