The S&P 500 rose nearly 1.5% and the NASDAQ rallied over twice that amount all in a week when, if anything, the economic data continued to deteriorate. Of course, the market and the economy are not the same thing especially in the short term so it isn’t that surprising to see them diverge. It is often said that the market anticipates but I think it is more accurate to say that the market reflects the aggregate expectations of market participants. That may not sound like much of a difference but there are a lot of factors that affect expectations, many of which are not immediately reflected – if ever – in the economic statistics. And current expectations often turn out to be wrong.
What is driving expectations – and the markets - right now is anticipation of future actions by the Federal Reserve. Ben Bernanke’s speech at Jackson Hole was interpreted as a promise that the Fed would take action to offset further disinflation. The Fed uses an inflation targeting regime and it is generally accepted that their target is roughly 2% core inflation. There are a number of ways to measure that price inflation but all of them are currently less than this perceived Fed target (core CPI reported last Friday showed a year over year change of +1%) and that would seem to imply that Fed action is required to push inflation – and therefore nominal GDP – back up to the target. With interest rates at basically zero that can only mean one thing; the Fed will eventually be forced to engage in so called quantitative easing. Or to us less nuanced types, money printing or inflation.
I suppose there are those who believe that this new money printing will increase real GDP and are buying stocks based on that expectation. And that is possible since GDP is merely a measure of activity. After all, excessive money printing was the primary cause of the housing bubble so it can affect real economic activity. That doesn’t mean it is desirable activity though and again the housing bubble is a great example of the Fed creating activity we would have been better off avoiding. Does anyone really believe that overbuilding of real estate was the best use of our capital this decade? Maybe we wouldn’t be in our current predicament if we had invested our capital in more economically productive assets. So I guess stock markets could be rising because investors are anticipating more economic activity. Anyone buying stocks for that reason may turn out to be doing the right thing for the wrong reason.
A lot of people – most of the Fed for example – seem to forget that stocks (and all other assets for that matter) are goods too and their prices are obviously affected by monetary policy. If the Fed does engage in QE, it would not be surprising to see stock prices rise at least until the damage caused by the inflation is revealed. The newly created dollars have to go somewhere and while the majority are likely to find their way into real assets – commodities and real estate – some will likely find their way into stocks or even bonds for a while. It also seems, based on recent market action, that the mere anticipation of future Fed action is sufficient to get investors to act. It is not coincidence that gold hit new highs and the dollar resumed its downtrend after the Fed chairman told the world he is intent on making sure future dollars won’t buy as much stuff as the current version.
When the Fed creates more dollars than the market demands the value falls and that is the true inflation. As the value of the dollar falls it will purchase fewer things than if the inflation had not happened whether those things are commodities, real estate, stocks, bonds, TVs or bedsheets. But inflation may not – will not - affect all things in equal proportion because there are other factors that also affect relative prices. For instance, we import many of our consumer goods from Asia where productivity is rising rapidly. That rising productivity translates into lower costs for producers and at least until now consumers. So the inflation we had throughout the last decade was reflected in real estate and commodity prices which the Fed failed to consider when setting policy. They appear to be making exactly the same mistake again. How can anyone be talking about deflation with oil at $75, copper over $3.50 and gold making all time highs?
Inflation may result in higher stock prices in the short term but inflationary Fed policy will sow the seeds of its own failure. Remember the dreaded oil speculators from 2008? Remember Congress threatening to enact all manner of regulations to prevent commodity speculation? Remember all the companies that went bankrupt trying to hedge or failing to hedge rising commodity prices? Well, stand by for a re-run if the Fed actually does pursue further QE or maybe even if they don’t. What role did $150 oil play in causing the last recession? How do you think the US economy would handle $4 gasoline right now? And Congressional mandates will make no difference; prices will rise if the Fed prints too many dollars relative to demand. The only question is what prices and how much. Politicians trying to stop prices from rising will be like King Canute trying to stop the tides.
Market sentiment has recently turned more bullish and a correction in stock prices would not be surprising. The Fed meets this week and assuming they announce no new asset purchase programs, that might cause sufficient disappointment to trigger a selloff. I would not expect it to last long though; market expecations will start to build for the next Fed meeting which will be the day after the mid term elections and therefore free of potential political conflicts. However, I don’t think investors should be concentrating on stocks as their asset of choice. If the Fed is really intent on reducing the value of the dollar, real assets will likely provide better purchasing power protection. When the currencies fail to hold their value, investors run to the real.