Tuesday, May 29, 2012

The Fed Climbs a Wall of Worry

By:  Shan Saeed

There's an old Wall Street cliché that says every bull market "climbs a wall of worry." 
This phrase is generally used to describe a situation where the market rises despite the presence of several uncertainties….I am also confused by many other policy making steps by the Federal Reserve. There have been more changes in monetary policy direction during the Bernanke era then at any other time in the modern era of the Fed. Not under Arthur Burns, not under G. William Miller, not under Paul Volcker, not under Alan Greenspan  have there been so many dramatically shifting Fed monetary policy moves. Under Chairman Bernanke there have been significant changes in direction of the money supply growth FIVE different times. Thus, for me, I am not at all surprised at the current stop and go economy. The current erratic monetary policy makes it exceedingly difficult for businessmen to make any long term plans.  Indeed, I find it extremely difficult to give long term advice to some investors, when in short periods I have seen three month annualized M2 money growth go from near 20% to near zero, and then in another period see it go from 25% to 6% .

I am also confused by many of the monetary programs instituted by Chairman Bernanke. For example, Operation Twist. This is not the first time an Operation Twist was tried. The Operation Twist was tried in 1961, at the start of the Kennedy Administration.  A paper was written by three Federal Reserve economists in 2004 that, in part, examined the 1960's Operation Twist.

Here are some the current uncertainties that make up the wall that the market continues to climb.

• The ever-evolving European debt crisis
Spain is currently under the gun as yields on its bonds are rising steeply. The rising bond yields and protests in the streets are reminiscent of Greece two years ago. The problem is that Spain is much too large a country to bailout like Greece. This situation is unlikely to end well but the European's will scramble to do something that will delay a Spanish default or a disintegration of the European Union.
• Iran
Sanctions on Iran continue. These sanctions have never worked on Iran or North Korea for that matter. But for now, government officials will pretend that they have a good chance of working while they privately weight the consequences of military action or simply allowing Iran to acquire nuclear weapons.

Debt in USA
The total public debt is now at about $16 trillion, up from $10 trillion in 2008. The debt is spiraling out of control but Washington continues to do nothing. As the election approaches, the Congress is likely to be even more polarized than usual, if that's possible. Some day it will have to face more problems, just not today.

• Slowing global growth
Economies throughout the world are slowing in 2012. Much of Europe is in or on the brink of recession. And the Chinese economy recently posted slower than expected growth.

• High gasoline prices
Gasoline prices at nearly $4 per gallon threaten to choke of the relatively strengthened recovery in the United States. The high prices take a bite out of consumer budgets and hurt spending in other areas. As well, businesses incur higher expenses and have difficulty passing those expenses on to consumers in a still tough environment. The high prices take a toll on profits and hiring.
• Slowing corporate earnings
Corporate earnings have been one of the few bright spots in the economy since the financial crisis. Companies trimmed down and slashed expenses during the recession, as the economy gained some traction and revenues started to grow, corporate earnings skyrocketed and continued to surprise on the upside since 2009. But, the party might be over. Forecasts are for near zero year over year earnings growth in first quarter.

The S&P 500 rallied 32 percent between last October and early April. It has given up a few percent since but it doesn't appear that a significant sell off will occur soon, unless of course one of the aforementioned problems develops into a crisis. The index may sputter for a while but it will likely resume moving higher at some point in the not too distant future.

There is one reason that supersedes all the uncertainties and should propel the market higher – the massive amount of liquidity in the system injected by the Fed through QE, QE2, Operation Twist and near zero interest rates. Its financial suicidal .  Between $2.5 trillion and $3 trillion injected into the system has no place else to go. The economy isn't growing enough so that banks are making a lot of loans or corporation expanding and hiring people. But, the money is finding its way into the market and propping it up. This game won't last forever. But it could last for a while. Get ready for the bloodbath in the global financial markets. 

Disclaimer: This is just a research piece and not an investment advice. All financial transactions carry a  RISK

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