The central banks are the problem not the solution

This chart shows clearly how the Federal Reserve has driven US equity markets to an altered state:

http://www.zerohedge.com/news/2014-06-06/whats-wrong-picture

No question the relationship between equities and bonds has materially changed over the last 2 years or so. In particular, how do we explain this relentless 2 year US equity bull market on fundamentals?

Core earnings over the highlighted period in the chart above, have been broadly flat and are now turning down, as shown in these two articles:

http://www.zerohedge.com/news/2014-06-03/top-first-quarter-corporate-profits-tumble-most-lehman

In addition the housing market has now begun to decline again:

http://www.bnn.ca/Shows/Money-Talk.aspx?vid=376068

Furthermore, for the third year in a row, the economy is cronically underperforming both Wall Streets concensus and the Federal Reserve’s own forecasts, and is already underperforming by an even wider margin in 2014. Q1 2014 was MINUS 1%, and Q2 estimates are falling as it becomes increasingly evident that that Q1 was far more than a temporary weather effect. Near 3% estimates for all of 2014 increasingly depend on almost 5% growth in the second half!

Really the only explanation for the US equity market performance is liquidity being systematically pumped into the markets by the Federal Reserve, banks and big corporation buybacks. This seems to have continued into 2014, but now valuations have reached long term valuation levels that have in the past led to cronic underperformance for investors. Expected returns for US equities over the next 10 years are now close to zero.

http://www.hussmanfunds.com/wmc/wmc140512.htm

Over the second half of 2014 multiple factors will increasingly become a challenge. As described above the weakness of earnings and the housing markets may start providing a headwind. In addition, as calculated by Richard Duncan, Federal Reserve liquidity is about to turn flat in Q3 and negative in Q4.

https://www.youtube.com/watch?v=_oOnAy0zSFM

Market function itself is becoming an issue. Markets are experiencing falling volume, volatility and liquidity. Prices are losing their price discovery function and no longer reflect fundamentals. Hedge funds are consistently performing badly, and Wall Street firms are experiencing declining volume and revenues. Unhealthy markets also are a drag on the economy as confidence in captial allocation declines.

This altered state has also been taken to the extreme in the precious metals markets. Silver supply has been in deficit of demand for the last 2 years and yet continues to trade below cost of production! That’s not how markets are supposed to work. It does not get any more altered than that. This article goes some way in describing this bizarre set of circumstances:

http://blog.milesfranklin.com/silver-prices-at-historic-disparity-with-fundamental-reality

To add insult to injury we are now even getting Federal Reserve lectures on the financial stability:

http://www.frbsf.org/our-district/press/presidents-speeches/williams-speeches/2014/june/monetary-policy-financial-stability/

This must be the most bizarre set of circumsnaces we have ever had in the markets. Markets need to function otherwise economic activity starts declining. The Federal Reserve wants to claim great success in its policies but interest rates have been near zero for over 5 years. A recession with rates at zero would be a disaster. Could the ever rising equity market and suppressed precious metal markets actually be a sign of desperation? Victor Sperandeo is one of most successful traders of all time, taking account of his 40 year track record. Here is his latest blog where he makes this case:

http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2014/5/29_Legend_Says_Markets_Pushed_Higher_To_Conceal_Grave_Danger.html

Central Banks are facing a crisis, and they know it. The greatest problem of all? The rationale of central banking. Essentially the central banks have reached the point where they themselves cannot allow what needs to happen for the economy to restructure. Without that option they believe they just have to keep things moving along. Somehow. Anyhow. Then hopefully something will show up to save them from themselves.

These two articles explain why the central banks themselves are the problem:

http://mises.org/daily/6773/The-Fed-Wont-Let-the-Economy-Heal

http://mises.org/daily/6770/Why-Central-Bank-Stimulus-Cannot-Bring-Economic-Recovery

The very mindset and purpose of central banks is now the issue. Naturally central banks can not change this, so the rest of us are left in this twilight zone of Federal Reserve adjusted reality.

Contrary to the popular view that economic growth causes prices to rise and that rising prices are needed for economic growth, per-capita economic growth is only possible via increased productivity. Increased productivity will, all else remaining the same, lead to LOWER prices (the same amount of money will be ‘chasing’ a larger quantity of goods and services). Some analysts refer to this as “good deflation”. The computer industry is an excellent example. If the entire economy were able to achieve the same productivity growth as the computer industry, then most prices would be in steep downward trends and the average living standard would be in a steep upward trend.

The other way that deflation can occur is via a contraction in the supply of money and/or credit (a contraction in the supply of credit will typically provoke an increase in the demand for money that has the knock-on effect of lowering prices). This is sometimes called “bad deflation”. In this case, the deflationary force is caused by the prior inflations of money and credit stemming from the artificially-low interest rates brought about by the central bank.

See the problem? In its attempts to “fight deflation” central banks are not only reducing the chances of “good deflation”, it is also doing more of what created the potential for “bad deflation”. Nobody wants “bad deflation”, but after a period of rapid money/credit inflation there is no rational way to avoid it. The central bank can only postpone the inevitable by taking actions that will lead to a more painful future denouement in the form of a deflationary great depression (the best case) or a hyper-inflationary great depression (the worst case).

Imposing a false narrative on market prices also simply compounds the problems as it destroys natural price signals and productive capital allocation.

We are now all engaged in a financial death dance with the central banks, who have now become determined to control and even defy reality to justify their belief in flawed models.

We need to be fully aware that this dynamic is highly fragile. Investors need to understand the real issues and be clear about their strategy to deal with this highly unusual set of circumstances. Jim Rickards latest book, “Death Of Money” is strongly recommended in this regard.

A highly robust and balanced allocation has become a necessity. Yet, at the same time a high degree of flexibility will also be needed, as no-one, least of all the central banks, can know how their current collective insanity will be resolved.

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