Fundamental Flaws Fading The Fed

“Don’t Fade the Fed!” has been the most successful trading and investing strategy for over 6 years. This simple recipe has been driven by the Federal Reserve, and other central banks, as their “market activities” have expanded to dominate markets, and have increasingly targeted the stock market as the cure-all for any economic shortcomings.

This has now reached the point where the correlation between economic growth and stock markets has now been completely reversed. Today economic weakness is the best news possible for stock markets. With an active central bank, weak economic news now simply means that “stimulus” is sure to follow, and it has paid market participants to front run the policy driven equity buying.

The stock markets in China and Japan have shown that currently the weaker the economy the more stock markets go up. Remarkably, it seems that the more policy has failed the more stock market boosting policy is initiated.

How far can this madness go? How much control do the central banks really have over markets short term and long term? After 6 years of the weakest recovery since WWII why is growth still so weak, even while policy has never been more aggressive?

As short term equity market performance celebrates the relentless decline of long term economic growth, long term equity market risks are accelerating. As challenges to the real economy continue to rise it has never been more important to be clear about the difference between the real economy and central bank inspired fantasies.

The best way to assess this is, first of all, ceaseless attention to how real economic fundamentals are developing. Then to track the immediate economic rate of change in data flow. Then lastly to see how the fundamentals and data interacts with the markets.

Here is the latest information from these three separate perspectives:

Real Economic Fundamentals

As a trader/investor over the last 30 years, I have found mainstream economic forecasts are only useful as a benchmark. From a practitioner’s viewpoint the most valuable sources become readily apparent from their track record and empirical validity.

This week I have a notable addition. Steve Keen has developed a model that I believe should take economic analysis to a new level. I have not seen a model which explains more clearly 4 of the most important  economic phenomena of the last 45 years.

Steve Keen’s analysis explains:

1. The exponential growth of debt over the last 45 years.

2. The relentless decline in economic growth over the last 45 years.

3. The explosion of inequality over the last 45 years.

4. The economic implosion of 2008.

Academics will debate forever, but for track record, empirical evidence and clarity I know of no equal to what you can find in this video:

http://chrisbelchamber.com/debt-inequality-and-crisis/

Long story short, all my credible sources conclude that current economic policy is deeply flawed. Boosting the stock market is unlikely to be any more successful than boosting house prices in the 2007 housing bubble. It may or may not be time to “fade the fed” from a market perspective, but from an economic perspective it is very dangerous not to “fade the fed”, and sooner or later this is likely going to be decisive.

Economic data flow rate of change

The economic data flow rate of change will almost certainly decline in 2015 relative to 2014. Q1 2015 is already off to a negative start and estimates are already falling fast on Q2 estimates.

http://www.zerohedge.com/news/2015-05-29/welcome-contraction-q1-gdp-drops-07-corporate-profits-crash

Even Goldman Sachs has conceded to a significant decline in long term growth expectations.

http://www.zerohedge.com/news/2015-05-28/shocking-move-goldman-slashes-americas-long-run-potential-gdp-225-175

More immediately the economy not only has to work off very high inventory levels over the remainder of the year, but household income is increasingly strained.

http://www.oftwominds.com/blogmay15/household5-15.html

While healthcare costs are rising rapidly.

http://www.oftwominds.com/blogmay15/healthcare-doom5-15.html

With the S&P 500 hitting new all-time highs, earnings should be exploding higher. To the contrary, for the 2nd consecutive quarter, they are moving lower. With 92% of companies reported, S&P 500 earnings have declined 13% in the first quarter of 2015. This follows a 14% decline in the prior quarter.

EPSGrowth

What about the top line?  Surely this just an accounting issue.

But sales growth is also showing a decline, -1.8% over the prior year, the first year-over-year decline since 2009.

Market manifestation

In last weeks note we talked about the twilight zone for markets and certainly there is a great deal of frustration from traders and investors about the current state of the markets, where at least for a short time, it seems that central banks have completely taken over.

However, in 2006 it seemed that house prices could only go up, and in 1999 it seemed that technology stocks could only go up. Market highs take time and the current degree of intervention is substantial, however this is just another cycle like the others. There is growing evidence of economic weakness despite official rhetoric, and the US stock market uptrend has become significantly weaker. The chart in the link below shows that the breadth of stocks that are still rallying is weakening.

http://www.zerohedge.com/news/2015-05-28/bull-market-dealt-significant-blow

“Fading the fed” is no easy task but the time will come when the failure of policy will become undeniable. If economic growth continues to stumble this year, the credibility of policy will become a major issue which could increase volatility substantially.

Chasing short term performance in an erratic and weakening uptrend is questionable, and is an increasingly high risk strategy now given both market internals and the weakening trend in the rate of change of economic data.

Shifting to a longer term risk averse strategy should already be underway given current trends, and may be increasingly advisable if current trends continue.

 

 

 

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