Understanding Risk And Control. “It’s not the economy (or fundamentals) – It’s The Fed!”

 

“It’s not the economy (or fundamentals), stupid – It’s The Fed!”

Decaying Control System

5 Crucial Questions For Investors

Short Term Outlook

Conclusion

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“It’s not the economy (or fundamentals), stupid – It’s The Fed!”

http://www.zerohedge.com/news/2016-01-11/what-makes-world-go-around-2-uncomfortably-truthful-charts

The hardest point to get across to investors today is that the markets, today and for the last 3 years, are far from normal. Applying conventional norms to looking at markets and short term returns may be more likely to mislead than inform you.

The central banks have materially altered price behavior, this observation is overwhelmingly clear both from the chart above, and the two charts below. The chart immediately below shows how every major turning point has coincided with material central bank action.

0116marketcontrol

 

 

 

 

 

 

Decaying Control System

For the last three years it is hard not to conclude from the header chart above that the S&P 500 has been dominated by the Federal Reserve Balance Sheet. Nothing else checks out. GAAP earnings have been flat and revenues even weaker. Economic growth has been weak to very poor, depending on whether you look at it in real or nominal terms.  All normal market correlations with the S&P 500 have broken. So by a process of elimination the S&P 500 seems to have become a control system determined by the size of the Fed Balance Sheet, and central bank initiatives.

0116fedbalROC

 

 

 

 

 

 

 

 

 

 

 

 

If so the US stock market has become a controlled price. However the funny thing about a control system in a complex world is that it has so many unintended consequences. It also has feedback loops. A strong control system can ignore these issues at first but the pressure keeps building. In the short term risk seems very minimal as the control system does not allow much volatility, but if the control system breaks down then prices have to find a level that could be very far from control system levels. Fundamentals may have shifted dramatically in the meantime.

Over two months ago I described the markets as a “Decaying Control System”

http://chrisbelchamber.com/compounding-policy-errors/

How this serves any useful purpose over the medium to long term term is unknown and highly doubtful. The Fed has failed to articulate this point, but continues with its program nonetheless.

 

0116meanwhile fed

 

 

 

 

 

 

 

 

 

 

 

 

5 Crucial Questions For Investors

Everything that has happened since reflects this observation. That being the case to understand what is happening in the markets investors need to factor in this new dynamic in a big way. It is likely to be determinative in 2016.

Investors should ask themselves the following questions:

1. Are you aware of the extent to which market prices have become a part of a control mechanism?

2. If so then do you understand how crucial the Fed control system has become to your financial wealth?

3. Do you assume the Fed control system will be in place for ever more, even though no price fixing system has lasted?

4. If the Fed control system is suspended then would US stock prices correct to fundamental values, which could be very substantially lower, as valuations are near all time record highs?

A case can be made:

http://www.zerohedge.com/news/2016-01-13/albert-edwards-hits-peak-pessimism-sp-will-fall-75-global-recession-looms

5. Is it possible that circumstances will force a change to the control system as it fails and requires a new policy response?

Short Term Outlook

In the interest of brevity I will take some short cuts to what looks most likely in the year ahead.

The major uptrend in the US stock market has now broken, and in December the Fed made a major blunder in raising rates into a deflationary cyclical downturn, which these notes stated clearly at the time.

This has temporarily boxed in the Fed to a tightening bias that is compounding the economic downturn and could lead to the Fed loosing control of the markets, and lower US equity prices, until the Fed is forced to change policy again and try and pretend that its policy tightening was not a mistake.

More QE will only provide temporary relief. This has been become obvious everywhere, in particular in Japan, and is also clearly the opinion of the BIS in their report 6 months ago.

Jim Rickards believes that the only long term solution, which may still be some months away, will be to directly monetize debt, normally referred to as “Helicopter” money, as it is often characterized as throwing bags of cash out of helicopters to spray it across the land!

Conclusion

The Fed seems to have trapped itself in a policy blunder of epic proportions by tightening policy into a deflationary downturn. Until it changes policy there is significant risk of a major correction in US equities, as the central banks may lose control of the markets.

The Fed may shift back to QE, but until it moves away from QE any recovery will only be temporary.

Ultimately, debt monetization will come to seem like the best policy alternative.

The most crucial component of portfolio allocation at the current time is most likely cash and treasuries, but the sector with the greatest long term upside may well be gold and precious metals.

 

 

 

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