Rather than write one or two lengthy posts this week I'm going to lay out a summary. From there I'm going to support each of my points and explain how I think the US financial markets have gotten to where they are today. Through this summary I hope to reveal some new insights into the recent market rally and possibly find a way for bears to enjoy trading it. Rest assured I have not defected from my bearish sentiment, and the days ahead will explain my feelings. So stay tuned, have an open mind, and you just might realize a thing or two along the way.
Just Like Helium, Up-Up and Away
Over the past couple of weeks more and more people are beginning to believe the great recession has ended. I have been considering this and trying to decide whether or not the current market run up is just a strong bear market rally or something more. Like all bears, over the last couple of weeks I have been squeezed in my trading (as well as in my thinking) and it has been growing increasingly uncomfortable. When faced with this type of pressure almost everyone steps back, and takes a second to re-evaluate things. For me, while trying to regroup, I came up with some new ideas and deeper thoughts into what may be really happening in our markets. So perhaps by reading this I'll be able to shed some newfound insight into how to trade the market over the coming weeks.
Before getting started a couple of quick things: Over the last 12 sessions the markets have been run by trading bots, have gained ground, have traded at low volumes, and most importantly have neither considered technical nor fundamental levels as being important. Thus, the information I'm putting out is from a macroeconomic perspective, though it is likely not the type of analysis you're probably used to reading. Although my thoughts may be a little unorthodox; sometimes when the economy and the market are working in an unknown manner unorthodox thinking is all that makes sense. Seeing as my feelings are a bit bold I will support each of my points with as many details and factual data points as possible over the coming days. So without further adieu...
10 Step Economic Recovery Plan
Let's say you are the US government and you need to get the economy going again. What do you do?
1. GDP = (A) Private Consumption + (B) Gross Investment + (C) Government Spending + ((D) Exports - Imports))
2. The US Government directly controls letter C from above and thus 25% of GDP inputs.
3. To further influence GDP the government must control more of the equation. By controlling debt, or the means by which most gross investment comes from, the government could control 50% of the GDP equation. Since private banks are failing, in order for banking to survive, these banks "must" be bailed out. Through the first bailout a large portion of letter B also falls under government oversight.
4. When originally deciding on the GDP equation, the Government wisely includes part D. Exports less Imports are included as any decline in imports (during a recession) helps to assist overall GDP. Conversely (during boom times) import gains will be offset by the other three components of GDP. Thus including letter D benefits GDP much more than it can hurt it and the equation becomes self moderated for long term growth.
5. Now that the Government has control of Parts B and C, and since Part D doesn't really matter, in order to move GDP they need to influence consumption. Knowing that part A can't be controlled, at the beginning of the recession the government uses "stimulus" to encourage private consumption (lowering interest rates, rebate checks, making cash available to banks etc.) in order to lead GDP forward.
6. Over time the government realizes its attempts to influence private consumption aren't working as they had intended. In general, the fallout from gaining control of gross investment takes more of a toll on the economy than expected. Fear driven by government assistance into the banking system forces consumers to spend less, this makes businesses cut back, and this leads to more jobs being lost; a vicious cycle. As private consumption falls, banks have a hard time lending since there is no one available to spend. The government severely underestimates the influence of letter A and the power of the US consumer in the GDP equation. To make matters worse the government didn't expect American's who had the ability to spend to start saving and fuel the vicious cycle further.
7. The Government realizes that the vicious cycle from point 6 must be broken in order to change private spending sentiment in order to turn the tide on private consumption. Knowing that it can't take control of private spending, the government increases the availability, and lowers the cost of capital at banks, through item B, thinking this will flow through to private consumption; this also doesn't really work. As usual item D is of no real concern as the Government knows that through increased spending, Item C will increase, encourage a weak dollar, raise exports, and further pad the GDP stats.
8. Since spending on gross investment did not work well, the Government has to find a new way to get private consumption to move; thus they decide to try and improve overall sentiment. Knowing that directly or indirectly over 50% of CPI weighting consists of housing, energy, or automotive related pricing. The government decides to offer subsidies in the form of a first time home buyer's credit, takes over the auto industry, and promotes cash for clunkers. They continue to hold rates at near zero percent to promote lending in order to assist part B, continue spending at alarming rates to hold part C up, which also drives part D. At the same time they begin to use their influence to effect oil prices through calculated supply and demand decisions. All of this helps energy, autos, homes, and ultimately boosts CPI.
9. Through the use of the techniques in recovery plan point 8, CPI effectively increases. As CPI increases economists and forecasters change GDP growth estimates and recovery time lines. This slowly begins to lift sentiment as analysts latch on board and begin cheerleading. As sentiment begins to turn some businesses begin to expand and some consumers are comfortable to spend. This lifts private consumption slightly, but with all the other support to points B, C, and D this boost is overly pronounced.
10. As sentiment begins to turn, private investment picks up slightly. Slight gains in private consumption, in conjunction with government controlled parts B and C, begin to move GDP in the right direction. However, GDP moves in that direction as a result of heavy intervention and an unsustainable amount of government spending. Unsustainable levels of government spending will begin to raise problems for private consumption over time, as gains in this area have only come due to subsidies. This in turn will damage gross investment gains as well as these too have been driven by spending from the government to improve private consumption. As these areas of the GDP equation begin to fall apart under the weight of intervention, unemployment will not recover accordingly. As a result of this, housing prices will also continue to fall and further erode gross investment across all sectors as banks suffer from credit losses. Here, even harmless letter D, (exports - imports), will be damaged as the government loses its ability to hold its spending rate and must repay debt. The government will have created another vicious circle from which it will be evern more difficult to escape than the first time around.
The Eleventh Hour
Based on this assumption, and the details I'll lay out over the coming days trading may become fun again for the bears. It is my belief that short term investing around the sectors that the government is trying to support may continue to be profitable in the coming weeks. Specifically, investigating trades that involve the auto industry, energy, government debt, US currency, or housing may be incredibly beneficial in the near term. Remember though bulls and bears, don't look past point number 10 as this government plan is unsustainable into the future; it will fall apart eventually. All in all stick with me for the next week or so, review the support I provide for my theory, and decide for yourself if this is in fact the 10 Step Plan to a recovery or the 11th hour before a total meltdown.