The Rocking Boat of Stocks

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When you’re an addict there are only two extremes. You’re either flying high or you’re coming down. And as Tom Petty wrote, coming down is the hardest thing. It doesn’t happen slowly. It happens fast.

Stocks, bonds, and commodities all flew high in the first quarter of the year. Hedge funds, traders and the public abandoned caution, levered up, and dove into anything they thought would benefit from easy money. And it worked. But now we’re coming down.

This is one of those unintended consequences of living in a low interest rate world. All the world’s money printers have lowered their prices. With the returns on cash sufficiently trashed, and the cost of borrowing low, the barriers to entry for becoming a Fed-funded speculator were gone. Whether they liked it or not, investors became speculators and all the bets were one way: long.

Now, all the bets seem to have moved the other way at the same time: short. Maybe this is simple profit taking and de-leveraging. Maybe it’s panic. But it’s definitely an example of market moves becoming more volatile. Everyone is on the same side of a trade, and then switches to the other side. First port, then starboard. The boat gets rocked.

Naturally, when you’re on a boat that’s rocking, you start to wonder if this sucker’s going down. Probably not today, although it wasn’t a big reversal day on Wall Street. The focus has turned to earnings.

Investors discovered that ignoring them in favour of Fed policy doesn’t change what’s going on. Business in America is okay, but not radically improving enough to justify higher multiples on stocks.

The gold price is limping back to the US$1400 range. Is it a temporary reprieve? In our weekly update to readers of The Denning Report, we’re taking up the idea there is a behind the scenes battle within the global financial system for physical ownership of the world’s best collateral (gold). But on the front lines, there’s the relationship between gold and stocks, shown in the chart below.

To recap, the ratio between the gold price and shares in Berkshire crashed through the 14 level we had our eye on and kept right on going. It overshot. But what is that on the right side of the chart? Could it be one of those dramatic ‘V’ shaped reversals that mark a bottom in a market?

It could. But the ratio has been oversold based on the relative strength index (RSI) for most of 2013. This reflects the drugged-up trading mentality referred to above. Stocks had a great first quarter relative to gold. The early signs are that the second quarter won’t’ be as great.

But let’s not forget the drug dealers in all of this. ‘Three Fed presidents say disinflation may prompt easing,’ reports Bloomberg this morning. ‘If inflation looked like it was going to sag further on a persistent basis, I would certainly consider stimulus for the purpose of bringing inflation up to target,’ says the Richmond Fed’s Jeffrey Lacker.

Other Fed Presidents agree. ‘We should defend the inflation target from the low side,’ said St Louis Fed president James Bullard. That is such a bizarre way of putting things that it’s hard to know what he means. But we think he means the Fed should keep pumping money into the bond market as long as consumer price inflation remains low.

Investors have rejected this strategy in the last ten days. One way of reading gold’s fall is that speculators don’t think QE will lead to asset inflation. Thus, the stock sell off. Yet the Fed persists with a strategy that doesn’t produce real economic growth and leads to huge volatile swings in financial markets. Go figure.

In the meantime, even the Chinese are starting to get the idea of pumping up markets by expanding the money supply. ‘Monetary easing might be helpful but the role is very much limited,’ said Jin Liqun, the chairman of the board of the China’s sovereign wealth fund. ‘It is a necessary but not sufficient condition.’

It’s not exactly an unqualified endorsement of QE. In fact Jin also said, ‘If printing money could solve the problem, it would be so easy. Every country can print money…Some people believe quantitative easing is a panacea. It’s not a panacea. If you don’t do something else to support this policy, it’s a recipe for disaster.’

Plan for disaster. But how we get there should be interesting. As for Australia, there may be some relief coming for mining companies in the form of a lower Australian dollar. It won’t help with the sell-off in commodities as QE speculators take their bets off the table. But it will help with lowering the cost of doing business in Australia, which is incredibly high.

a ten-year chart of the AUD

Above you’ll find a ten-year chart of the world’s latest greatest ‘reserve currency’. We put that in quote marks because no reserve currency worthy of the name would be quite so volatile. People using that designation prefer to focus on the last two years, with the Aussie at parity or better against the US dollar. They ignore the huge 37% drop in 2009 – the last time the world deleveraged in a hurry and commodities lost their lustre with speculators.

Is a big fall in the Australian dollar possible? Of course. Is it imminent? That’s harder to say. The Aussie dollar is overvalued by about ten per cent, according to IMF deputy director Min Zhu. That’s a pretty generous assessment, given the fall in the terms of trade and bulk commodity prices.

For Aussie investors, a fall in the dollar is a mixed blessing. It’s probably bullish for industrial stocks and exporters. But to the extent it’s driven by falling commodity prices and lower capital flows, it’s bearish for resource stocks. There’s probably a pair trade in there. But we’ll leave that to Murray over at Slipstream Trader.

In the meantime, life goes on. And with all due respect to Tom Petty, coming down may not even be the hardest part. The hardest part is when instead of a little consumer price inflation, you get a lot. When funny money no longer boosts asset prices, but leads to exploding consumer prices, we go beyond a monetary experiment and into a sociological one. Stay tuned.

Regards,
Dan Denning
for The Daily Reckoning Australia

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From the Archives…

China’s Credit Boom Krakatoa
12-04-13 – Greg Canavan

The Market Is High
11-04-13 – Greg Canavan

Gold vs Bitcoin
10-04-13 – Greg Guenther

Is Cyprus More Important Than You Think?
9-04-13 – Satyajit Das

Our Largest Asian Trading Partners Are in Trouble: China and Japan
8-04-13 – Greg Canavan

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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2 Comments on "The Rocking Boat of Stocks"

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slewie the pi-rat
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when people have currency and paper wealth, why not go back to the casino and keep playing? THAT is the addiction/the habit they are in )if they are lucky and it is ONLY a habit). seems OK and everybody else w/ these green stamps is there too, so it IS kinda fun, ya know! step 1) admit how much fun this is! step 2) admit that the counter-parties have lost their sanity due to THEIR addictions and they are “goin Stage 3” which is the accelerating phasic distortions leading to financial death. step 3) consider the counter-parties were never alive… Read more »
Brent Kelly
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Stocks have always rocked – running with the title of the article- or have always been volitile. The main reason I believe is they are highly liquid and can be traded not just daily but intra daily. If you are a day trader, all this highly technical analysis over monthly or weekly trends is important. 1-2% daily gains adds up quite nicely over a month. I cant help but feel that over the last 4 years analysis creates paralysis. The ‘ol school’ investment values and analysis I think still rings true today if you are a traditional long term investment… Read more »
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