The Fed’s Hands are Tied, For Now

The stock market’s on a six week win streak.  What’s more, from June 4 through last Friday the DOW’s up 9.7-percent.  Can you believe it?

We thought the stock market would meltdown this summer like Charlie Sheen following a weekend bender.  Instead it has melted up like a Great Plains heat wave.  Home Depot, PepsiCo, Chevron, 3M Co, Google, plus 42 other S&P 500 stocks have recently hit 52-week highs.

If this keeps up just about anything could happen.  In fact, the S&P 500’s a horse’s hair away from taking out its April high of 1,419.04, and reaching a new four-year high.  The way things are going, before long, the S&P 500 will take out its October 2007 all-time high of 1,565.

Ryan Detrick at Schaeffer’s Investment Research thinks stocks will continue to go up for two reasons: “First, price action continues to be constructive; and second, overall expectations are still too low.”

We’re not sure what Detrick means by “price action continues to be constructive.”  Perhaps he means that stock prices have been going up so, therefore, they should continue to go up.  For his second reason, Detrick doesn’t leave interpretation to the reader, “lowered expectations make it much easier to have good news and thus, buying pressure.”

In other words, according to Detrick, stock prices are going up because they are going up…and because no one expects them to be going up.  Maybe he’s right.  Maybe he’s wrong.  But we haven’t heard a better explanation…have you?

Hanging Upside Down by the Ankles

Times like these make investing seem easy.  Day after day…week after week…investment accounts swell.  Upon checking their 401K balance following market close each day your average working stiff feels richer, smarter, and younger too.  If he doesn’t keep his wits about him he might buy a red sports car, color his greying hair, or find some other wonderful way to make a fool of himself.

But what he may not stop to recognize, is that the lure of easy riches has enticed him to step into a gigantic bear trap.  Soon enough he’ll be hanging upside down by the ankles.  That’s what happened in in 2001 and 2008, if you recall.

Of course, we don’t know if the market will crash again for certain.  But if you zoom out 15 to 20 years on a historic price chart of the S&P 500, you can see the right shoulder of what technical analysts call a head and shoulder formation developing.  If the current upward trend doesn’t exceed the October 2007 high, a steep decline should follow.

Regardless, no matter how high stocks rise, it doesn’t change the fact that the economy can’t find a solid toe hold.  Unemployment’s still above 8 percent, manufacturing exports are stalling out because of a weakening global economy, and housing, while improving, hardly has the strength to boost up the economy.  On top of that, there’s the rapidly approaching fiscal cliff that will trigger a series of tax increases and spending cuts.

At the moment, it doesn’t appear that Congress has the will to stop the economy from driving over the fiscal cliff.  That means it will be up to Fed monetary policy to give the economy an artificial lift…

The Fed’s Hands are Tied, For Now

Last month, remember, Senator Chuck Schumer told Federal Reserve Chairman Ben Bernanke to “get to work.”  But what can the Fed really do, other than what it has already done?

The federal funds rate is at effectively zero, banks are flooded with credit, and the Fed’s balance sheet is at nearly $3 trillion.  At this point, the Fed’s monetary efforts won’t do a thing to help the real economy.  Adding another $1 trillion to the Fed’s balance sheet won’t do anything for business.  But it will likely inflate the stock market into a massive asset bubble.

The S&P 500’s over 1,400 and oil’s quietly made its way back to just under 100 per barrel.  In addition, gold’s at 1,619 per ounce.  On top of that, food prices could explode later this year.  At the moment, assets have already been over inflated with Fed money creation.  Their prices are utterly distorted from the realities of the actual economy.  If the Fed takes action now, prices – including consumer prices – could skyrocket just as the economy cools off.

The Fed’s hands are currently tied…and if you believe in free markets, and their ability to efficiently correct capital misallocations, that’s a good thing.  Bernanke maybe a madman but he’s not a fool.  He knows he must let some air out of these assets before turning on the gas again.  But some of Bernanke’s cohorts at the Federal Reserve seem to be lacking in this critical understanding…

Eric S. Rosengren, the President of the Federal Reserve Bank of Boston, wants a “quantitative easing program and one of sufficient magnitude that it has an impact.”  Moreover, Rosengren wants the new quantitative easing program to be “open ended.”    Like Rosengren, John Williams, President of the Federal Reserve Bank of San Francisco, also wants QE3.

For now, we believe Bernanke will hold off on QE3…at least until the S&P 500 drops below 1,200.  But if Rosengren and Williams get their way, in short order, the world will be incomprehensible.

Sincerely,

MN Gordon
for Economic Prism

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