Words Not Action!

"I think they're now in Phase Three which is really jawboning." - Gary Shilling

Over the past few months there really has been no action on the part of the Federal Reserve or for that matter any of the central banks of the world but there has been a lot of talk about potentially doing something soon.  Cases in point are some of the numerous headlines out of prominent newspapers such as the Wall Street Journal and the New York Times;

• Weak Report Lifts Chance of Fed Action - Wall Street Journal
• Fed Weighs More Stimulus - Wall Street Journal
• Fed Moves Closer To Action - Central Bank Prepares Steps to Spur the Economy Unless Recovery Picks Up - New York Times
• Wary Fed Is Poised To Act - Wall Street Journal

This continued across the so called pond in Europe:

• ECB Signals Readiness To Do More - Wall Street Journal
• ECB will do "whatever it takes to preserve the euro and, believe me, it will be enough" - Mario Draghi

On and on the jawboning goes but it is never followed up with any action.  That said the markets continue to react to the news and continue to climb higher and higher.  This is not the way that you stimulate the economy and as I argued in an earlier blog we are now in the hands of the politicians to implement policies to save us and this appears to be the feeling of the central bankers of the world.  They have pumped in as much money as makes sense and now unless the politicians implement sound policies they are left with little in the way of reserves.  A scary situation indeed.

So what drives the markets higher?  I recently read an article that threw some light on human behavior and particularly on the behavior of traders.  The authors of the article tested the testosterone levels of traders that were making money versus those that were not and what they found was that the more money a trader made the higher his testosterone went.  Furthermore traders are encouraged by their employers to take on more risk even as their hormones push them towards recklessness.  So it appears that the largest bets are placed right at the time when prudence is needed.  This certainly seems to pinpoint the arrogance of some of the large trading houses and Morgan Stanley's Whale trade.

On the surface then if traders are making money by forcing the market higher any signal is enough to push things higher.  In fact it is clear looking at historic trends that markets go far further than anyone considers possible before imploding spectacularly.  This lack of rationality right at the point when it is needed most has and will cause wild swings in market prices.

So while there are constant cries from the central bankers that they stand ready to act, the world is rapidly slipping into another recession.  As in the past the Federal Reserves policy has always been and seems to continue to be to try to kick start inflation.  Getting inflation going raises up the value of assets (although it only benefits the few who own the assets at the expense of those that do not) making debt a smaller percent of the asset value.  This way you can keep the debt level the same and magically you have it under control.  Printing money normally works but at this stage of the "recovery" and after unprecedented money printing this has not happened yet.

Behind the scenes the traders consensus is that with money printing comes inflation and with inflation comes fantastic returns to stock investors.  Buying into this strategy means becoming aggressive early.  Get in and wait for inflation to raise up all ships.  The first mover who is now trading stocks ever higher is expecting inflation to start, however until the velocity of money starts to move things will remain benign leading at some point to a revaluation of the stock portfolio.  Now what if the velocity of money remains static for an extended period?  Is that even possible?

Well the first thing to consider is that we are deeply into uncharted territory as far as money printing goes and it appears that we are not done yet.  I recall an article printed by the Economist back in 2006 saying that the global real estate bubble was a $30 trillion bubble.  We all have seen the effects of that burst bubble so can a few trillion here and there from central bankers plug this hole and stave off the vacuum caused by this pop?  With Europe almost certainly in a recession it looks likely that the US will enter one soon (although I have argued it will be shallow) but it could point to a prolonged slow recovery devoid of inflation and that could disastrous consequences.  Why?  Without inflation suddenly the debt that has been built up will not become a smaller percent of GDP but rather will continue to spiral higher leading to even larger budget deficits and long drawn out periods of recession as governments fight to contain spending right when it is needed most.

This thesis certainly is not appealing but it seems that with everything consensus is not often right and this time may be no exception.  Printing money on a scale as large as the coordinated global money printing binge taken on by the central bankers of the globe may result in an overburdening of debt.  This massive debt level (as I have argued) will crowd out private sector growth and will result in more and more frequent recessions.  I will delve more deeply into this topic next week but ensure that you stay patient and maintain the course of prudence and a commitment to not risking your hard earned assets any time soon because the market will only listen to jawboning for a short period of time.