QE2 and the Stock Market

The S&P500 melted up another 0.6%, but the movement was not confirmed by volume which fell off.  In fact, the only day volume spiked last week was on the one day when the stock markets sold off badly.  The VIX (or fear) index was essentially unchanged.  Divergences are popping up everywhere–many indicators (aside from volume) have been weakening noticeably over the last few weeks.

There was very little in the way of macro news last week.  Industrial production came in well below expectations.  New housing starts were ahead of estimates; housing permits came in below.  Initial jobless claims were almost as expected; the prior week’s claims were revised higher (in fact, about 90% of the revisions for 2010 have been worse than initially reported, creating huge doubt about the validity of the initial claims report).  Leading indicators and the Philly Fed survey both came in exactly as anticipated. 

Technically, the S&P has become extremely overbought, on a daily basis, over the last several weeks.  There is virtually no doubt that the Fed’s much anticipated round of quantitative easing is being priced into the stock markets BEFORE the actual money is actually created by the Fed.  The stock market’s recent moves have been driven more by short-term monetary policy and less by fundamental valuations based on individual corporations and the overall economy, which are both struggling to grow.

Paul Krugman, in his blog on the New York Times website, offered a concise way to think about the Fed’s policy of quantitative easing.  He pointed out that the Fed’s newly created money will essentially be used to buy long-term government securities.  He wrote:

What happens when the Fed buys long-term government securities? If we consider the Fed and Treasury as a consolidated entity — which, for fiscal purposes, they are — then what happens is that some long-term federal debt is taken off the market, and paid for by issuing more short-term debt in the form of monetary base. It’s just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

As to his opinion on whether QE and this swapping of short-term debt for long-term debt would fix the ailing economy, he wrote:

…how much do we think federal management of its maturity structure matters for the real economy? I think if you put it that way, most people wouldn’t be terribly optimistic.

At least he’s being honest.

But what about the stock markets?  What’s a good way to think about the current state of these markets and their relationship to the government authorities? 

Charles Hugh Smith, in his blog Of Two Minds, succinctly describes what many long-time professional investors and market analysts are feeling these days:

The U.S. financial markets have been poisoned, with long-term negative consequences. Only crooks, fraudsters and “marks” (those who still believe the propaganda about the “recovery” and “stocks are cheap” poison) will be left in a stock market propped up by the same socialization of risk which keeps the flimsy facade of a mortgage market from crumbling. High-frequency trading machines create the illusion of a market, and State intervention via proxies and other corrupt games provides the liquidity needed to fund the facsimile of a “rising market” and a “recovery” in the U.S. economy. But the public isn’t buying the fraud any longer; they finally “get it”: The well has been poisoned and only a fool drinks from a poisoned well.

This is why we can safely anticipate a hollowed-out stock market which trades at a steep discount to its present propped-up levels in the years ahead–until the crooked players are indicted and the financial markets thoroughly cleaned.

So who’s been making money in the US stock market over the last several weeks?  Well if it’s not the trading machines, then it’s the investors and traders who’ve metaphorically gone skiing down the side of a mountain packed with a ton of snow, snow that’s vulnerable to killing anyone skiing on it with an avalanche that can occur at any time.

Some folks are clueless about the avalanche risk.  They’re skiing away and having a great time, making money.  Many others are well aware of the avalanche risk;  it’s just that they believe that they’re such expert skiers that they’ll be able to tell when the avalanche is about to hit, and that–at the last second before it starts–they’ll be able to ski off the mountain and out of harms way.

In short, they’re acting as if 2008 never happened and could never happen again.  Yeah sure, they all got killed in 2008, but that was a long time ago, and in their minds, there won’t be a next time.

Good luck with that.

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