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The Tease of More Quantitative Easing


If a rally occurs on the next round of monetary stimulus, will stocks be right or are investors simply responding to stimulus without thinking?

The markets rejoiced with a frenzy of buying as the door appeared to open for a third round of quantitative easing. Chairman Bernanke lit the fire with those (in)famous words, "monetary stimulus", and asset prices were off to the races. No details have been released, let alone even contemplated, but the market cares little for details these days. All that matters is whether more money is coming.

This latest bit of financial common sense reminds me so much of a relatively well-known Far Side cartoon, where an amoeba wife is berating her lazy amoeba husband, "Stimulus, response, stimulus, response. Don't you ever think?" I am quite sure Gary Larson did not have risk investors in mind when he thought it up, but it is such an apt diagram for our financial times.

Why would quantitative easing, round three, be good for stocks? Based on the results from quantitative easing, rounds two minor and two major (the reinvestment of the mortgage bond portfolio began in August 2010 while the main addition of new treasury purchases began in November 2010), the knee-jerk reaction to stimulus is, perhaps, justified. Maybe if the matter were given more thought, stock investors would rethink their strategy.

Stocks rejoiced from the very start of the programs. From August 2010 through March 2011, the indices moved upward at an uninterrupted, forty-five degree angle. The Japanese tsunami, a catastrophe with far-reaching impacts, was only a temporary jolt to the stimuli-driven mind. It was quickly forgotten as the S&P 500 (SPY) and Nasdaq 100 (QQQ) drove to new multi-year highs. Then inflation worries began to build, but nearly seven weeks of small, incremental declines were quickly erased in four consecutive sessions -- just in time for the second quarter's end.

It used to be said that stocks climb a wall of worry under constant pressure of potential bad news that could derail the risk appetite of a broad spectrum of the investor class. When bad news came, corrections used to be much sharper and far more compressed than the upward moves that preceded them.

In so many ways, we are now living out a Far Side cartoon, including the general inversion of process and logic. For six consecutive weeks, stock sellers rode the wall of worry; not over news, but over the idea of missing out on the next massive rally. That downward trend was the cautious move, the slowly developing inclination developed by actual data. Rather than the traditional trend of investors deploying capital capriciously and carefully, yanking it out quickly at the first sign of trouble, we now see investors sell carefully at a very measured pace and then rapidly buy at the first sign of a potential rally. Just like bad news that used to jolt the old market into correction, Greece happened to get "fixed" and stocks were off to the races.

Quantitative easing seems to have changed the very nature of equity investing. That is no small accomplishment itself, though I have to question the value of such a change.

The question of value is the real subject here. Markets are soaring as if the economy is roaring, but no objective observer would say that it is. There were two very divergent, concrete results from QE 2.0. First, risk assets experienced a rally that seems woefully out of place for an asset class that is supposed to value economic fundamentals. Second, the prices of so many other risk assets rose in correlation. But where stocks are indirectly "good" through some esoteric "wealth effect", the price of oil and food are directly "bad" for households and consumers.

If stock inflation more than offsets commodity inflation, then stocks may be right to value quantitative easing. On the other hand, if the direct effects of commodity prices more than cancel the "wealth effect", as the last three months worth of data suggest, then stock investors are simply responding to stimulus without thinking. The wealth effect, if it exists in a world of shrinking credit, has the greatest impact on economic activity and flow at the highest ends of the income spectrum. Consumer inflation, through commodity prices, has a far more deleterious and measurable effect on a broader cohort.

To cancel out this inherent inequality of flow, wage incomes must rise with prices or else those without a positive net worth will fall further behind. So any theoretical attempt to restart spending "velocity" through inflationary expectations is functionally weakest at the point of the labor market.

Normally, corporate profits are a positive indication of future labor market strength. Historically, this relationship is not an immediately direct one, but rather rising profits begin to pull up the profitability of smaller businesses. This is precisely because corporations and large businesses have much more inherent flexibility within their economies of scale. That flexibility comes in very handy during contractions, where costs can be shed relatively easily without cutting into fundamental productivity. That flexibility translates into an economic buffer.

Small businesses, without inherent flexibility, are totally dependent on the mercies of revenue growth. Without it, profitability is not an option.

Universal profitability is the key that unlocks labor market flow. In less dire times, the Fed has counted on debt to bridge any gap, even for small businesses. But credit is simply not available to any firms but those that are already liquid, and even then only through corporate bonds (such as Google's (GOOG) $3 billion bond offering, despite the company's cash and equivalents holdings of $37 billion). Small businesses are trapped in a monetaristic corner, and low interest rates are no help.

There is little doubt that tax and regulatory uncertainties are playing a role here, though I will leave that to other commentators. I have advanced the argument that monetary policy should shoulder more of the blame through a new financial incentive structure that favors the ongoing imbalance between speculation and domestic investment. Stock buybacks amongst the highly profitable, large corporate sector are plentiful, but domestic capital expenditures languish. The former plays a vital role in pushing stocks higher, so monetary policymakers seeking out the "wealth effect" favor it.

But stock buybacks come at a very real price. Even large corporations, flush with cash and seeing robust profits, have to choose how to deploy money resources. Repurchasing stock boosts share prices but puts no one to work. It may increase the "value" of management's yearly and accumulated bonuses, but it does nothing to increase the productive capacity of the firm or the economy. In an environment where stocks rise more than 100% in two years, is there enough of an incentive to be productive? Long range productive planning and execution becomes an afterthought in periods of speculative frenzy.

Wherever productive capacity has been meaningfully advanced, the dollar's weakness ensured that the economic benefits that accompany capital expenditures were realized outside our borders. The other, more meaningful legacy of the quantitative easing programs is that corporate profits are increasingly generated by overseas activity. Dollar devaluation is a powerful enticement to deploy as many resources as possible elsewhere -- generating income in another local currency to willingly capture all the financial benefits from that lovely accounting translation of foreign net income into devalued dollars. Profits never looked so good as when they get that currency translation boost.

In the spectrum of resource allocation, are American workers currently worth any risk? The monetary incentives are stacked so much against them due to quantitative easing, that the domestic labor market cannot acquire any of the flow that the Fed creates. No matter how much "velocity" the Fed manufactures by managing expectations, it only circulates within and amongst the most liquid and connected.

The basic definition of an economy is the free flow of goods and services to as wide a constituency as possible. The introduction of money does not change that basic premise. An economy must experience the flow of money from business to labor and back to business. Our current convoluted system is more like from business to labor to government to transfer beneficiary back to business. For big business, flow goes from them to foreign labor to foreign government to US treasuries. This is not the most efficient way to foster revenue growth.

Until the Fed solves this flow imbalance, one that it created, quantitative easing will continue to impoverish the wider economy. The dollar will continue its devaluation, which will bring about rising food and energy costs. That will eat away purchasing power of consumers, accomplishing the opposite of a "wealth effect".

If we distill all of these policy noises down to its basic case, bullish stock investors are essentially betting that the Fed has learned the inflationary lesson. To be successful, the Fed has to decouple consumer inflation from asset inflation, stock prices have to be able to rally without dragging oil prices higher with them. The beneficial correlation of the falling dollar on stock prices -- particularly against the euro -- has to be removed from the its devilish influence on oil and food. Perhaps that explains the withdrawal of oil from domestic and international emergency stockpiles?

Is there any chance that Washington, across fiscal and monetary actions, can harness only the "positive" side effects of a devalued dollar while surgically removing the "negative"? Even if they are successful with oil and food prices, that would leave the problem of corporate profit and resource commitment incentives unresolved. A weaker dollar will continue to push real, productive capital outside our economy.

QE 2.0 "worked" only as far as consumer inflation let it, and only then because it started with relatively low commodity prices. Any restart to monetary expansion is a different animal, jumping off with much higher commodity prices right at the start.

Stocks used to care about such realities, but monetary stimulus is a powerfully addictive substance. No one wants to miss the next big rally and leave money on the table. It worked last year, but households were in relatively better shape. Should inflationary pressures build much further, stock investors may rapidly shift to that other investment addiction, fear .
No positions in stocks mentioned.

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