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How Long Can the Party in Stocks Last?

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By the time the Fed becomes institutionally aware that inflation is raging across the globe, it will be too late.

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So it is my view that the trillions of dollars of thin-air money and deficit spending are finally finding their mark (asset prices) and doing their work, just as I predicted they would. Where some called for deflation to be the irresistible force that would drag us all down, I've consistently leaned toward the side of inflation. Although, to be fair, I have always hedged that view somewhat, with a 70/30 split held for nearly five years that was recently amended to 80/20 (in 2010 shortly after QE2 was announced).

On a Tear

Unfortunately for the rest of the world it's not simply the stock market that is the lucky beneficiary of all this Fed largess. Thin-air money, once released into the wild, tends to have a mind of its own.

Commodities are now setting new records almost daily. Where the stock markets still have some catching up to do, commodities are exploring virgin territory.

Rising Prices

This is serious business, folks. The future is not going to arrive "someday." For the billions of people who spend a huge portion of their income on food and fuel, it has already arrived.

Looking at the above chart of the past 12 months, what we see is that everything, from metals to stocks to bonds to grains to energy, has experienced profound price increases. That pretty much covers everything you need to live on and the bulk of the paper universe. Such a chart is a historical rarity for any one country, yet it currently happens to apply to the entire world. You are living in historic times, which certainly belabors the obvious.

Your Lying Eyes

On the flip side, the story we are being told almost daily is that inflation is very low -- too low, even -- in a worrisome sort of way. I am reminded here of an old Richard Prior skit where his wife walks in on him in bed with another woman. To her increasing agitation, he denies that he has been cheating on her, finally shouting, "Who are you going to believe? Me, or your lying eyes!?"

Well, my lying eyes see something very different in that chart above from what I am being told; instead of worryingly low inflation, I see rapidly rising inflation that is very close to slipping out of control.

I spend as much time on this subject as I do because the decisions you make based on whether you are protecting yourself from inflation versus deflation are as different as to whether you grab an anvil or a life raft on your way out the door when facing an emergency.

I do my best to let the data do the talking, and right now it is saying inflation.

See The Week in the Inflation vs. Deflation Debate for more perspectives.

How Long Will It Last?

The old saying is, "Don't fight the Fed." That's good advice. I have dutifully been following the developing story by watching what the Fed does, not what it says, and by letting prices tell me which way the wind is blowing. It's a regrettable position to be in, because it's nearly impossible to make any long-range plans when you have no idea what the Fed is going to do next. But here we are.

How long the stock market rally will last is therefore unknowable, but stocks and bonds and commodities will remain elevated in price for as long as the Fed continues to dump hundreds of billions of thin-air money into the markets. The only problem is that there's no clear exit strategy for the Fed.

Putting money into the markets is a very easy thing for the Fed to do. Letting rope let out under full sail is easy; tugging it back in is difficult.

The Fed faces a similar asymmetry. Market participants are always eager to take fresh money hot off the press. An infinite number of things can be done with that money almost instantly. But coming up with money to give back to the Fed for Treasury of MBS paper? All sorts of difficulties arise.

"Wait, we'd have to sell a lot of things to free up that kind money and what, exactly, are you proposing to hand us in return? Treasuries? Um, no thanks, not right now. Agency debt? Uh, no, that doesn't fit our portfolio needs right now either. Perhaps next week?"

Further, when the Fed goes to get its money back from the marketplace, that action will drain liquidity, creating ripples throughout all sorts of markets, especially and including knocking the stock market down. Very few people complain about adding thin-air money; a crowd roars its disapproval for the reverse.

Too Late

The bottom line is that by the time the Fed becomes institutionally aware that inflation is raging across the globe -- and I often wonder when they'll finally awaken to the threat -- it will be too late. Inflation will have the momentum, and it will take a vast overreaction on the part of the Fed to restrain it. They'll have to drain enormous amounts of liquidity and tolerate vastly higher interest rates to be able to do that, and I doubt they have the courage for such bold action. I think they will hesitate, equivocate, and ultimately be late.

History suggests that inflation is best tamed early, but the Fed is already late and demonstrating a remarkable callousness by doing the exact opposite of fighting inflation. While we cannot know what it is that the Fed sees, or which demons it is fighting that provide the internal rationalization for risking a hyperinflationary outcome, we can only conclude that these threats are more spectacular than the alternatives.

Unfortunately, these events conform to the main themes that I have been writing and advising about for the past several years. Sadly, they are not a surprise at all; the only mystery to me so far is how they have managed to carry on as long as they have.

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No positions in stocks mentioned.

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