The S&P500 tumbled 2.1% last week on a notable jump in volume, which serves only to add validity to the price drop. The VIX (or volatility index) jumped over 22%, also confirming the drop in price. The schizophrenic action of the stock market continues to play out—after being very overbought two weeks ago, the market has rapidly moved away from that condition. While it’s not oversold, it’s no longer stretched to the upside as badly as it was only 7 trading days ago.
The macro data took another turn for the worse last week. The international trade balance came in much worse than expected, suggesting that Q2 GDP will be revised lower. Core producer and consumer prices were higher than expected. This means that the Fed has much less room to resume QE anytime soon; with core inflation jumping, more QE would only shove inflation even higher. Initial jobless claims met expectations, but they were still in the solid 400,000 range. The Empire State manufacturing survey fell again—after it was projected to rebound strongly. Industrial production was much lower than expected. And the shocker for the wee was consumer sentiment, which collapsed to 63.8 the lowest level since March 2009 when the latest market lows were being put in.
Technically, the uptrend that began two weeks ago is on the verge of breaking down, but to be fair, it hasn’t done so yet. Many other momentum, oscillator and breadth indicators are showing continued signs of weakness. And to be sure, there are little to no signs of technical strength.
So what’s been keeping the stock markets resilient? They are, after all, only a few small percentage points below their recent cycle highs.
Well, it’s hard not to come back to our friends at the Federal Reserve for the answer. As mentioned in prior discussions, the correlation between the S&P500 and the Fed’s QE programs has been almost 90%. And since one is a single decision (QE essentially dictated by Ben Bernanke) and the other is a result of billions of relatively small and rapid transactions, most independent of each other, it’s fair to conclude that the Fed’s action CAUSED the market melt up.
So then, the next question arises—why fight this force? If the Fed has pushed up prices, then why not just accept them and join the party at Club Stock Market?
But this one is more subtle. Jeffrey Snider (via ZeroHedge) does a good job separating these two important and very distinct concepts. He states “successful investment is predicated on buying something valuable before the wider world recognizes that value, with the greatest hope that the rest of the world will see that value.” Eventually, and almost always, the world does recognize the true value, and price catches up. In fact, this is the core concept behind Graham and Dodd and their value investing doctrine. Value is not price. Determine value, and price will follow.
The Fed, however, is trying to turn this reality upside down. Per Snider, the Fed has been “ensuring that marketplace actors have enough money to prop up prices” to “create the illusion of value through price action. By maintaining high valuations due almost solely to their own purchases, they hope to “attract” additional investors into the process.”
This will fail. Because per Snider, this trick depends on the public’s continued belief in the infallibility of the central bank. The instant this belief gets shattered, a deadly game of musical chairs will ensue. And most participants will not get a chair; they’ll see their stock prices collapse because they were not fast enough to find a chair before the music stopped.
In the end, all taxpayers end up paying for the collapse, because they will be called upon (actually, forced) to recapitalize the Fed when its pump and dump scheme falls apart.
And fall apart it will. They always do.
While “Central banks are betting the financial health of their constituents on the theory that they can buy prosperity”, history has shown that money printing has never brought true wealth or prosperity.
History shows that the Fed will fail. The question is simply when.