The perennially-optimistic crowd on Wall Street never lets the truth get in the way of a good story. So whenever the stock market doesn't move their way, they come up with a myriad of excuses to explain the fall. The members of what my good friend Peter Grandich likes to call, "The Don't Worry Be Happy Crowd" appear in the main stream media and try to deflect attention away from the truth.
What these cheerleaders are unwilling to admit is that the Federal Reserve's myriad of QEs and manipulations of interest rates have been pumping air into the stock market. Therefore, every exit attempt from its manipulations has, and will, begin a painful (yet necessary) deflation of this bubble.
Instead, they fall over themselves to deliver some alternative explanation for the deflation of asset bubbles after the Fed stops pumping in air. The heavily-relied-upon excuse after the first quarter's negative GDP print and 6% drop in the stock market was the weather. Likewise, it was no surprise that this October's vicious market selloff wasn't blamed on the Fed's imminent exit from QE. On the contrary, the view being promulgated was that the market was selling off due to Ebola fears.
The infectious disease that is ravaging Western Africa is nothing to joke about, as it has caused the death of thousands of people. However, in the United States to date, less Americans have died of Ebola than have been married Kim Kardashian. But those who cheer the Feds every move would have us believe Ebola, not the end of QE, was the primary cause of the market's woes. After all, the Keynesian view of the world is that government spending and central bank money printing are the very embodiment of all that is good, and Ebola is bad, it kills people-so let's blame it.
And so the cheerleaders deftly weave this entertaining narrative; oil prices are plummeting because nobody is going to fly a commercial aircraft from fear of contracting Ebola. Americans will stop going to the mall, won't buy another car and will not leave their house. For a fleeting moment, Ebola had purportedly brought the U.S. economy and market to its knees.
Yet, the market bottomed on October 16th about one minute after the "hawkish" St. Louis Federal Reserve President James Bullard, hinted central-bank bond buying may get extended. Bullard apparently didn't get the Ebola talking points. The S&P 500, which had tumbled that morning, managed to reverse course back to unchanged after his statement, despite no new Ebola news. In fact, Mr. Bullard's statement sent the S&P up nearly 5% during the ensuing four trading days. And just like that, the markets fear of Ebola vanished--perhaps Bullard should have been named the new Ebola Czar.
The truth is it's not snow or a third world infectious disease that is driving this market. It is QE and the Fed's ability (for the time being) to keep interest rates near zero.
The Fed started its bond purchase program known as QE1 in late 2008. Then, ramped up QE in March of 2009 when the economy was on the brink of destruction and the S&P 500 stood around 666. But the stock market didn't turn around until QE 1 was put in full force.
Then, when the first round of QE purchases were completed in March of 2010, the S&P fell by over 13% during the next few months. During roughly the same time period, the 10-year note yield fell from 3.85% to 2.38%, commodity prices tumbled around 10% and the M3 money supply dropped from a positive 2%, to a negative 6% annual rate of change.
Similarly, once QE2 ended in June of 2011, the S&P fell by 17% within three months. The 10-year note yield dove from 3.2%, to 1.8%, and again coincided with a plummet in commodity prices and M3 money supply.
Now these events may have coincided with some other non-correlating events such as; the Icelandic volcano eruption that temporarily closed European airports, the occupy Wall Street movement and the end of Oprah's 25 year run on ABC - but none of those events caused these deflationary forces to ensue; it was the end of QE. In fact, for the past six years the stock market has been unhinged from fundamentals and has traded predominantly on central banks' monetary policies.
However, the "happy crowd" is ignoring the dynamics of inflation and deflation. The Fed's exit from QE is a deflationary event, just as massive money printing is an inflationary event-plain and simple. Since asset prices are currently so high into the stratosphere, it takes an overwhelming amount of QE to override the gravitational force of deflation. When the stimulus is withdrawn, inflated asset prices begin to deflate back to normalized levels.
Deflation is a healthy and healing process; as asset prices and debt levels deflate from artificial levels. But, this also coincides with a temporary decrease in GDP growth. This is the true message investors should glean from commodity, stock and bond markets. Deflation and recession is also what the 2% Ten-year Note is telling you.
Of course, the perpetually bullish will argue the drop in energy prices and borrowing costs will be great news for the consumer and imminently boost the stock market and the economy. They said the same thing when the WTI oil price began its drop from $147 per barrel in the summer of 2008, to $33 six months later. But don't be fooled by those who are incessantly upbeat. Deflation, although a healthy occurrence in the long run, will not just bring down inflated commodity prices, but will take equities and real estate down along for the ride.
If we allow deflation to run its course, we can emerge as a much stronger economy. But, the Federal Reserve will not sit idle as air streams out of the asset bubbles it has worked so very hard to create. When asset prices stop rising, our central bank will come to the rescue with another round of stimulus, as the market cheerleaders cheer them on yet again.
