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With the expected release this Friday of a whopping 190,000 non farm
payrolls added, it is no surprise that some investors are considering
economic recovery and the accompanied rate hikes. The following image from today's MarketWatch home page expresses this idea
clearly:
This leads me to think that this Friday is initially a win-win for the stock market; both prospects
of economic recover with positive news, or continued loose monetary
policy with negative news may initially boost the market. Given that on
this report the the trend usually reverses, if the market does react
with a surge of strength, I believe it will be a short term top. The
tricky part for a trade is that the stock market is closed on Friday. Let's hope strength spills into Monday's open for a short sell.
Refer to this prior post on the importance of the Fed to capital markets.
PLEASE NOTE: DISQUS IS DOWN AGAIN (big surprise!).
I have observed that the Non-Farm Payroll economic release
and the FOMC Rate Decision are usually days that mark the end of the prevailing
stock market trend. I believe this is essentially a fundamental, rather than
technical, phenomenon.
The prices of the stock market are related to these five
essential macroeconomic factors: consumers spending and savings, the business
cycle, fiscal policy, and monetary policy. Of these, the market seems to
acknowledge consumer habits and monetary policy to be the most important
factors. The former is represented by payroll data, and later by interest rate
policy. (The weight of two of the ten leading economic indicators, related to
monetary policy, has accounted for 40-60% of the index.)
There is a consensus view of the employment data and the
rate decision, and as the release approaches, the market tends towards the
valuation “justified” by the coming data. This is just like a stock price
rising in anticipation of an earnings announcement. Once the data is released, “sell
the news”—the data becomes fully discounted and the trend towards the next
release, a month or quarter later, begins.
That is one very viable explanation for this trend reversal
phenomenon that occurs consistently in the stock market. That prices did not
reverse after last Friday’s payroll data, and will reverse at or near the Fed
announcement, tells me that the financial markets are currently more concerned
with interest rate policy than the economy. Changes in this policy can create a
change in investor mind-set that governs the next long term stock market trend.
Why is monetary policy so important? It affects the economy
and inflation, and also the supply and demand for investments—bonds versus
stocks. I will end this brief essay with an excerpt from a brilliant and
eye-opening passage, taken from the book, Inside
the House of Money. Read it carefully, and many times, and return to it in
the future:
There is only one true macro
trade, and that’s the price of money. Everything else is a function of the
price of money.
Central
banks control the price of money and drive everything with their central bank
rate. They use monetary policy to get supply and demand moving in the economy
by encouraging people to move out along the risk curve. The risk curve, in
essence, is the credit curve.
There is
really only one central bank and that’s the U.S. Federal Reserve. The Fed sets
the price of money.
In actual
practice, the price of money is not the Fed’s overnight rate, but the interest
rate that corporations use to evaluate investment opportunities. I would argue
that’s the 18-month and two-year interest rate. From there, you move out along
the risk curve to government bonds, corporate bonds, and then to equities. At
the tail end, you have foreign exchange fanning out.
Tuesday morning's New York Times had an interesting article on the federal budget and the fact that annual deficits are projected out as far as the eye can see. The federal forecast extends through 2020, and it shows year after year of trillions upon trillions of dollars of red ink.
One aspect of this I've always wondered about is: how accurate have past federal forecasts been about surplus/deficit projections? Intuitively, I had always assumed Washington's projections would have leaned heavily toward the rosy side. It turns out this supposition was correct.
The Times put together a very interesting graphic – shown below – illustrating, over the years, what the projection of the ensuing ten years would be (shown in light blue) versus the reality (shown in dark blue). As you can see (although I know the faint blue is hard to discern), in almost all cases, government projections were too high by hundreds of billions of dollars. I've highlighted some of these clusters of optimism with the rounded red rectangles.
Even the forecast from last year (the light blue line on the right side of the graph) has already been shifted downward (e.g. much worse deficits) just one year later.
What does this mean? It means that, even though the projections for the next ten years are the worst ever in the history of the United States, they are probably far too optimistic.
Mention that the Fed may have been engineering equity price outcomes in polite company and you will be scorned as a wacky conspiracy theorist. Earlier this month, the people at Trim Tabs went public with the observation that they could not see where the money flow was coming from to explain the 2009 rally, and suggested maybe that the "plug" involved the Fed.
The Contrary Investor, a subscription site I gladly pay for year in and year out, put up an intriguing and well argued piece last night that shows how this "plug" might have worked. In short, the Fed conveniently times its MBS purchases for option expiration week, liquidity provided therein to TBTF banks goes to their prop desks, up go equity markets. Repeat each month.
Stabilize the housing market, get 201(k)s back to 301(k)s, and we will be in the clear. It certainly seemed to be working. Oddly, the resentment against GS prop desk profits may in fact reflect deep-seated public resentment against the stock market ramp, which retail investors have not embraced. Do they know it is "fake?"
