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Bernanke's Easy Money Death Spiral


QE is impeding capital investment by raising cost of capital volatility risk. Here's why the more easy money we get, the longer it will take to build a sustainable recovery.

As a corporate manager, you can't forecast the return on invested capital if you can't forecast the cost of that capital or don't believe it to be stable. The immense yield curve volatility -- and thus risk curve volatility -- over the past decade has removed the ability for corporations to effectively calculate their net return on capital. Instead of deploying capital for investment in fixed assets, managers simply sit on the cash and, as Grantham notes, buy back stock or retire debt.

If that wasn't bad enough, the returns on what little capital that had been invested appears to be peaking. I monitor two return metrics for the S&P 500 (INDEXSP:.INX): The return on assets (ROA) and the return on capital (ROC) less the Moody's BAA bond yield. I plot the ROA over commercial and industrial (C&I) loan growth with the ROC over the S&P 500 price. The idea is that when the ROA is rising, it creates a demand for capital (loan) to invest in those assets, which in turn generates a ROC, which then produces capital appreciation (stock prices).

In late 2011, the ROA of the S&P 500 reached a post-crisis and near-decade high of 9.5%, which corresponded to double digit growth in loan demand. At the same time, the reported ROC less corporate bond yields (partly due to QE) reached a decade high spread of 11%, no doubt helping fuel the rally in stock prices. Since the 2011 peak, both return metrics have seen a notable flattening if not outright decline, with October 2012 ROA reported at 8.6% and the ROC at 10.45%. While still at robust levels of profitability, these two primary drivers of the equity market rally are starting to wane. With interest rates still at record lows, it appears the stimulative effect of low interest rates on corporate profits has reached its maximum benefit.

On November 12 in Rally Off 2009 Lows Flushes Hedge Fund Shorts, I cited two important pivots that investors should watch for the market to back test: The 1400 level on the S&P and the 150-00 level on the US bond futures contract.
The stock market has clearly done some serious technical damage, but unless we are crashing there should be an attempt to back test 1400, at the very least to work off oversold conditions.... I wouldn't even rule out an attempt to rally back toward the old highs into Thanksgiving, however if we are putting in a cyclical top, that's a rally you will want to sell.

For the bond market, we have a similar setup. Last week's short squeeze was swift and severe. The US bond futures contract traded over two standard deviations above the regression line we have been following since June's breakout rally. Traditionally that is not a move you want to buy. When the market settles down a bit, I expect a back test of 150-00. Obviously that level needs to be respected, and if we hold convincingly, you have to prepare for higher prices and lower yields.

You might expect counter-trend moves to occur during lightly participated trading sessions, and last week we saw both back test pivots hit. During Friday's abbreviated holiday session when no one was trading, they managed an 18-handle rally to close the S&P at 1409. During Wednesday's equally boring session, the US bond contract hit 150-00 held and closed the week at 150-01. This week, the pros come back to work and it is make or break for the year-end trade.

Last week, I argued from a lender's perspective that contrary to Bernanke's assertion, QE was impeding the extension of credit by raising interest rate risk. This week, I argued from the CEO perspective that QE is impeding capital investment by raising cost of capital volatility risk. Despite compelling evidence that monetary policy is inhibiting the capital allocation process, Bernanke continues to argue as he did last week for further accommodation.

The irony is that, if I am correct, the more easy money we get, and the longer it will take to build a sustainable recovery, which will forever prevent Bernanke from ever normalizing interest rates. We are just stuck in this never-ending easy money death spiral that only the market can end. And that probably doesn't end well.

Twitter: @exantefactor
No positions in stocks mentioned.
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