When Will the Fed End its Quantitative Easing Policy?
(February 27, 2011)
Dear Subscribers and Readers,
Quote of the week: “Corporeality is transient, feeling is transient, perception is transient, mental formations are transient, consciousness is transient.” – Buddha
Known as “The Trinity,” the syndicate of U.S. coffee importers of B.G. Arnold, Bowie Dash & Company (both of New York), and O.G. Kimball & Company of Boston dominated the US coffee industry of the Gilded Age—specifically during the boom of the coffee industry in the 1870s. Similar to the activities of investment banks in recent years, the Trinity made significant profits by trading coffee, and at times, artificially holding up coffee bean prices. B.G. Arnold was known as “the Napoleon of the Coffee Trade.” The firm is said to have made as much as a million dollars in 1872 by engaging in speculative activities. By 1880, however, the game was up, as Brazil flooded the market with a bumper crop. The Trinity could no longer bid up prices, and by the end of the year, all three firms failed. A new coffee exchange—one that would promote price transparency and liquidity--was proposed because of this collapse.
As exemplified by the collapse of the Barings Brothers, the diminished role of the Rothschilds, the failure of the Medici banking dynasty in the late 15th century, and the near-collapse of Morgan Stanley and Goldman Sachs in late 2008, success in the financial markets is generally fleeting. For every Bernard Baruch and Warren Buffett, how many other investment or hedge fund managers have made fortunes, only to lose most of it (not to mention many who have never made fortunes in the first place)? To think that one can beat the market in the long run is close to insanity—akin to those subscribing to the ideals of communist rule and government ownership of major industries in the 20th century. As Jesse Livermore so astutely observed “A man may beat a horse race, but he cannot beat horse racing.” The house always wins. Success is transient (as Middle Eastern dictators have recently found out to their dismay).
I now want to welcome readers who are subscribers of Mr. David Korn's weekly e-newsletter. David writes a weekly newsletter that includes his summary and interpretation of Bob Brinker's Moneytalk, as well as his own model newsletter portfolio and discussions related to personal finances. David has graciously asked me to be his guest columnist this weekend (which I am honored to be). I have written for David's subscribers before – in fact, the first time I wrote for David was nearly six years ago. I'm glad to see that both Dave and our commentaries/subscribers are still going strong. One of my mottos has always been “Substance over form.” Sure, presentation and communication skills are important – but what really matters in the long run is the soundness of our advice and the honesty behind the delivery. We never try to generate readership by making outrageous “sky is falling on our heads” claims; nor do we pander to the public by claiming the ability to predict every little move in the market or engaging in revisionist history. Sure, the financial markets is a brutal world (that's why many folks cannot survive without doing the things they are doing), but we choose to let our results speak for themselves.
Let us now begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;
12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;
13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.
In last week's commentary, we noted that “Despite ongoing negative divergences in our technical indicators, extremely overbought sentiment indicators, and declining global liquidity (not to mention increased geopolitical risks), the market keep powering higher. We have been looking for a correction since late last year, and still expect a major correction sooner rather than later (we now expect it to be a 6% to 12% correction). Should the Dow Industrials rise to the 12,600 to 13,200 level, we will likely shift to a 50% short position in our DJIA Timing System.”
We did not get our opportunity to short; but we believe that the market is finally correcting—and with our technical and sentiment indicators still in overbought territory—the correction will continue for the foreseeable future. In light of this correction, there is no doubt that the Federal Reserve will continue its “QE2” policy of purchasing an additional net $600 billion of Treasuries as discussed in its November 3, 2010 press release. From late June to mid-November last year, the size of the Fed's balance sheet (the amount of securities outstanding) remained steady in the $2.04 to $2.07 trillion range. Since the implementation of the Fed's “QE2” easing policy in mid-November, securities outstanding on the Fed's balance sheet has rocketed higher by $260 billion as of February 23, 2011—a record high. As shown on the following charts, the Fed had been purchasing more Treasuries as the agency debt and agency MBS on its balance sheet matured over the last six months:
Note that any further spike in oil prices would be viewed by the Federal Reserve as one-time “see-through” events, they will be viewed as merely short-term supply constraint problems—as opposed to any structural pressure on US inflation (although the ECRI Future Inflation Gauge is at a nine-month high). In gauging whether to prematurely end or taper off its QE2 policy, the Fed will consider the US output cap and its effects on the headline CPI, the core CPI, the Fed Cleveland Median CPI, various PCE-based inflation indicators, and the TIPS breakeven inflation rate. For now, the US output gap is still negative, as exemplified by a higher-than-normal unemployment rate and an industrial capacity utilization rate that is 4.4% below its average of the 1972 to 2010 period.
In a presentation titled “Quantitative Easing, Global Inflation, and Commodity Standards” last week at the Bowling Green Area Chamber of Commerce, St. Louis Fed President James Bullard dispels the potential use of a “global output gap” or a commodity standard as drivers for Fed policy (and more specifically, on when to halt its quantitative easing policy). He notes that while the developed world still has a negative output cap, emerging markets are running at full tilt—and thus there is essentially no global output gap. Since many emerging markets try to peg their currencies to the US Dollar (or least maintain an orderly rise or decline against the US Dollar), the Fed's QE2 policy has resulted in monetary policies that are relatively loose in many emerging market countries, in general. The $64 trillion question is: Should the Fed take into account the global output gap, and more specifically, is it responsible for global inflation?
While I believe the US economy is on a sustainable recovery (as long as Schumpeterian growth remains in play) and thus QE2 is no longer needed, I also recognize the political importance of maintaining QE2. Should an unforeseen downturn occur in the future, the Fed could easily ramp up its asset purchases again while its QE2 mechanisms are still in operation. If the Fed prematurely ends QE2, then it would be difficult to justify more asset purchases again down the road—the Fed would lose significant credibility as Congress and bank analysts accuse it of “flip flopping”—any loss in confidence in the Fed does far more damage than an actual policy mistake (sometimes, they go hand-in-hand as Japanese policymakers found out in the early 1990s). More important—to the Fed's credit—it is charged with targeting US inflation; not global inflation. Any positive output gap in emerging market countries need to be dealt with on a domestic basis, through either higher interest rates or a higher currency vis-à-vis the US Dollar. For the US Dollar to maintain its global reserve status, the Fed must put the US domestic economy first. The Japanese did not learn this lesson in the early 1990s and the Yen thus quickly lost its standing in terms of foreign reserves held by global central banks (at one point, senior policymakers from the Bank of Japan stopped seeing their counterparts because they were too embarrassed). Because of all these factors, I expect the Fed to maintain its QE2 policy for the foreseeable future—although we may change our views should global equity markets recover quickly before June.
Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:
For the week ending February 25, 2011, the Dow Industrials declined 260.80 points, while the Dow Transports declined a whopping 287.75 points, or 5.4! An equivalent percentage decline in the Dow Industrials would be 673 points! Since both the Dow Industrials and the Dow Transports just made new cyclical bull market highs a week ago, we do not believe the cyclical bull market that began in March 2009 is over yet (our long-term technical, liquidity, and valuation indicators also support this thesis0. However, the market remains highly overbought, and many of our short-term technical indicators are still signaling negative divergences while our sentiment indicators are still highly overbought. In light of all these developments, we expect the market correction to continue for the foreseeable future (our target range is 7% to 12% from its February 18th highs). We remain neutral in our DJIA Timing System, and will only shift to a long position once our technical and sentiment indicators become oversold.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The four-week moving average of these sentiment indicators decreased slightly from a reading of 26.8% to 26.6% for the week ending February 25, 2011. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1998 to the present week:
Ever since peaking at 30.8% (its highest reading since late February 2007) five weeks ago, the four-week MA has vacillated in the 26.6% to 28.7% range. At the same time, the 10-week MA just broke its 24-week uptrend that culminated in a four-year high last week. This sentiment indicator remains highly overbought—and with the ten-week MA now in a downtrend (and combined with our bearish liquidity and technical indicators), I expect the market correction to continue for the foreseeable future. We will retain our neutral position in our DJIA Timing System, and will only shift to a long position when our technical and sentiment indicators become oversold.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
The 20 DMA rose from 128.1 to 128.8 last week, while the 50 DMA declined a whopping 5.9 points, from 136.3 to 130.4. Note that both the 20 and the 50 DMAs remain near heavily overbought levels (relative to their readings over the last three years), and with the 20 DMA still below the 50 DMA, bullish sentiment (and the stock market) thus is biased to the downside (this downward bias is confirmed by our other sentiment indicators). Combined with the overbought conditions in our other sentiment indicators, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe the market correction will continue for the foreseeable future.
Conclusion: Despite decent economic growth, there remains a significant output gap in the US economy. With most inflation indicators still at a benign level—and with global equity markets in the midst of a correction—I expect the Fed to maintain its QE2 policy for the foreseeable future. Make no mistake—the Fed is not concerned with either a global output gap or any spike in commodity prices. Emerging market countries who complain of the Fed “dumping fuel onto the inflation fire” would have to tighten themselves and not rely on the Fed—by raising rates, encouraging currency appreciation, or increasing productivity. In the meantime, the market remains overbought despite last week's correction. I expect the market to correct 7% to 12% from its highs. We would not be surprised if the Dow Industrials has already made its high for the first half of 2011. We remain neutral in our DJIA Timing System and will only go long once our technical and sentiment indicators become oversold. Subscribers please stay tuned.
Henry To, CFA, CAIA