Fed Buying Physical Gold by Proxy

by Rob Kirby from Financial Sense:

A couple of weeks ago, I pitched an idea to some associates of mine who are involved in SERIOUS [tonnage] PRECIOUS METALS procurement – physical metal only – let’s just say HUGE money.  I asked them if they would be interested in purchasing an “option” – cash up front - for the exclusive rights [first right of refusal on off-take] of a gold producer [miner] for a set number of ounces for 3 – 5 years “at the market” – using LBMA pricing [a.m. / p.m. fixes] in the future.  The answer I got back from my associates was “show us a terms sheet, we definitely have interest”.
So, I spoke to a friend who is very close to an intermediate producer who is in the mode of raising money right now.  I had them ask the producer if they would have interest – the producer said, “YES, we are interested - but just to let you know – J.P. Morgan has been asking us if we would sell them the same option”.  So, while gold producers have shuttered their “gold hedge books” – the Bullion Banks are ‘synthetically’ trying to keep physical output captive – I would suggest FOR THE EXPRESSED REASON THAT THEY SELL EVERY PHYSICAL OUNCE AT LEAST 100 TIMES OVER.
Gold is going to get EXTREMELY scarce in the future folks.  Big money interests are now cutting off [or bidding for / gaining exclusive access to] the traditional bullion supply chain “at the pit”.
The shorts of ‘paper gold’ at J.P. Morgan [the Fed in drag] are selling the daylights out of the paper market and simultaneously buying exclusive rights to producers’ future production so they can try to fudge their way through an unmitigated fraud and settle a big enough chunk of their bad bets to keep this ‘systemically ruinous’ precious metals ponzi-scheme alive.

Price of Gold and Interest Rates Are Joined at the Hip

The academic research that outlines the inter-relatedness of gold and interest rates is succinctly laid out in a 2001 treatise, Gibson's Paradox Revisited, by Reg Howe.  From this one can deduct that ANY rigging of the gold price must go hand-in-hand with simultaneous rigging of interest rates.
Folks would do well to realize how neatly emerging details of Fed surrogate Morgan’s  ‘stealth’ activity in the bullion market dovetails with their obscene, obsequious activity elsewhere in their derivatives book – particularly their JUMBO TRILLIONS sized interest rate swap positions.

Stealth activity on the part of the Fed – utilizing proxy institutions to generate limitless artificial demand for any and all U.S. Government Debt – effectively gives the Fed control of the long end of the interest rate curve [the bond market].
From a timing perspective, it is also noteworthy that gold price rigging – long maintained by GATA – is alleged to have begun in earnest during the Clinton Administration with the appointment of Robert Rubin as U.S. Treasury Secretary [along with understudy Lawrence Summers] in Jan. 1995.  Coincidentally [or perhaps not?] we can trace the genesis of the “explosion” in the use of derivatives [mostly interest rate] to that exact same time frame.  In fact, if we follow the time line in ‘reverse’ – the growth in the use of derivatives appears like a trail of bread crumbs – right back to the time when Professor Lawrence Summers, under the tutelage of Sir Robert of Rubin, brought his academic alchemy to Washington:

Does anyone with a pulse really believe that ANY Bank Holding Company in the U.S. would be permitted to have a derivatives position in excess of 75 TRILLION [five times the size of U.S. GDP] if they were not ‘in bed’ with the FED????
If you except the premise that, “J.P. Morgan “is” the Fed”, then, “IT’S REALLY THE FED WHO IS BUYING GOLD” and they [unfortunately, this means “America”] likely have NONE LEFT to sell.
NOTHING could be more bullish for the price of gold going forward.
Everyone needs to get it through their heads; these criminals are NOT IN IT for profits.  The survival of our “BROKEN FIAT MONEY SYSTEM” “IS” their only goal.

Conclusions: 

Officialdom will never admit it and it will NEVER be reported in the mainstream financial news but our financial system has NEVER been in a more precarious state. A banking crisis of unparalleled proportions is coming – probably soon – the exact timing is still sketchy.
Got physical precious metal yet?

Pray for True Justice

(Sept. 14) -- As arguments begin Tuesday in a Florida District Court where 20 state attorneys general and the National Federation of Independent Business are challenging the constitutionality of the health care law, the American people can be forgiven for feeling a bit ill at ease about the direction their country is going. James Madison would feel the same way.

Madison's vision of limited government was integral to the creation of the U.S. Constitution and its ratification, and he thought the limited nature of the federal government was so clear from the text of the Constitution itself that even the Bill of Rights should have been unnecessary.

So imagine his response if the Congress of 1789 had proposed a law like the Patient Protection and Affordable Care Act -- i.e., Obamacare. Nowhere does the Constitution grant the power to force individuals to buy a product.

One constitutional provision, the Commerce Clause, allows the federal government "to regulate commerce ... among the several States." But regulating the health of the citizenry had always been the role of state, not federal government, and the notion that medical care would be considered interstate commerce would have been shocking to Madison's contemporaries since in almost all cases the doctor and his patient live in the same state.

But the government -- and the way we view the Commerce Clause -- isn't what it used to be.

The landmark case of Wickard v. Filburn was decided in 1942 and has dramatically expanded the application of the Commerce Clause. In Wickard, the federal government wanted to apply its agricultural regulations to Roscoe Filburn, an Ohio farmer who was growing wheat for personal use on his own farm. He wasn't selling it, so it never entered commerce. And it certainly didn't cross state lines as it went from his field to his own table. Nonetheless, the Supreme Court determined that his wheat production had an incidental effect on the national market for wheat since Filburn and those like him would then not be buying their wheat in interstate commerce.

Wickard v. Filburn was crucial in clearing the way for the pathbreaking expansions of government in the New Deal. Now that our government is engaging in a renewed expansion into the lives of the American citizen, that case is becoming relevant yet again and is central to the government's case defending Obamacare against federal lawsuits brought by more than 20 states.

It claims the impact of health and health care costs on the national economy can be felt through their effect on governments and individuals who subsidize coverage for the uninsured, the costs to the economy of poorer health and shorter lifespan, and the rate of personal bankruptcies.

This argument has shocking implications for the notion of limited government, because the same reasoning could be used to expand government even further beyond its already bloated state.

As Sen. Tom Coburn, R-Okla., queried during Senate Judiciary Committee hearings on Elena Kagan's nomination to the Supreme Court, what would prevent Congress from claiming even something as novel and intrusive as mandating individuals to consume a certain quota of fruits and vegetables affected interstate commerce?

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After all, doesn't bad nutrition lead to more costs for the governments and taxpayers who subsidize health care, result in sickness and early death, and possibly contribute to the health care costs that themselves can trigger bankruptcy?

Indeed, is there any action that Congress could not argue has some effect on the economy, and if on the local economy then, by extension, on the national economy? But the health care law goes even further than that, because Congress has chosen to regulate not only actions, but inaction -- the failure to buy or provide qualifying health insurance.

Congress had no scruples in passing a bill whose constitutional basis was paper thin. President Barack Obama was proud to sign it. Now only the federal courts stand between our burgeoning federal government and the Constitution's model of limited government.

Carrie Severino is counsel and policy director for the Judicial Crisis Network and a former law clerk for U.S. Supreme Court Justice Clarence Thomas.

Gold Still Higher Following More Japan QE

Past 10-Year Returns Are Poor Predictors of Future Returns

by Bill Hester, Phd. at Hussman Funds:

Can the process of forecasting long-term stock market returns be simplified to include just one step – calculating the prior decade's return? This is one of the arguments that analysts are currently using to convince investors that the coming decade will offer above-average returns. It's important to take a closer look at the argument because it's become widely discussed and reported. A strategist at a major investment bank argued recently that poor 10-year trailing returns is reason enough to expect lofty returns over the next decade. A similar argument was recently made in Barron's, and by various mutual fund companies.

Some of the research is structurally flawed. One piece examines the 50 worst 10-year returns since 1871 to construct a sample to calculate subsequent 10-year returns. The study used monthly data, so many of the observations clustered within a single year. 11 of those "worst" returns occurred during the past decade. Of the remaining 39 months for which the subsequent 10-year stretch of returns is known, 32 of them occurred around 1920, so the study is heavily influenced by a single period. The implicit argument is that the next decade will look much like the Roaring 1920's.

But even using a broader set of periods with poor trailing returns, the average return during the decade that followed has typically been slightly above average. In fact, some of the individual periods have provided strong returns, especially when they marked the beginning of secular bull markets, like in 1942 and the early 1980's. The graph below shows the 10-year rolling total return of stocks since 1929.

Looking at the graph, it is clear that 10-year returns for the market have varied a great deal, creating long "secular" periods of above-average and below-average returns. There are just few periods where 10-year trailing returns fell to very low levels – after the stock market crash of the early 1930's, in the early 1940's, and again during the late 1970's and the early 1980's (on an inflation-adjusted basis, the 10-year returns during these last two periods were also negative). A cyclical bull market followed the low returns of 1933, and secular bull markets followed the low returns of the early 1940's and early 1980's. When looking at the data below, we'll include the 100 worst months of 10-year trailing total returns beginning in 1929. This group of months will capture the bulk of the periods just mentioned.

The Drivers of Returns

Once the observation is made that long periods of negative trailing returns have been followed by strong subsequent returns, it's logical to ask whether there are other characteristics that those strong decades shared. To that end, it makes sense to begin with the fundamental underpinnings of stock prices: growth and valuations.

The valuation argument is relatively straight forward. On a cyclically adjusted earnings basis (where profits are averaged over the prior decade), the average cyclically adjusted P/E ratio following periods of poor long-term returns was 12. That compares with the long-term average of 16 using the entire historical period, or 14 if you exclude the Bubble Years surrounding the year 2000. Either way, not surprisingly, valuations tended to be quite low and below average following decades of poor stock performance. The cyclically adjusted P/E ratio is graphed below, with the red line showing the long-term average following poor long-term returns.

At the low in 2009, the CAPE was close to the average level of prior periods that followed poor 10-year returns. But the current argument being made by analysts is not about investing at last year's low. It is about investing at current levels of valuation. And here, the graph shows that today's CAPE of over 21 sits far above the levels that typically lead to strong long-term returns.

To drive earnings over the long-term, economic growth matters too. Here the gap between today's characteristics and prior periods widens further. In the 10-year periods that followed low return decades, the US economy grew at an average nominal rate of 10.5 percent a year (using annual GDP data through 1946 and quarterly data thereafter). So, clearly the economy has eventually grown rapidly following periods where stocks suffered poor long-term returns. This makes sense. It was a long, hard slog from the depths of the depression until full recovery. It took until 1941 for output to climb above 1929's level of GDP. But once it did, the economy grew quickly, both during the build-up to the War and during its aftermath. The economy also grew quickly coming out the early 1980's recession, after a long stretch of mediocre economic performance and poor stock market returns.

This data suggests that we should modify the assumption that poor past returns, in and of themselves, reliably lead to strong subsequent long-term returns. It is more accurate to argue that following poor 10-year returns, provided that valuations are depressed based on normalized earnings and the economy is likely to grow at double digits rates of nominal growth - investors can probably anticipate higher subsequent long-term returns.

There are a couple of arguments that put that latter assumption into question today. One is the secular downshift of nominal economic growth that has occurred during the last two-and-half decades. The graph below plots the rolling 10-year change in nominal GDP. Although a long-term drop in inflation explains part of the decline, the inflation-adjusted also data shows a downshift. Ned Davis typically shows this chart to his subscribers along with one that depicts the increased levels of debt in the economy, making the case that higher levels of debt have been producing lower levels of GDP growth. Another reason for this downshift is that according to Commerce Department data, demographics and other factors have caused the growth rate of "potential GDP" to slow persistently in recent decades. Regardless of the cause, the graph does show that in order to attain high rates of nominal GDP growth from current trends, very high levels of inflation would likely be needed. And historically, abrupt shifts from low levels of inflation to high levels of inflation have delivered investors poor returns.

Estimating Long-Term GDP Growth

There are a couple of ways that we can obtain an estimate of GDP growth over the next decade. One is from combining estimates from economists and bond investors. The Livingston Survey, which is collected by the Philadelphia Federal Reserve Bank, periodically asks economists for their 10-year forecast for GDP growth. The most recent survey showed that economists expect the economy to grow at an average rate of 2.80 percent a year over the next decade, adjusted for inflation. The current spread between 10-Yr nominal Treasury bonds and 10-Yr Treasury inflation-protected bonds is currently about 1.8 percent. That gives us an estimate for nominal GDP to grow at about 4.6 percent a year over the next decade.

We can also obtain an estimate of the likely growth rate of the economy by relying on historical precedent. A paper that was presented at the Kansas City Fed's most recent economic policy symposium can help. The paper – ‘After the Fall' – was written by Carmen and Vincent Reinhart – and it discusses common economic outcomes following major credit crises. The work is an extension of This Time is Different, Carmen Reinhart's collaboration with Ken Rogoff on the periods leading up to and immediately following credit crises. In the paper the Reinhart's extend the window of the research and ask the question: what are the long-term effects on inflation, unemployment, and GDP growth following severe credit crises?

Their findings are sobering. For developed countries, around a standard severe credit crisis – those that were generally country specific – the unemployment rate averaged 2.7 percent in the decade prior to the beginning of the crisis. In the decade that followed, the jobless rate averaged nearly 8 percent. Stunningly, in all five advanced economies and in four out of five emerging economies they studied, the unemployment rate has failed to decline below the levels reached prior to each crisis (even though most of crises in developed economies occurred 20 years ago).

Their data on GDP growth following credit crises was equally uninspiring. For developed countries, GDP growth was typically 1 percentage point lower than the decade prior to the peak. Developed economies grew at an average real rate of 3.1 percent in the decade prior to each crisis, and at 2.1 percent in the subsequent decade. The outcome was even worse for periods that followed severe credit crises which were global in nature. The Reinhart's put the decade of the 1930's and the 10-year period following the 1973 oil shock into this group. Here the rate of economic growth in the decade that followed these global credit crises was cut by half. Developed economies grew at an average of just 1.8 percent a year following global credit crises.

The Reinhart's research also sheds some light on the tendencies of inflation following a collapse in credit. While they note the well documented periods following the 1929 stock market crash (severe deflation) and the 1973 oil shock (high rates of inflation), they also draw a distinction between these periods and the standard (but still severe) credit crises. For developed countries, inflation averaged 6.5 percent in the decade prior to each crisis and 2.2 percent in the decade that followed. Crises in emerging countries showed similar patterns. Inflation in these countries averaged 5.9 percent in the decade leading up to the crisis and 3.6 percent in the decade that followed. As the Reinhart's point out, “this is all the more remarkable considering that the emerging market countries all sustained massive devaluations/depreciations in their currencies at the height of the economic turmoil.”

Within this framework, we can construct an estimate for GDP growth over the next decade. In the 10-year period up to the peak of the 2008 credit crises, real GDP growth averaged 3.1 percent a year. Based on the Reinhart's research, it is reasonable to expect the economy to grow at somewhere between 1.5 percent and 2 percent over the next decade. Inflation averaged 2.5 percent leading up to the crises. That's low by historical standards, so a rough estimate based on their work might be about 2 percent. So, if the economy takes a decade to recover – which is standard for post credit crisis periods – then the US economy would be expected to grow at a 3.5 percent to 4 percent nominal rate over the next seven or eight years.

Following the worst 10-year returns for the S&P 500, the average cyclically-adjusted P/E was just 12, GDP growth over the following decade average 10.5%, earnings growth averaged 8.63%, and the S&P 500 return over the following decade averaged 11.33. Presently, the cyclically adjusted P/E is above 21, while the prospects for earnings growth are depressed, both based on potential GDP and on the typical aftermath of a credit crisis. It is worth remembering that investors in the Japanese stock market have had rolling negative 10-year returns since 1997.

The argument that above-average long-term returns typically follow periods of poor past long-term returns is not wrong, it's just incomplete. The more complete argument is above-average long-term returns can be expected to follow long periods of low or negative, provided that they end with low P/E multiples on smoothed earnings and precede a period where the economy can be expected to enjoy robust growth. Today, valuations are at levels that have normally been followed by 10-year returns that are well below average. At the same time, based on a template from more than a dozen prior credit crises, the argument that the economy will grow strongly over the coming decade finds little support.

John Hussman: Economic Deterioration Continues

October 3, 2010 Economic Measures Continue to Slow

John P. Hussman, Ph.D.
All rights reserved and actively enforced.
Reprint Policy
The latest evidence from a variety of economic measures continues to suggest deterioration in U.S. economic activity. Probably the best way to characterize the latest round of data from the ISM and other surveys is that the data is coming in a bit less negative than we've anticipated, but continues to deteriorate in a manner that is consistent with stagnant economic activity.

To obtain a broad indication of economic performance, we averaged eight different measures reported by the ISM and the Federal Reserve. These included the ISM National, Chicago, Cincinnati and Milwaukee surveys, as well as the Federal Reserve's Empire Manufacturing, Philadelphia, Richmond and Dallas surveys. The chart below shows the average standardized value of the overall indices, as well as the new orders and backlogs components (a standardized value subtracts the mean and divides by the standard deviation of a given series, so all of the variables are essentially Z scores).

Closer inspection shows that all of these measures dropped below zero last month. That said, these measures are not as negative as what we observe from the ECRI Weekly Leading Index. Taken by itself, this data implies tepid economic growth, but not outright contraction.

Still, with the S&P 500 at a Shiller P/E over 21, and our own measures indicating an estimated 10-year total return for the S&P 500 in the low 5% area, it is clear that investors have priced in a much more robust recovery than we are likely to observe. Our long-term total return estimates are consistent the historical norms based on Shiller P/Es - since 1940, Shiller P/E values above 21 have been associated with annual total returns for the S&P 500 averaging 5.3% over the following 7 years and 4.9% annually over the following decade.

The activity indices presented above are closely correlated with GDP growth. On that note, second quarter GDP growth was revised last week to 1.7% annualized, which was up slightly from the first revision of 1.6% growth, but down from the initial estimate of 2.4%. Based on what we observe in other data, third quarter GDP is likely to reflect continued tepid growth, though the overall activity indices did not decline enough to suggest that the economy contracted in the third quarter. Unfortunately, if we look historically at 6-month periods where real GDP achieved positive growth, but less than about 2.5% annualized and slower than the prior 6 month span, the S&P 500 has historically achieved zero total return, on average, during those periods. Slow, positive economic growth is only helpful for the market, on average, when that growth represents an acceleration.

Dividend payout ratios and operating earnings growth

A note on valuation. A number of observers have suggested that the low level of dividend payouts as a fraction of operating earnings is indicative of strong prospects for reinvestment, which is then extrapolated into assumptions for high rates of future earnings growth. Unfortunately, this argument is problematic on two counts.

First, forward operating earnings are not realized cash flows. As I've noted frequently over the years, forward operating earnings represent analyst estimates of the next year's earnings excluding a whole range of chargeoffs and "extraordinary expenses" as if they do not exist. While operating earnings provide a smoother measure of business performance, they don't provide a good measure of the cash flows that are actually deliverable to shareholders.

Losses that are booked as "extraordinary" are still losses, and represent the results of bad investments and a consumption of amounts that were previously reported as earnings. Similarly, the portion of earnings used for share buybacks is often expended simply to offset dilution from grants of stock to employees and corporate insiders, and again do not reflect cash that is deliverable to shareholders. In recent years, based on the widening gap between reported operating earnings on one hand, and the sum of dividends and increments to book value on the other, a great deal of what is reported as earnings ends up evaporating as extraordinary losses and share compensation.

The second problem with the low level of dividend payouts, relative to forward operating earnings, is that there is no historical evidence whatsoever that low payouts are accompanied by higher growth in future operating earnings. To the contrary, when dividends are low relative to forward operating earnings, it is a signal that operating earnings are temporarily elevated - typically because of transitory profit margins. As a result, subsequent growth in forward earnings is actually slower than normal over the following decade.

Dividend policy is set in a very forward-looking manner. Since dividend cuts generally result in very negative events for corporations, dividend payments are set to a level that management believes it can sustain. Relative to current forward operating earnings, indicated dividend payments are near the lowest level on record. If anything, investors should take this as a signal that managements do not expect present levels of earnings to be sustained at a level that is sufficient to justify higher payouts.

In contrast, high dividend payouts (as a ratio of forward operating earnings) typically reflect temporarily depressed operating earnings, and short-term margin compression. Accordingly, elevated payouts tend to be followed by above average growth in operating earnings over the following decade. The tendency for dividend payouts to lead operating earnings growth is depicted below (see Long Term Evidence on the Fed Model and Forward Operating P/E Ratios for details on forward operating earnings prior to 1979). Suffice it to say that the low level of payouts today most likely reflects elevated and unsustainable operating margins.

On the latitude for a constructive investment stance

Based on the data that we've observed in recent months, my view remains that a fresh downturn in the economy remains a not only a possibility but a likelihood. Little of the economic improvement we've observed since 2009 appears intrinsic, but instead appears driven by enormous government interventions that are now trailing off. Still, while I believe that there is a second shoe that has not dropped, I recognize that the full force of government policy is to obscure, stimulate, intervene and borrow in every effort to kick that can down the road. I believe that the unaddressed and unresolved problems relating to debt service, employment conditions and housing are too large for this to be successful, but as we move through the remainder of this year - as I've said throughout 2010 - we are gradually assigning greater probability to the "post-1940" dataset. Accordingly, there are developments that could potentially move us to a more constructive position. We don't observe those at present, but an improvement in economic evidence and a clearing of overbought conditions, leaving market internals intact, would be one configuration that might warrant less defensiveness.

How constructive is "constructive"? Without an improvement in valuation levels, a constructive investment exposure for us here would likely be limited to a removal of perhaps 20% of our hedges, because the improvement in expected return and reduction in expected risk will not be dramatic unless valuations retreat sharply. That said, we occasionally observe conditions that warrant placing about 1-2% of assets into call options, which would allow a subsequent market advance to soften our hedges without actually removing the put option side of our defenses.

A better configuration would include a significant retreat in valuations and a massive, if uncomfortable, amount of debt restructuring. Those two events would be the best way to put the recent (and probably ongoing) debt crisis behind us, and could easily allow us to completely lift our hedges for an extended period of time in anticipation of an unobstructed recovery.

To some extent, I view current market conditions as something of a "Ponzi game" in that valuations appear neither sustainable nor likely to produce acceptably high long-term returns, and speculators increasingly rely on finding a greater fool. As the mathematician John Allen Paulos has observed, "people generally worry only about what happens one or two steps ahead and anticipate being able to get out before a collapse... In countless situations people prepare exclusively for near-term outcomes and don't look very far ahead. They myopically discount the future at an absurdly steep rate." Undoubtedly, we have periodically missed returns due to our aversion to risks that rely on the ability to find a "greater fool" in order to get out safely. But it is important to recognize that speculative risks are not a source of durable long-term returns. At a Shiller P/E of 21 and a historical peak-to-peak S&P 500 earnings growth rate of 6%, a simple reversion to the historical (non-bubble) Shiller norm of 14 would require seven years of earnings growth and yet zero growth in prices. Stocks are not cheap here.

Meanwhile, the U.S. financial system appears to be a nicely painted dam, behind which a massive pool of delinquent debt is obscured. A significant correction in valuations and resolution of the growing backlog of delinquent debt may finally restore strong "investment merit" to the U.S. stock market, but only after a greater amount of pain and adjustment than most investors seem to anticipate.

In general, we want to take risk in proportion to the improvement we observe in the return that we expect per unit of that risk, primarily based on long-term historical evidence about what has occurred in similar conditions. For now, we remain defensive.

Market Climate

As of last week, the Market Climate for stocks was characterized by rich valuations, elevated (but not extreme) bullish sentiment, generally positive but overbought price trends, and continued negative economic pressures. Overall, our measures suggest an overvalued, overbought, overbullish condition, but with shorter term factors struggling between emerging economic weakness and overbought conditions on the negative side, and speculative trend following on the positive side. For our part, the current set of conditions is associated with an unfavorable return/risk profile, so the Strategic Growth Fund and the Strategic International Equity Fund remain well hedged.

In bonds, the Market Climate last week was characterized by moderately unfavorable yield levels and positive yield pressures. The Strategic Total Return Fund continues to carry a portfolio duration of just over 4 years, mostly in straight Treasury securities. We've clipped a small portion of our precious metals holdings on strength in order to hold our exposure to roughly 10% of assets, but the overall Market Climate remains favorable in that sector for now. The Fund continues to hold about 5% of assets in foreign currencies and about 2% of assets in utility shares.

Gold-Dollar Recurring Theme

Gold has reached another new all-time high, and the Dollar has reached another low overnight.

Gold

Dollar

Gold Prices to Continue Rising?

NEW YORK (TheStreet) -- Spot gold prices were dipping in the red Monday afternoon due to profit taking, which kicked in after the yellow metal hit about $1,320 on Friday.
"People saw it all weekend long," EverBank president Chuck Butler said of the Friday price level. This profit taking "just makes a lot of sense." According to a coin dealer Butler spoke to recently, there's been an increase in individual selling of gold recently to pay bills -- electricity bills for instance. Butler noted that this selling is sparse compared to the panic selling seen a several years ago, when gold tumbled from $1,000 to $900 to $800.
Looking further into the future, Butler believes that gold can be pushed beyond $1,300 -- even to $1,500 in a year. Although the Fed has already indicated that it's open to more quantitative easing owing to very low inflation levels -- and much of this announcement has already been priced into the current spot gold prices -- "I think the Fed will surprise" with how big they're going to make the size of the additional quantitative easing, which will put further downward pressure on the dollar and "spur even more gold buying," Butler said.
Butler added that the S&P Agriculture Index has been at a two-year high, indicating higher inflation and more buying of gold and silver as an inflation hedge. The Australian Commodity Index, Butler continued, is equal to 2008 levels right now, indicating a "huge" boom in commodity prices, which "has a lot to do with the push we've seen with gold and silver recently."
Silver prices, he said, could advance to $50 in a year. Silver is used as both an investment and industrial metal.
In terms of the recent price action of silver, Butler thinks that "it has risen quite nicely in the last couple weeks on the coattails of gold," though without any "real emphasis" on silver vs. gold: "we've seen it in equal amounts ... when gold sold off, so did silver."

New York spot gold prices were falling by $3.90, or 0.3%, to $1,314.70 an ounce Monday afternoon.

New York spot silver prices were lower by 10 cents, or 0.5%, at $21.99.

New York spot platinum prices were losing $6, or 0.4%, at $1,669 an ounce, while its sister metal was slipping.
New York spot palladium prices were surrendering $16, or 2.8%, at $557 an ounce.

A handful of mining stocks and precious metals ETFs ended Monday's trading session in negative territory. Mining stocks offer another form of exposure to precious metals.
North American Palladium(PAL) closed at $4.24, down 4.9%, while Stillwater Mining Company(SWC) finished at $16.24, down 4.4%. Barrick Gold(ABX) ended at $45.98, down 2.2%.
SPDR Gold Trust ETF(GLD) fell 0.4% to $128.46 and ETFS Physical Palladium Shares( PALL ) tumbled by 2.2% to $55.90.

Phases of a Bubble Cycle

Doug Kass: Quantitative Wheezing!

Ten days ago, during my guest-hosting stint on CNBC's "Squawk Box," Appaloosa's David Tepper made some very optimistic comments about the U.S. stock market and on the domestic economy. In part, based on those remarks, equities embarked on a sharp run up that began that Friday morning and has continued to date.

Sometimes it's just that easy.... What did the Fed just tell me? What did they say? They want economic growth. And they said, We want economic growth, and we don't even care -- not only do we not care if there's inflation but we want a little more inflation. Have they ever said that before?... They want the market up. So, what am I-I'm gonna say, No, Fed, I disagree with you?... Either the economy is going to get better by itself in the next three months. And what assets are gonna do well? You can guess the assets that are gonna do well. Stocks!... Or the economy's not gonna pick up in the next three months, and the Fed is going to come in with QE. And then what's gonna do well? Everything!... Let's see. So what I got-I got two different situations. One, the economy gets better by itself.... The other situation is the Fed comes in with money.... You gotta love a put.... I gotta buy; I can't take the chance of not being a little bit longer now.... That does not mean that I'm going balls to the walls.... That's how easy it is right now. -- David Tepper, "Squawk Box" comments

Let me begin by make one thing clear: We can admire our icons, but we can question and be in disagreement with them:

• I worshipped at the altar of Tiger Woods' golf game, but he moved down many pegs after the disclosure of his many trysts.
• I worshiped at the chess altar of Bobby Fischer, but his idiosyncratic behavior turned me off to him and to chess.
• I worship at the baseball altar of anything having to do with the New York Yankees, but I disagreed with the manner in which Brian Cashman and George Steinbrenner appeared to treat former manager Joe Torre, when he was asked to take a pay cut following the 2007 season.
• I worship at the altar of Quentin Tarantino's movie productions. While most of his body of work can be viewed as pure genius, I hated Kill Bill (both volumes).
• I worship at the altar of Julia Roberts' acting prowess, but her recent performance in Eat, Pray, Love (more like Sit, Watch, Groan!) was sententious, patronizing and saccharine.
• I worship at the music altar of the Grateful Dead, but I have attended numerous Dead concerts in which Jerry Garcia was so stoned his voice was unrecognizable.
• I worship at the political altar of President Obama, but, at times, I have been critical of his policy and lack of focus regarding the need for a transformative jobs program.
• I worship at the consumer advocacy altar of (my ex boss) Ralph Nader, but he never knew when to get off the stage and cost Vice President Al Gore the Presidency.
• I worship at the investment altar of Warren Buffett, but I shorted Berkshire Hathaway's (BRK.A) shares in early 2008, based on the belief that his portfolio was too skewed toward financials (an industry that that had lost their "moat" feature), and I disagreed with the timeliness of his derivative short of the S&P 500.
• Similarly, I continue to worship at the hedge fund altar of Appaloosa's David Tepper, but this morning I want to question the conclusion he made during his "Squawk Box" appearance that, if the economy fails to recover up to expectations, the Federal Reserve will embark on a successful QE 2 that will dutifully bring a rally in the U.S. stock market.

Shock and Awe (QE 1) to Shucks and Aw (QE 2)?

• interest rates are already low
• absence of global cooperation in reflating
• weak confidence and uncertainty of policy
• bank loan demand and credit extension weak
• bank reserves are already plentiful
• increased suffering by the savers class
• QE 2 fails to address structural unemployment issue
• long-term costs considerable

Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren't even sure if it has any effect on the economy.... The Bank of Japan tried quantitative easing to revive their economy and avert deflation, but it didn't work.... Bernanke knew back in 1988 that quantitative easing doesn't work [Bernanke and Blinder research]. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.
-- Ed Yardeni

The economic signs continue to point to the need for more quantitative easing. (This view is generally agreed to by bulls and bears alike.) What is not agreed to is the likely effect of QE 2, especially when compared to the first round of quantitative easing.
Will David Tepper be accurate, or will the "shock and awe" of QE 1 be replaced by "shucks and aw" in QE 2, having very little incremental benefit? (See Ed Yardeni's comments above.)
Last week, Credit Suisse's Andrew Garthwaite captures the consensus that QE 2 will be implemented in November/December and that it will be successful for the following reasons:

• By driving down real bond yields (which helps government funding arithmetic, lowers the savings ratio and pushes up DCF valuations of assets);
• Through the funds flow effect: it gives asset allocators money, which they partly invest in other assets;
• Via the currency: a weaker dollar forces other central banks to adopt QE (Japan, U.K. and maybe eventually after a stronger euro the ECB). This, of course, will eventually lead to a revaluation of emerging-market currencies (which is what most policy makers in the developed worlds desire) as GEM countries have an inflation backdrop that will not permit them to participate in QE. (They either have to accept an asset bubble or currency revaluation, probably a bit of both);
• Through psychology: the lower the bond yields, the more fiscal tightening is postponed (as we have now seen with the likely renewal of the Bush tax cuts).

I previously chimed in that there is little doubt that QE 2 will have some positive influence but questioned the degree of its impact:

• It will pull the U.S. dollar still lower, serving to improve our exports and slow down our imports and resulting in a more balanced trade deficit.
• The yield curve will likely flatten further -- in theory, serving to encourage banks to lend.
• The consumer will continue to benefit by a further drop in mortgage rates as debt service ratios improve. Refinancing activity will also increase; a pickup in consumer spending could follow.
• Even though housing will continue to be haunted by an unsold shadow inventory, lower mortgage rates raise the odds that the residential real estate markets stabilize sooner and, with less pressure on home prices, that consumer confidence might recover quicker.
• Real interest rates will drop further, so risk assets should theoretically gain in price.

The times, they appear to be a-changin', and the effect of QE 2 -- its ability to move the needle -- despite David Tepper's assurances, remains uncertain. Back then, QE 1 was instituted at a very depressed level of worldwide economic activity, during a period when market participants were fearful of a financial collapse. Balance sheets were unstable, and funding was problematic. There was unanimity of opinion (over here and over there) that our financial institutions needed to be backstopped, and they were by central bankers in a synchronized and coordinated global fashion.
Everyone was "all in."
Today, our financial markets are stabilized, credit and spreads and risk markets are in far better shape, and our stock market is up violently from the March 2009 lows.
We needed (and got) stability two years ago, but today we need growth.
Today we have a broken domestic money multiplier, we suffer from structural unemployment, interest rates are already at zero (and our savers' class continues to suffer from policy), lackluster credit demand is lackluster, our domestic banks hold large excess reserves but are reluctant to extend credit in the face of economic, and regulatory uncertainty and the housing market (price and activity) is losing some of its historical correlation to interest rates (as it is haunted by a large shadow inventory of unsold homes). Also, with the ECB not playing ball with respect to a global coordination reflation program, not everyone is "all in" today for QE 2.
From my perch, it is growing increasingly hard to see QE 2 as a significant needle mover and as a successful/meaningful follow-up to QE 1, but it is easy to see some intermediate-term fallout.
Dr. Bobby Marcin offered a negative and extreme view of QE 2 recently:

[The Fed] has pulled out their one trick pony named All-Ease-All-The-Time. The Fed insists this trick is panacea for the economy.... [The Fed believes that] asset speculation creates wealth and economic prosperity. Bernanke believes currency debasement will create jobs, reflate housing, spike financial assets.... And, it will accomplish this by only gently nudging inflation up to 2%. What a joke.
The next QE performance will create trillions of paper dollars and create no jobs and minimal GDP growth and inflate no home prices. It might goose financial assets a bit temporarily, but that seems to be the ... end game.
QE 2, however, will crush the dollar, hurt pension funds and savers, spike inflation (especially in commodities) and distort market pricing signals. And if it persists, will force investors out on the risk curve and may initiate bubbles in bonds, stocks and commodities. Easy Al has relinquished the circus ring to Bubble Ben.
In an act of suspension of disbelief, the markets wants to applaud this pony trick. How foolish. Printing money and inflating asset prices creates no sustainable wealth or economic activity. It creates the illusion of wealth and fosters major economic imbalances. That's our problem today, yet the clowns running the circus don't understand that sentence.

Bobby's prose might appear inflammatory, but there are kernels of wisdom/truth contained in his rant. Rather than a consensus-like response that QE 2 will be successful economically and market-wise -- currently the U.S. stock market is having a benign response to a weakening dollar (as it did in 1987) but for how long?) -- I would offer some additional questions investors should be asking:

1. What will the costs of QE 2 be?
2. At some point, shouldn't increased monetary intervention by the Fed (and fiscal intervention by the government) cause market participants to lower the market multiple as opposed to increasing it?
3. Isn't QE 2 simply reducing the quality of earnings and, similar to Cash for Clunkers or the Homebuyer's Tax Credit, borrowing from future growth?
4. How does QE 2 resolve the single-most headwind to growth, structural unemployment?
5. At the very least, at what point have the prospects for QE 2 been priced in?

The above issues and the uncertain impact that QE 2 will have on our currency helps to explain the very public debate going on now among the Fed members that we have witnessed over the last week. And it also helps to explain why some of those members are encouraging an incremental policy, not a "shock-and-awe" QE 2 but a "shucks and aw" QE 2. As my idol and icon, Grandma Koufax, used to say to me, "Dougie, I will always love you, but sometimes I don't like some of the things you do."
In a similar vein, with respect to one of my icons/idols, Appaloosa's David Tepper, I must respectfully take some exception to the certainty of a salutary investment and economic consequence of QE 2 that Tepper displayed in his remarks on "Squawk Box" -- namely, that investors will win whether the economy strengthens or weakens and is followed up by QE 2.
Heads investors win, tails investors win?
At current stock prices, that is not a coin toss that I wish to bet on right now.

Setting Up for Bearish Equity Reversal?

Intraday chart shows Dow down 100 points with 90 minutes remaining in the day, but anything can happen in the last hour of trading!

Daily chart looks bearish (both prices, volume)

World's Super-Rich Are Buying Gold

from Reuters:

GENEVA (Reuters) – The world's wealthiest people have responded to economic worries by buying gold by the bar -- and sometimes by the ton -- and by moving assets out of the financial system, bankers catering to the very rich said on Monday.
Fears of a double-dip downturn have boosted the appetite for physical bullion as well as for mining company shares and exchange-traded funds, UBS executive Josef Stadler told the Reuters Global Private Banking Summit.
"They don't only buy ETFs or futures; they buy physical gold," said Stadler, who runs the Swiss bank's services for clients with assets of at least $50 million to invest.
UBS is recommending top-tier clients hold 7-10 percent of their assets in precious metals like gold, which is on course for its tenth consecutive yearly gain and traded at around $1,314.50 an ounce on Monday, near the record level reached last week.
"We had a clear example of a couple buying over a ton of gold ... and carrying it to another place," Stadler said. At today's prices, that shipment would be worth about $42 million.
Julius Baer's chief investment officer for Asia is also recommending that wealthy investors park some of their assets in gold as a defensive stance following a string of lackluster U.S. data and amid concerns about currency weakness.
"I see gold as an insurance," Van Anantha-Nageswaran said. "I recommend 10 percent as minimum in portfolios and anything more than that to be used for trading purposes, to respond to short-term over-bought or over-sold signals."
ULTIMATE BUBBLE?
Billionaire financier George Soros, echoing comments from investment guru Warren Buffett, last month described gold as the "ultimate bubble" because it is costly to dig up and has no real value except its market price.
But a rising price for the precious metal has in itself generated more and more demand from investors looking for a way to hedge against a fresh recession. Gold bears no yield and is uncompetitive in an environment of rising interest rates.
The uneasy outlook for inflation, hard currencies and global growth has triggered a five-fold increase in a physical gold fund launched by Pictet one year ago, the Swiss private bank said.
UBS's Stadler said the precious metal has become a staple of investors' portfolios, despite questions about whether it makes for a smart long-term investment.
"If you talk to ultra-high net worth individuals, that level of uncertainty has never been higher in the last two, three, four years," he said. "If they ask me, 'Is inflation going up or are we entering a deflationary cycle?,' I don't know. But obviously nobody knows."
Anthony DeChellis, managing director of Credit Suisse's Americas private banking unit, said at the Reuters summit in New York that clients are more interested in capitalizing on the rise in gold prices than using the precious metal as a safe-harbor investment.
"They're asking, 'If it's a bubble, how far can I ride that bubble,'" he said. "I cannot say we've seen a spike in gold interest, but there's an interest in the phenomenon of it."
Samir Raslan, Citigroup Inc's (C.N) regional head for central, eastern and northern Europe, Africa and Turkey, said clients were not going overboard on gold.
"I wouldn't say that clients are over-investing. It's part of an asset allocation, but it's not something that they are deciding all of a sudden," he said.
And not all bankers are recommending exposure to gold.
Andreas Wolfer, head of private banking at UniCredit Group (CRDI.MI), attributed the run-up in the price of gold to frayed investor nerves after the 2008 financial crisis as well as concerns about sovereign debt in the euro zone.
"We have seen it but we have not overweighted it in our asset allocation," Wolfer told the Reuters summit in Geneva, which has emerged as a major trading hub for precious metals as well as other physical commodities.
"We strongly believe in an asset allocation having a clear and diversified portfolio, which sounds a bit boring but in the end it brings the best returns," Wolfer said.
(Additional reporting by Kevin Lim in Singapore and Joe Rauch in New York; Editing by Greg Mahlich and John Wallace)

Factory Orders Resume Slide

from Fox Business:

New orders received by U.S. factories fell by 0.5% in August, resuming a downtrend as demand for transportation equipment fell sharply, according to a Commerce Department report on Monday.

Total orders fell to a seasonally adjusted $408.9 billion after an upwardly revised 0.5% increase in July and a 0.6% fall in June. Economists surveyed by Reuters had forecast a decline of 0.4% in August.

The August decline in factory orders was due mainly to a 10.2% decline in the volatile transportation equipment segment, in which motor vehicle-related orders were off 3.6% and non-defense aircraft down 40.2%. Excluding the transport segment, factory orders rose 0.9%.

Orders for machinery rose 5.2% in August, while orders for computers and electronic products rose 3.7%.

ISM Internals Were Ugly!

So inflation and inventories were up? And today, factory orders were down, which harmonizes with the build in inventories! Not good!

from ETFGuide.com:

By, DARYL MONTGOMERY Oct 01, 2010 The headline number for the September ISM Manufacturing index didn't indicate how bad the report's internals were. Consumer income was up in August due to extended unemployment benefits. The budget deficit for 2010 is supposedly going to be only $1.3 trillion, although more than this amount was already borrowed by the federal government by August. Altogether the 'good' news on the economy has actually been pretty bad lately.

Consumer income had a nice rise in August thanks to extended unemployment benefits (not regular unemployment benefits). The final budget deficit figures for fiscal year 2010 have been leaked and the U.S. is supposedly only in the hole for a massive $1.3 trillion. The ISM manufacturing index came in at 54.4 and the  the mainstream press is citing a strong manufacturing sector as the reason the U.S. stock market had its best September since 1939.  Altogether, the news could be summed up as 'stupidity you can believe in'. By almost every measure except the headline number, the ISM report was a disaster. The highest number inside the report was prices paid, an inflation measure, which came in over 70. Prices apparently went up a lot in August. This component had the biggest increase by far, which wasn't difficult because only one other component went up - inventories. Inventories usually pile up because sales are slowing down. The negative big gains were more than matched with negative big losses in the report. Order backlogs, supplier deliveries, employment, and the production components all had big drops. Well, that certainly should have led to a big stock market rally all right. As for the supposed improved budget deficit figures, as of this August, $1.377 trillion dollars had already been borrowed to fund the federal government in fiscal year 2010. This number would have been $115 billion larger (for a total of $1.492 trillion) if there hadn't been 'financing by other means'.  Financing by other means had a big increase in August and is projected to have another big increase in September. There are also substantial 'off budget outlays'. See http://www.fms.treas.gov/mts/mts0810.pdffor the August Treasury report on 2010 fiscal year spending. Makes you wonder if the U.S. government is using the Enron Accounting Manual to do its books. Finally, some people might argue that an economy that is dependent on extended unemployment benefits for increased consumer spending could just perhaps be somewhat troubled. Few if any of these people write for the mainstream press of course, which generally treated the news of an increase in consumer income and a rise in the savings rate to 5.8% as just more rosy news. If this is such good news, obviously the U.S. should institute ultra super extended unemployment benefits. After all, look at what these policies have done for Europe – riots in the streets and turmoil in the bond markets. The euro has been rising though and obviously this must be due to improved manufacturing in the U.S., if you follow the logic of the mainstream press.  If not, you might just conclude that there is a whole bunch of government manipulation of the markets going on.  Disclosure: No positions. Daryl Montgomery Organizer, New York Investing meetup http://investing.meetup.com/21

A Downside to QE? No!

from ETFGuide.com:

By, DARYL MONTGOMERY Oct 04, 2010 Two-year treasuries hit another record low yield on October 4th, yet 10-year yields rose in September. The Fed's quantitative easing program is reponsible for both. While the Fed is 'printing money' to help stimulate the economy, rising 10-year rates will have the opposite effect.

The two-year treasury yield fell to another record low on Monday, touching 0.3987%. The 10-year treasury yield was up slightly however in September, rising for the first time since March. Federal Reserve money-printing is behind both falling shorter-term rates and rising longer-term rates. A survey by Bloomberg of more than 60 mainstream economists indicates they expect 10-year treasury yields to keep rising in 2010 and through 2011. Perhaps someone has been passing around some notes on the approximately 500 hundred year old 'quantity theory of money', which states if the amount of currency is increased without an appropriate increase in economic growth, inflation will result (and consequently interest rates will have to rise, with the biggest increase taking place on long-term bonds).  For this not to happen, the laws of simple arithmetic have to be violated. The Federal Reserve has essentially been maintaining that that is what has taken place for the last two years. Bernanke of course does not directly state that we have entered a new economic age where two plus two no longer equals four because he would be laughed out of Washington and even the never questioning U.S. mainstream media wouldn't print such garbage.  Bloomberg also reports that a survey of primary dealers (the people who buy the paper that the Treasury issues) estimates that the Fed will buy $100 billion to $1 trillion in Treasuries by the end of the year. According to Deutsche Bank however, the market has reacted as if $315 billion to $670 billion of quantitative easing has taken place recently. The Fed announced on August 10th that it would be conducting further quantitative easing this year. The stock market then had its best September in seven decades. Money printing is an easy way to juice up stock prices. And since there is an important election on November 2nd, it would make sense to think all or almost all of what is scheduled for 2010 will take place before people vote. It looks like that is exactly what is happening. While the Fed's actions can make the stock market look good in the short-term (investors need to watch out for what follows however) and can make shorter-term rates like the two-year go down because of all of the buying that it is doing,  longer-term rates will go up if the market sees this as inflationary. The 10-year treasury is the bench mark for everything from home mortgages, to credit cards, to corporate bonds. Higher yields on the 10-year are a drag on the economy. The Fed has supposedly reinstituted quantitative easing to stimulate the economy, although there is little evidence that the Fed has managed to stimulate the economy very much in the last three years. The stimulus has instead come from massive government budget deficits. The Fed seems oblivious to the existence of a liquidity trap, a condition where increased 'money' generated from the central bank just moves around the financial system and never gets into the real economy. Under such circumstances, doing more of the same won't make things any better, but can easily make them worse. Disclosure: No positions. Daryl Montgomery Organizer, New York Investing meetup http://investing.meetup.com/21

Government's Share of Personal Income Tops 30%

On Friday, the Wall Street Journal reported US Stocks Rise, Boosted By Upbeat Income, Spending Data

The U.S. Commerce Department said consumer spending rose 0.4% in August after rising the same amount in July. Incomes, meantime, increased by 0.5% in August after a 0.2% rise in July. The numbers were slightly better than expected. Economists surveyed by Dow Jones Newswires had forecast spending and income would both climb by 0.3% in August.

Not only is the data from August, but raw numbers without an explanation as to what really happened paints a very misleading picture.

Jeff Graham at the Capital Hill Blog explains how Government Propped Up Personal Incomes In August

News accounts are highlighting the fact that the 0.5% increase in personal income in August was the biggest of the year. But the data weren’t evidence of a healthy and sustainable private-sector expansion.



Government transfer payments accounted for 60% of the increase, and the government share of personal income crept further into record territory at just over 30%. That’s up from just above 25% before the recession.

Transfer payments include Temporary Assistance for Needy Families (TANF), Supplemental Security Income (SSI), Food Stamps - now called Supplemental Nutrition Assistance Program (SNAP) , medical insurance (Medicaid and Medicare), and housing assistance.

Transfer payments are social schemes to redistribute the wealth. However, given the US is running an enormous deficit, one can argue these schemes are funded by the government printing money and giving it away.

Regardless of how you look at it, government share of personal income at 30% is outrageous. Moreover, more than half of that 30% is transfer payments, an equally outrageous happening.

Influence of Quantitative Easing on Risk Assets

At least Bank of America is honest as to why it continues to recommend investors pursue risk assets: "Liquidity-friendly global central bank policies remain the lynchpin of our constructive view on risk assets...Our economics team believes that QE2 will come in the form of purchases of Treasury securities of $500bn - $750bn every six months until the economy reaccelerates." In other words, this is precisely what Morgan Stanley's Jim Caron said on Friday when he confirmed that in this market nothing else matters, except what side of the bed Ben Bernanke wakes up on: "Investment decisions across many asset classes today are tantamount to an educated guess on what the Fed decides to do regarding QE. In the near-term this trumps fundamentals, valuations and almost everything else. Thus the risk in the market is man-made, not freely determined by the market. In general, this is not a good thing because it may invite greater risks in the future." To be sure, the market is now trading nothing less than QE news, but with that comes the added uncertainty of how the world's central banks will react to this latest dollar debasement episode: while QE1 was crucial and needed by the entire world to prevent the collapse of the system, things this time around are far less clear cut. Yet it is so difficult to fight the tape: as the attached chart demonstrates, for the duration of QE1 (3/5/2009 through 3/31/2010), global equities surged 80.5% while since April 2010, and without the benefit of the Fed's generosity, global equities have only generated 0.8% in returns. Furthermore, Jim Caron points out that unlike QE1, there is a very distinct possibility QE2 will fail miserably (all fans of buying what David Tepper is selling would be wise to be very weary). Luckily, just like in the Morgan Stanley case, BofA now highlights that there is a distinct possibility of "fat tail" risks and advises clients how best to position against these.
But first: here is why the "market" is nothing less than a euphemism for liquidity overflow actuions by the Federal Reserve now.

It is thus painfully obvious that there is nothing in the economy that drives stocks: all risk assets do is correlate with near unity to what the Fed is doing or will do in the immediate future. In other words, stocks no longer discount the natural growth of the economy, but are merely an excess-liquidity discounting mechanism.
BofA's Jeffrey Rosenberg agrees that only those who believe in a November QE2 event should be involved in stocks:

Fourth Quarter Investment Drivers

The key drivers of our constructive fourth quarter tactical asset allocation are:

• Our expectation that both liquidity-friendly global central bank policies and the absence of deflation or a double-dip in the economy will encourage a cautious consensus to reduce cash
• Low growth and low rates will cause liquidity to narrowly flow to assets that offer growth, yield, and quality, such as emerging markets. Stronger-than expected growth is required to broaden the rally in risk into areas such as the global financial stocks and the energy complex in commodities
• Our continuing belief that while we favor risk assets, the probability of “tail risks” is higher-than-normal and recommend multiple hedging solutions

In the beginning there was QE…
Liquidity-friendly global central bank policies remain the lynchpin of our constructive view on risk assets. The impact of Quantitative Easing (QE), the central bank policy of purchasing financial assets, has been profound on asset price performance. Buying risk assets when the first QE program was announced on March 5, 2009 and selling risk assets when QE programs were ended on March 31, 2010, yielded handsome returns (Table 3). Industrial metals (+98%), equities (+81%) and high yield bonds (+73%) were big winners during this period.

…then the “Japanification” of rates…
In contrast, since the end of QE, asset price returns have been more modest (see Table 3) with the exception of the “fear” trade of precious metals (+18%) and the “safety” trade of government bonds (+9%). Between the end of QE in March 2010 and the eve of Bernanke's "proactive" speech (26 August 2010) 10-year yields declined 100bps in the US, UK, Australia & Germany (see Table 4). The collapse in interest rates towards Japanese levels was encouraged by stagnant summer markets in both US labor and housing as well as a deceleration in global lead indicators. The “Japanification” of interest rates in developed markets further reduced the incentive for investors to hold cash.



…and now “Growth at Any Price”

But since late August, the absence of deflation and data to support a double-dip, coupled with the new promises of fresh liquidity injections from the Fed and the Bank of Japan, has caused a melt-up in certain asset prices. Within equities, investors seem prepared to invest in “Growth at Any Price” as a wave of liquidity hits emerging markets (with the notable exception of China), creating a classic situation of "too much money is chasing too few goods". Stocks in India, Indonesia, Korea and Turkey have soared. Similarly, commodities such as sugar, corn, silver have also seen recent dramatic gains in price.

High liquidity, low growth

We believe policy will ensure that ample liquidity remains in the financial system and this will be supportive of asset prices. The sources of fresh liquidity are the Fed and the Bank of Japan. In the immediate future we believe liquidity is likely to be particularly supportive of assets that offer growth, yield, and quality, and our allocation is skewed towards emerging markets and spread products in fixed income. The 4Q risk trade should be aided and abetted by upgrades to Chinese growth, one reason to raise commodity weightings. Stronger-than-expected data on US labor and housing markets is required to broaden the rally in risk into areas such as the global financial stocks and the energy complex in commodities.

The Fed promises more liquidity
Central banks want inflation and we believe the Fed has both the will and the ammunition to step up to the plate if the data begins to threaten deflation. We expect that the Fed will announce a new program of Quantitative Easing if the economic fundamentals deteriorate further over the next three months. Our economics team believes that QE2 will come in the form of purchases of Treasury securities of $500bn - $750bn every six months until the economy reaccelerates.

These purchases would not only keep the Fed balance sheet steadily growing, but would likely provide a “shock and awe” catalyst for financial markets. The implicit promise of QE2 has clearly caused investors to close short positions in September and may eventually mean that QE2 is not necessary after all.

The Bank of Japan has added liquidity

Meanwhile the August “crash” in the JGB market caused a surge in the Japanese yen, ultimately forcing the Bank of Japan to intervene in currency markets for the first time since 2004. The intervention was unsterilized and if sustained will cause Japan to finally expand their balance sheet in line with recent Fed and ECB actions (Chart 5). Note Japan has intervened to buy US dollars on three occasions over the past 20 years (‘94-‘95 ¥9trillion; ‘99-‘00 ¥10trillion; ‘03-‘04 ¥35 trillion) and on all three occasions, the Japanese successfully widened rate differentials and weakened the yen (though in 2002-2004 it took time to work).

Yet even wild-eyed optimists such as David Tepper who are betting the ranch (or at least giving those that will buy Tepper's stocks and bonds that impression) that QE will be a resounding QE1-like success will have the be careful: as Jim Caron follows up his Friday observations, there is no guarantee at all that doing "more of the same" will either help the economy (for a change), or have the same impact on risk assets.

QE2 May Not Be a Panacea

However, it is not a foregone conclusion that QE2 is either necessary or effective for the following reasons:

QE2 will not necessarily lead to higher growth: Purchases of private sector assets or government bonds (Greece) can be useful when markets malfunction. However, when they result in sub-equilibrium levels of risk-free yields and/or artificially depressed risk premia on other assets, QE can result in further asset mispricing and misallocation of capital. The result could be another decade of poor quality economic growth, both in the US (zombie companies are allowed to survive) and globally (EM boom-bust bubbles);

Corporate and household borrowing costs are already appropriately low: Partly due to past QE measures, Treasury yields and 30y mortgage rates are already near historical lows in both nominal and real terms – see Exhibit 1, which shows 30y mortgage rates deflated by year-on-year changes in personal incomes and the core PCE deflator. QE(2) cannot by itself resolve the various factors – e.g., capacity, legal constraints or poor credit profiles − which have hampered a reduction in effective levels of mortgage rates paid due to a lack of mortgage refinancing options. Likewise, real corporate borrowing costs are not onerously high in either nominal or real terms (see Exhibit 2);

Deflation risks are modest: Although low levels of core CPI have raised Japanese-style debt deflation concerns, recent IMF research1 suggests that while economies with significant negative output gaps tend to post similar percentage declines in inflation (disinflation), outright declines in prices (deflation) – such as experienced in Japan − are very rare due to stickiness of prices and wages (see Exhibit 3).

Recent year-on-year increases in producer prices of finished goods, of core PCE and GDP deflators and signs of increases in rents and owner-equivalent rents also suggest a pick-up in core CPI in coming months, as also expected by Morgan Stanley economics (see Exhibits 4 and 5); and

QE imposes a carry tax on the banking system: As a result of Fed purchases, higher-yielding, low-risk Treasuries and mortgages on deposit bank balance sheets have been replaced by US$1,991 billion of current account balances of banks with the Fed remunerated at only 0.15%. Besides depriving deposit banks of higher yielding risk-free assets, this has imposed a tax on the banking system, making it more difficult for the banks to boost their capital ratios. In turn, we believe that QE could actually impede, rather than stimulate bank lending, which – besides credit issues – is hampered by a shortage of bank capital instead of bank liquidity.

Caron's daming conclusion is that the best the Fed may hope for is to retain the status quo rather than to generate any incremental improvement in assorted financial indicators, let along the economy. If correct, this is a sad summation, as it means that soon the Fed will be forced to intervene more and more often merely to preserve existing gains in risk assets, instead of achieving any new headway in the road to Dow 36,000.

Perhaps the best the Fed could hope to achieve is to cap any potential rise in US Treasury yields and/or realised Treasury volatility through additional purchases of US Treasuries in the event of significant further USD weakness. Certainly, the Fed’s QE measures already appear to have their desired effects in healing US/global credit markets. By contrast, a resumption of bank lending and/or a reduction in effective mortgage rates paid by households are more likely to be driven by a resolution of various structural factors (household/corporate deleveraging, easing of mortgage origination/refinancing constraints, etc.) than by additional QE measures.

And if there is one chart Mr. Tepper should look at, it is the following:

So should investors sit paralyzed at this point, now that QE2 is not the definitive catalyst for a surge in stocks that Tepper expects? Not at all - in fact it may be time to go all Taleb on Bernanke's ass. Here are the best ways to hedge risk according to Bank of America, along the 6 key verticals of the unknown which are summarized as: 1) negative growth shock, 2) positive G7 growth shock, 3) risk shock, 4) G7 deflation, 5) inflation, and surprised #6 being no surprise.

1) Cross-asset correlations remain high: use it to your advantage. Substituting another asset class as a hedge may be helpful, as we remain in a riskon/ risk-off world (Chart 13). For example, between April and June the Australian dollar fell almost as much as the S&P 500 despite put options being much cheaper.

2) Finding good hedges is easier than figuring out what will go wrong. Successful hedging involves identifying assets that predictably react to the most number of risk-off events. Equities, industrial commodities, credit and certain FX crosses have been consistently reacting to risk-off events. Hedging with rates may be more appropriate for specific tail risks.

3) The cheapest crash hedges remain in Asian equities and FX such as AUD. Chart 14 illustrates the relative cost of hedging with  out-of-the money puts on various assets vs. hedging with a S&P 500 put. Assuming a market decline back to 2008 lows, NIFTY, TWSE, HSI and HSCEI provide similar protection to S&P but at much lower costs (NIFTY is 56% of the cost for the same level of protection). Australian dollar puts offer crash protection at 80% of the cost. Most of these hedges also performed well during the sell-off in April/May this year when the S&P 500 fell 14% as they delivered greater protection at lower cost (For further details on how our favorite tail hedges performed during the risk-off events of 2010, see “Global Equity Derivatives Insights”, 21 September 2010.).

4) Sell expensive tail protection, and exchange for cheap. With tail hedging growing in popularity some obvious tail hedges such out of the money Eurostoxx 50 and S&P 500 options are still historically very expensive. Selling this protection through put spreads captures this premium to reduce the cost of hedging against modest declines. Cheaper tail protection can then be purchased elsewhere such as in AUD or Asian equity markets.

5) Hedging with credit remains expensive vs. hedging with equity options. With equity volatility normalizing faster than credit spreads, hedging with equity options is cheaper than buying protection on major credit indices. Option hedging also benefits from total hedge costs being known up front, versus credit hedging where hedge costs increase as spreads tighten (We are not considering credit options, as we believe they are even more expensive than hedging with credit).

Table 5 compares the cost of buying a one-year put option on the S&P 500 and Eurostoxx 50 to buying protection on major US and European credit indices. The hedge ratios are determined to provide the same protection if both credit and equities re-traced to their stress levels of 2008/09. Buying protection on U.S. HY credit appears the most attractive credit hedge, as it costs 67% of a 1 year at-themoney S&P put. However, we believe HY would only widen to ‘09 crisis lows in a major Sovereign scare, and would be less stressed in most other risk-off events, reducing the value of credit as a hedge. Also, our 1 year forecast for HY spreads of 440bps would increase the cost of a HY hedge beyond that of an S&P put.

6) VIX puts still a good way to pay for hedges if nothing bad happens. With shorter-dated equity volatility falling faster than other asset classes, the term-structure of S&P volatility is again approaching its steepest levels in 20 years. This allows puts on the VIX to roll down the term structure and provide a positive pay-out is nothing bad happens. The profits from these trades can then be used to fund other hedges that expired worthless and can be an effective way to reduce the overall cost of a hedging plan. The most efficient implementation is through VIX put spreads currently, rather than outright puts.

It is without doubt that QE2 will shape the face of risk assets over the next two years. And all those who naively have bought stocks in anticipation of a Tepper-endorsed outcome of a stock surge, may be wise to recognize that not only is there a distinct possibility that the Appaloosa founder is not only wrong, but currently on the other side of the trade. To all these, we highly recommend applying a basket of fat tail protection trades as suggested above. After all, the prevailing groupthink is that the Fed will succeed now as it always has (compare last week's CFTC COT data to see just how little debate there is on the topic). Should the crowd be proven wrong once again, as always eventually happens, watch out below.