I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

Monday, February 28, 2011

The Nasdaq Composite continues to give much cleaner signals

Not much to say. See my last post for commentary.

Summary: This is still a potential count. There are some topping signals in place. However, the SPX needs to break support and MAs to confirm a decent correction is in the works (i.e. at the very least a new low needs to be set by Wednesday). At the moment, I am in a 'prove it to me' stance with this count, I remain skeptical.

Thursday, February 24, 2011


First: This is a hypothetical count. I am not entirely convinced we are seeing a top yet. However, my trend system issued a slew of short signals today on the 60 minute chart for the sector ETFs. However the SPY is still trading above lateral and MA support. So I am definitely leaning toward a top being in, but I am still waiting for some confirmation.

Second: The SPX is giving confusing action with the lower low today, making the count very ambiguous. But like I have been saying for pretty much the last year, the Nasdaq Composite (not the NDX [Nasdaq 100]) gives much cleaner waveforms, and waveforms that are more 'correct'. By that I mean if you are unsure about the SPX, but the COMPQ is giving you a cleaner count, 9 times out of 10 in the last year the cleaner COMPQ count is right.

And today's lower low on the SPX was not a lower low on the COMPQ. In fact, it looks like a perfectly nice B wave for a zigzag. This makes the second wave on the SPX an expanded flat. You can try to force it into a 4th and 5th wave, but I think that's wrong. Classic B wave expanded flat fakeout undershoot + a strong C wave reversal. That's what I think.

Third: You will notice I am counting this as an A-B-C down from the top. I still hold to the idea that this is a correction within an ongoing bull market, not the start of P3. I think the next wave we will be in is either an Intermediate or Primary Degree X, too early to tell. But whatever it is, I think it will ultimately be another corrective wave.

Wednesday, February 23, 2011


Like I have said many times before, I like talking about Gold when it pulls back, after everybody says that it topped. I don't like talking about it on breakouts.

My last set of charts (see Unloved and Gold) were showing Gold as it was bottoming into support.

The reason I wanted to show it right now is that there is another piece that is pointing to the technical objective of 1550-1600 that I have been showing for the end of this wave, and I wanted to discuss it before Gold officially 'broke out' again. There is the cup and handle that formed in the first half of 2010 which has that as an objective (again, when properly viewed on a log scale chart). And the impulse channel for the final wave also has that as a target.

Another thing to keep in mind is that Gold tends to have very violent and sharp 5th waves. Which is why I never bought the 'triple top' call on Gold as the end of the current Primary degree wave.

Still, this is all just noise in the bigger picture. I think this bull market in Gold is far from done.

So far...

As nice and impulsive down as the 5 minute chart looks so far ... it is still a 'blip' on the longer term charts (like the daily chart below).

It could be the start of something, and then it might not be. We are still trading well above major moving averages. There are a couple of support levels below and then the 50 day MA. If this will be a decent correction, we should take those out within the next few days.

However, even though the SPX (and by definition SPY) is still looking like everything 'could' be gumdrops and lollipops for the bulls, the internal mix of the market is not so good. My trend system (which looks at SPX [long term], SPY [short term / intraday], IWM, and the 'X' sector ETFs) issued it's first conflicting signal set (at least one long and one short signal) in months (it has been long or neutral for all the sector ETFs since September). That is another clue that goes into the 'topping process' pile.

Tuesday, February 22, 2011

Time to correct?

The count since July looks like it could be done (and I still maintain that it is corrective, not impulsive. See: Impulsive vs. Corrective).

The microcount looks impulsive down from the top (and no, I don't think it's the start of P3. See yesterday's post for my thoughts). However we need to start breaking uptrend lines (including the one shown below) for this rally to be considered to be over.

Again, this is a corrective wave, so there are still a myriad of ways this can still mutate and rally higher. Only when we start breaking trendlines, support lines, and some important MAs will this rally be over and a correction will begin. Not before.

Monday, February 21, 2011

The BPSPX and the Secular Bear Count

My friend Columbia recently put up an excellent observation on the BPSPX (http://elliottwavetrendsandcharts.com/wordpress/?p=331). I have been messing around with a long term BPSPX chart of my own. And recent market action is forecasting an important development (assuming my large count theory is even remotely right).


1) Not All Five-Wave Moves Are Impulses: A Short Treatise on Elliott Wave
2) Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally
3) Historical Count: 2002-2007
4) Five-Wave Structures Revisited: The Identification of an Impulse Wave
5) The Large Count with Historical Perspective
6) The Large Count with Historical Perspective (Part 2)
7) Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?
8) Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'
9) Lessons (To Be) Learned... again.
10) Secular Bear Market Projection in Historical Context
11) Wave Speeds and Log Charts (and No, the large count is still not an impulse)

There are three major observations that I have made with my analysis

1) The P2 count is (mostly) dead. It is still technically possible for the SPX, although many major indices have already invalidated it by making higher highs than the 2007 peak. As soon as the April peak was taken out, I abandoned that count (in November). For more of my reasoning on that, see beginning of this post: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?

2) The secular bull market count is invalid (i.e. we do not have a major impulse up starting from the March 2009 low). See references #1, #2, #4, #5, and #11 above for (much) more detail on this.

3) The count is significantly more complicated that I think most are assuming. I have seen either a "major" (decades long) top call here, or the resumption of a "Fed-induced" inflation rally. I think both really miss the mark.

I have been studying market internals with respect to this rally and comparing it to 2002-2007 (which I think is a *very* relevant comparison wave). My studies have led me to compare this current secular bear to the 1966-1975 bear market. Not only because I believe they are both 4th waves (I believe 1966-1975 was a Cycle Degree 4th wave and the current secular bear is a SuperCycle 4th wave: Secular Bear Market Projection in Historical Context), but also because the internal wave structures and the wave momentum characteristics are remarkably similar.

From Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching':

The 1966-1975 Bear Market:

The 2000-20xx Bear Market:

This leads me to my BPSPX (Bullish Percentage of SPX stocks) observations. My BPSPX study goes hand in hand with my 'price stretching' study above.

First, here is the chart and I will discuss observations below:


A) This is yet another reason why I don't think a 'major' top is occurring here (i.e. the end of P2). The BPSPX this week made its highest reading ever. But we can clearly see from the last two major peaks that the BPSPX does not peak at the end of a rally. It peaks well before the end (usually by a couple of years).

This very much goes in line with all of the sentiment surveys, and the people interpreting them saying "major bullish sentiment is the sign of a top!". While it is true that bullish sentiment accompanies tops, simply because we have bullish sentiment doesn't mean we have a top. Right now we are in the phase of 'it takes bulls to make a bull market' (as Guy Lerner points out). So I am much more inclined to see bullish sentiment as a coincident indicator rather than a contrarian indicator. There will be a time in the future when other drivers are in divergence (such as analysts estimates compared to actual earnings) and this does eventually become a contrarian indicator again. But (IMO) that time is not now.

So based on the behavior of the last two major market tops, the BPSPX is saying that this is likely not a major market top. The VIX is also saying the same thing: The VIX and Market Tops and Bottoms

B) The BPSPX (during 2002-2007) peaked at the end of the first leg of the rally, right before a consolidation period. And I think a similar setup is now occurring.

Many want to see the A-B-C type move from 2009-now as a 'complete' wave. But I think that is incorrect. I think it is simply the first phase of a larger move. I think the corollary is the 2002-2007 wave. But whereas the 2002-2007 was a Primary Degree Wave (Primary B of Cycle W), I think the current wave is a Cycle Degree Wave (Cycle Degree X of SuperCycle 4). As such, the wave structures will be larger and take longer in comparison. We saw the exact same behavior in Cycle Degree 4 (1966-1975. Look at Intermediate X of Primary W in comparison to Primary X. Same basic shape and wave characteristics, but Primary X was larger and took longer to complete [as expected]).

C) Nobody (well, maybe the minority) is expecting this. Again, I see mostly major top calls or a huge continuation of the rally to 1400-1500 (or higher!) in the current leg of the rally. I have seen very few calls for a consolidation for a year or so. Yet, I think that is exactly what we will get.

So my theory either has the contrarian edge ... or it is complete garbage :)

Thursday, February 17, 2011

Wave Speeds and Log Charts (and No, the large count is still not an impulse)

Here I am still harping on two things. You are probably as tired of hearing them as I am of saying them. But I have to keep bringing them up because they are important.

1) Why charting must be done using a vertical log scale **

I went though this in detail here: Why Arithmetic Stock Charts Are Worthless. If you haven't read it, read it. Seriously.

Stock price movement is logarithmic / exponential. Sorry, this needs to be emphasized. ALL GAINS AND LOSSES IN THE STOCK MARKET ARE EXPONENTIAL!! NOT ARITHMETIC!!. To see why, consider this example:

Is a 200 point move equivalent to any other 200 point move? NO. If 200 point move A occurs when an index is at 4000 (5%), it is much less meaningful than if a 200 point move B occurs when an index is at 500 (40%).

This is why linear scale stock charts are almost meaningless.

Because we don’t measure stock performance on an absolute basis, we measure it on a RELATIVE basis. A 50% gain is a 50% gain. Whether you bought a stock at 10 and it moved to 15 or you bought the stock at 1000 and it moved to 1500. This makes all gains and all moves in the stock market exponential / logarithmic.

Stock data on a linear chart improperly exaggerates the importance of moves at the top of the chart and improperly diminishes the importance of moves at the bottom of the chart!.

The other reason why this is important is in measuring wave speeds. Historical comparisons cannot done on a "points per day" basis, for the same reasons listed above. After a large wave advancement, a 10 point per day move with an index at 4000 is much less impressive than a 10 point per day move with an index at 500.

Since all growth in the stock market is exponential, you want to figure out exponential growth rates. A straight line on a log scale means "a line of constant exponential growth". This is a much more meaningful way to compare wave sizes when it has moved over a large distance (such as a move in the SPX from 700 to 1300).

** NOTE - There is an exception to this general statement that arithmetic charts are worthless. It is the crux of Gann's analysis, and arithmetic charts are critical to this analysis. Because there is a *very* specific way you must set up your templates to make them work. And when you do, very specific angle relationships show up that otherwise won't.

But in general an arithmetic chart with no special format will not give you proper relationships on a trendline analysis.

2) The move off the bottom is not an impulse, and continues to not be an impulse

Please see these references:

1) Not All Five-Wave Moves Are Impulses: A Short Treatise on Elliott Wave
2) Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally
3) Historical Count: 2002-2007
4) Five-Wave Structures Revisited: The Identification of an Impulse Wave

There are no absolutes in the stock market. There are exceptions to almost every rule. And you have to deal in probabilities. So I can't say definitively (just like no one can) that the move is not an impulse. But based on how many tendency violations (and indeed at least one 'rule' violation) there are in the wave from the 2009 bottom, you would need to assign a very low probability to the impulse count. Maybe the low single digits.

In no way should it be a primary count, and anyone who says that it is an impulse above all other possibilities, is doing a huge disservice to everybody.

Are we in a bull market right now? YES! Absolutely!

Are all bull markets impulses? NO! ABSOLUTELY NOT!

This is the source of the problem. Many want to see this as the beginning of a secular bull market, even though the internal wave structure does not even come close to conforming to one.

This is a very powerful cyclical bull market. And I think it will likely continue for years. But it can absolutely be a corrective wave structure and still be a cyclical bull market. Want proof? Just look at 2002-2007. We have a prime example in just the last decade (including numerous ones over the past 100 hundred years).

Wednesday, February 16, 2011

Max Pain

Max pain hasn't been too reliable the last couple of months, but today the SPY peaked at 134 on the Wednesday before OPEX and SPY max pain is at 130. That's a 3% disconnect.

Assuming that part of the disconnect gets filled by Friday (which I think is very likely), and the fact that earnings season is nearly done, I think we will finally get our overdue correction.

Again, I don't think this will be 'the top', just a correction within the continuation of this cyclical bull. See Secular Bear Market Projection in Historical Context.

Tuesday, February 15, 2011


See my last post Impulsive vs. Corrective for details.

Count still looks corrective to me.

One of the smartest comments I have read yet regarding Quantitative Easing

In my last post Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability [see: MTaA / Caps] I sought to show why Quantitative Easing was not in fact inflationary. In order to understand why, an understanding of how our banking system works is needed. Once you see how the moving parts all fit together, it becomes obvious that QE is an asset swap. Nothing more. There are absolutely no new net financial assets added to the banking system as a result of QE.

I have talked about all of these issues in great detail in the posts above. If you have not read them, please do so before reading the rest of this post. I will do a little summarization here of the ideas I wrote in my previous posts.

The two views of why some think that QE is inflationary usually boil to down to:

1) The Fed is Printing Money ($600 Billion in the case of QE-II) and this is obviously inflationary, or 2) An increase in reserves will stimulate lending in our Fractional Reserve banking system (via the Money Multiplier Model).

These might on their faces seem like a perfectly legitimate statements and be the bases for argument. But they are incorrect. In order to understand why, you need to understand what the primary function of a Central Bank is: Maintain control of its policy interest rate (for the Federal Reserve, this is the Fed Funds Rate). Open Market Operations (OMO) are designed to either add or drain reserves from the system so that interbank lending competition for the lending and borrowing of reserves (which affects rates) matches the target interest rate. The Fed controls the supply of reserves in the system, and adjusts them so that they equal the net demand at the target interest rate.

Most people however make no distinction between bank reserves (which are used to clear transactions either interbank, to the Treasury, or to the Fed) and the cash that is out in the private sector that you and I use everyday. They have completely different roles. Bank reserves are not lent out to the private sector. They cannot used for 'speculation'. A bank reserve is nothing more than either cash sitting in a bank vault (if the manager opted to keep the reserves as printed dollars), or it is stored electronically as a checking account at the Fed. But it's role is different than private sector cash.

Before I go on, let me ask you: What is a Treasury Bond?

You might say "A United States Treasury security is government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt.". This is a true statement, but it isn't basic enough.

A US Treasury Bond is a savings account at the Federal Reserve. That's all it is.

So when a bank chooses to hold a Treasury vs. a bank reserve, they are holding an interest bearing claim vs. a non-interest bearing one (or low-interest bearing in the case of a bank reserve, 25 bp). When a bank decides to sell a Treasury to buy a reserve, or vice versa, they are simply exchanging a holding with the Treasury's account at the Fed for one directly with the Fed.

Next question: How do reserves as a whole change in amount in the banking system?

Let's simplify the scenario in that there are no Treasury Bonds. As I stated before (see The Matter of Deficits, Sovereign Default, and Modern Monetary Theory) there is no longer any reason for the US Treasury to issue bonds. Under the Gold Standard the Treasury bonds allowed the government to run a deficit by by borrowing more money than it had backed by Gold. When the Gold window was closed in 1971, that constraint was severed. In today's completely fiat currency system, US Government debt finances *nothing*. Treasury issuance's only role now is strictly to facilitate monetary operations [NOTE! I am *not* saying this is good, I am not saying this is bad. There is no judgment in this paragraph. I am simply recognizing the reality of our current monetary system.].

In reality where there are Treasury bonds, whether the bank holds reserves and Treasuries (which are the most liquid asset on the planet next to cash) or it holds just reserves, a swap between Treasuries and reserves is just an asset swap. Moving back and forth from one to the other is not inflationary and does not change net financial assets in the banking system. Therefore, absent any vertical money creation, at any point the amount of Treasuries held by banks + Bank Reserves is a fixed number. This means the banking system by itself cannot increase or decrease the amount of net reserves in the system. It can swap reserves for Treasuries, or vice versa. It can lend reserves amongst each other. But it cannot affect the net amount of bank reserves in existence.

All transactions within the banking system net to zero (for every asset on somebody's balance sheet, there is a corresponding liability on someone else's balance sheet. When a loan is created, a corresponding deposit is also created). This is why all transactions within the banking system are called 'horizontal'. This includes actions taken by the central bank. The Fed cannot arbitrarily print money and give to a bank [maybe it will be given that power in the future, but it does not have that power today. However you may rightly point out that the Fed bought essentially worthless MBS's at phoney market rates from banks. This is tantamount printing the money, buying worthless paper in exchange for new reserves, so that the bank now has reserves that it could buy Treasuries with and the Fed is stuck with worthless paper. So while the technicality of the asset swap was maintained, the Fed knowingly overpaid. I would argue that instances like these are inflationary if the Fed never tries to unload that paper.]. Whenever the Federal Reserve 'prints money', it is always buying something that exists already. So just like interbank transactions net zero, so do most central bank transactions [again, there are some exceptions to this rule, but OMO is the policy tool of choice and nearly all activity engaged by the CB is OMO. And the point being that OMO is an asset swap].

The way that net reserves in the banking system change is through Congressional spending.

The Treasury is the only party that can create money 'vertically' within our banking system. Treasury spending is the only transaction in which there is no corresponding liability. I am not talking about Treasury bond issuance here. Like I said above, Treasury bonds 'fund' nothing. When the Congress wishes to spend, they authorize the projects and direct the Treasury to spend. When the Treasury spends, it simply spends. It doesn't wait for 'bond revenues', it doesn't wait for 'tax revenues'. Both of this concepts had applicability under a Gold Standard. They have absolutely no applicability in a fiat currency system.

When the Treasury spends, money is created out of nothing. There is no asset swap. The Treasury either credits private bank accounts directly or issues checks that transact through the banking system. The result is a net increase in reserves. When the Treasury taxes, the result is a net decrease in reserves. In no way do taxes 'fund' anything in a fiat currency system.

... [ However government spending *MUST* be in some proportion to private sector productive capacity otherwise inflation will ensue. There is no 'free lunch' here. But the point of this section is to discuss the specifics of monetary operations, which is highly relevant to this post ]

The point of this background was to address the two ideas that somehow QE is inflationary.

Central bank Open Market Operations do not increase net financial assets within the system. They are managing the amount of bank reserves to ensure enough reserves exist for smooth interbank transaction settlement and the supply of reserves meets the demand for reserves at the central bank's target policy rate. So when the Fed does buy a Treasury bond from a bank, the Fed issues bank reserves to that bank (to be carried on the Fed's balance sheet). But from the bank's perspective (and by extension, the banking system as a whole), the bank had to sell a Treasury bond in order to receive reserves. The net financial assets within the banking system are unchanged.

You need to understand the concept of vertical transactions versus horizontal transactions to determine at what point the money supply either expands or contracts. All transactions within the banking sector (not the Fed and Treasury) are horizontal in nature. Every asset created has a corresponding liability. Nearly all Central bank transactions are also horizontal in nature, and OMO which is the central banks preferred tool for effecting monetary policy, produces horizontal transactions (it changes the composition of overall assets, but not the amount). The only way money is either created or destroyed is vertically, which happens by Treasury spending or taxation (spending as detailed above, bond issuance is *not* spending and it funds nothing. Bond issuance effects monetary operations, it does not finance anything in a fiat currency system).

That tackles why Central Bank OMO operations (of which QE is nothing but a subset) is not inflationary.

Regarding the Money Multiplier model, I explained in detail in my last post why building bank reserves was not inflationary. I will not regurgitate it here, but here is the quick synopsis (read my last post for a very detailed description):

Banks are not reserve constrained. When a bank wants to lend, it simply lends and tries to find reserves after the fact. The amount of bank reserves it has does not figure into lending decisions (although capital requirements do). In fact there are quite a number of banking systems that have no reserve requirements at all. So a Federal Reserve induced increase in the amount of bank reserves by a reduction in the amount of Treasuries (which is the asset swap mentioned above) will not make a bank more prone to lend, since it was never reserve constrained to begin with. In short, the increasing reserves targets only the supply side of the lending equation (and is never a constraint operationally), and says nothing about the demand side (the private sector's willingness to take on more debt).

The conclusion of my last post is that QE is not inflationary, and I stand by the conclusion. Further, I outlined my thoughts as to why the rally since the QE-II announcement was speculative (not driven by inflationary pressures). It is either completely speculative, or there is a liquidity composition change due to Treasury purchasing by the Fed from those that would want to speculate. However the reserves that the Fed issues in exchange for those Treasuries cannot be used for speculation, so the Treasury sales by speculators are likely not 'sales'. PDs might be lending out cash (again, not the reserves) in exchange for the Treasuries for speculation purposes (through the repo market), and holding reserves essentially as collateral. This would make for a carry trade. A carry trade is also an asset swap. And what should be more alarming (if this is what was actually happening), is that carry trades always have to be unwound eventually. However, whether this pet theory of mine is correct or not, all causes for this rally are speculative. There are no inflationary drivers behind this massive rally.

There is one distinction that ikkyu2 made on my Caps blog, which deserves to be brought up. Like I say above, one of the purposes of reserves is to ensure the smooth settlement of all interbank transactions. What would happen in the case of a massive wave of defaults, which would cripple the bank system (sort of the opposite of 'smooth') and tend to be highly deflationary. Could the preemptive building of bank reserves be an offset to future potentially (perhaps even likely?) deflationary activity? Please see comment #9 and comment #10 for this discussion.

But, getting to the real point of this post:

I just did my synopsis above of how the banking system actually works from the standpoint of interest rate management (which is essentially reserve management) and money creation. It is adapted from Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability [see: MTaA / Caps]. That is the 'long' version (this is actually a very complicated subject and these posts are by no means definitive. There are much more in-depth an comprehensive resources out there if you want to research this topic further).

But for a very succinct version of QE operations and why they are not inflationary, please read Mitch83's comment on TPC's post: Bernanke helps fuel an increasingly expensive market:

Original: http://pragcap.com/bernanke-helps-fuel-an-increasingly-expensive-market/comment-page-1#comment-44246

The point is: As a bank there is nothing you can’t do with treasuries that you can with reserves (or as you say “pure green liquid cash” = Dollars) in financial terms.

Regarding the operational realities involved in QE2 treasuries are “money” the same way reserves (“cash”) are. Of course you as an individual can’t go to the grocery store and pay with treasuries. You have to have cash. But banks don’t go to the mall with “green liquid cash” and buy stuff, they do their “payments” and other operations in a different way:

First, as Scott Fullwiler explained, if banks want to buy, they just buy, no matter if they have the same amount of reserves (a.k.a “cash”) or treasuries on the asset side of their balance sheets. If necessary they clear an overdraft with the Fed and later get reserves on the interbank markets from other banks, use their treasuries in the repo market (treasuries get leveraged), borrow at the discount window at the Fed (using the treasuries as collateral) or simply sell the treasuries on the bond market to raise the needed reserves (“cash”).

Second, if banks lend, they just create deposits (“out of thin air”) and corresponding debt claims by expanding their balance sheets (and that of their customers). Banks don’t lend out reserves or deposits from other customers. They even don’t have to have reserves on their balance sheets to create loans, meaning they are only capital constrained in lending (with ratios of 10% you see lending is also a form of leveraging), not reserve constrained. If a country has reserve requirements (RR), then the banks get the reserves they need afterwards (if necessary) to meet these requirements. But in fact RR are completely unnecessary (many countries even don’t have RR). Reserves play a predominantly unimportant role in bank lending.

So you can see banks / HFs etc. could do/buy the same things without restriction before and after QE2, as QE2 just replaces treasuries with reserves (the Fed buys in the secondary market, not in the primary market -> no debt monetization, QE2 = asset swap). The “spending power” of the private sector is exactly the same before and after QE2, meaning no net financial assets are added. The only difference is that an interest bearing asset (treasuries) is replaced with an almost non-interest bearing asset (reserves), reducing private sector income, which is in fact slightly deflationary.

The hope of the Fed is the releveraging of the private sector by impacting investors/consumers/lenders psychologically. As Scott Fullwiler said monetary policy is all about increasing the leverage of the private sector (horizontal level), whereas fiscal policy deleverages the private sector by actually adding net financial assets (vertical level). The Fed thinks that if confidence of the private sector is restored by QE2-QEn the releveraging game will continue, no matter how the balance sheets of the private sector look like. I think with QE1 the Fed as lender of last resort/”market maker” succeeded in restoring confidence in and of the credit markets and partly the “shadow banking system” (although as I see it it didn’t recover greatly or started releveraging in a big way, I think this is part of QE2-QEn).

Monday, February 14, 2011

Who? Who does not want to wear the ribbon?!!

Nothing particularly predictive or useful here. Just having fun playing with MA ribbons. This is really just a bit of (ch)art. :)

Friday, February 11, 2011

Secular Bear Market Projection in Historical Context

I would like to show how my count of this secular bear market fits within the long term context.

In order for that to happen, there is some background information that is needed, which gives the order in which I have reached my conclusions:

1) Not All Five-Wave Moves Are Impulses: A Short Treatise on Elliott Wave
2) Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally
3) Historical Count: 2002-2007
4) Five-Wave Structures Revisited: The Identification of an Impulse Wave
5) The Large Count with Historical Perspective
6) The Large Count with Historical Perspective (Part 2)
7) Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?
8) Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'
9) Lessons (To Be) Learned... again.

First we start with the last major impulse wave, which was the Supercycle impulse from the end of the Great Depression until the 2000 market peak. I discussed those counts in Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally

The previous Supercycle Degree Impulse (1933-2000)

The previous Cycle Degree Impulse (1975-2000)

Next is the comparison of previous secular bear markets that have a similar character to the bear market that I believe we are experiencing now. From The Large Count with Historical Perspective

A) The NIKKEI from the last few decades. There are some precedents (especially in an index whose economy faces many similar macroeconomic headwinds we now face) for very complex and sideways X waves.
B) 1966-1975 Bear Market. X waves can sometimes be a simple bridge (like in the triple zigzag on the SPX from March 2009 - Apr 2010) where they are roughly the same same as the B waves in a 7 or 11 wave sequence. Other times X waves can be very complex and sideways and be on the same order of size and time as the W and Y waves.
C) A Study of Historical Bear Markets. The Pragmatic Capitalist put up a very interesting post looking at several bear markets to come up with an "average secular bear market"

This leads me to what I think this secular bear market could look like for the long term:

Next is the comparison of the form of the 1966-1975 bear market to the current ongoing secular bear market. From: The Large Count with Historical Perspective (Part 2)

Here are some additional studies looking at the similarities of the momentum internals between the 1966-1975 bear market and the current secular bear. From: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'

The 1966-1975 Bear Market:

The 2000-20xx Bear Market:

Finally when I smash all that together, this is how my secular bear market projection fits within the historical context:

There are a few things to notice here. I am differing from the view presented in Frost and Prechter: The Elliott Wave Principle where the Great Depression was actually a Supercycle 4th wave. I don't like that idea. Two's are very often the sharp, fast and deep retrace waves, and Four's are commonly the sideways waves. We even see that behavior in the wave form at the Cycle Degree from 1933-2000.

Columbia and I have talked about this before, and I believe we are thinking along very similar lines. We have some differences in our large counts (here are his latest thoughts on the long count), but the overall jist is similar.

Whatever count precedes the 1929 peak (and there are many theories on it, absolutely no one has a 'lock' on that count), I think we are still in a Grand Supercycle impulse. And I think we are in the 4th wave of that impulse. And yes, in the historical context, I think this will amount to a relatively sideways wave.

Thursday, February 10, 2011


Like I have said so many times before, I like talking about Gold when it is unloved, not when it is a momentum toy and everyone is talking about it. Like I wrote in my last post: Gold.

But I think the 4th wave is done and momentum is about to swing back to up. Again, I don't really care. The short term moves in Gold are noise to me. I think this bull market in Gold is far from done.

I am just keeping tabs on Gold's bull market. And I think it has much further to go.

Wednesday, February 9, 2011

Lessons (To Be) Learned... again.

Will the bears ever learn their lessons?
Will the bulls ever learn their lessons?

What lessons should we be learning? What am I even talking about?

gideon made an interesting comment on my last post and my response basically turned into a post. I have some ideas on lessons. Here is part of the comment:
[I] am finding the whole big X wave count to be nihilistic, and depressing. I cannot get over how 11 years into this bear there have been ZERO lessons learned. NO decrease in leverage or risk, no criminal charges, no budget cuts, no reduction in PEs or increase in Div yields.

gideon is referring to the large Cycle Degree X wave that I have been proposing, here are some references: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market? and here: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'

But to the real point of this post: 'What are the important lessons that the market keeps telling us and we keep forgetting?'

.... Mean reversion and overshoots.

It always happens. The markets are cyclical. There are all kinds of cycles. But the long ones that govern what we call 'secular trends' have been around for a long time.

John Mauldin's recent post talked about this very issue: http://www.johnmauldin.com/outsidethebox/a-sideways-view-of-the-world. Secular trends, cycles, and mean reversion is a theme in a number of my macro posts.

The problem is that the market never gets there all at once. Even within secular cycles, there are oscillations (cyclical bull and bear markets). And anyone who gets too ideological on the secular trend will get blindsided when a cyclical countertrend emerges.

And I am 100% speaking of myself. I fully admit I have allowed my bearish bias from playing this cyclical bull market correctly. There was a significant amount of honest-to-goodness bullish macro and fundamental developments (the stuff that any bull market is built on top of) that I was discounting because I believed it was in the 'noise' compared to the bearish macro.

I was wrong. I am not afraid to admit that. As an analyst I have to understand my mistakes and why they happened.

The 2007-2009 crisis was a powerful cyclical bear market within the secular bear. But cyclical bears always give way to cyclical bulls, and vice versa. Nothing ever goes up or down in a straight line, and when one trend gets established and people 'know' it will either continue or resume after a brief pause ... it changes.

And it's just human nature. I talked about this phenomenon before (see here: http://caps.fool.com/Blogs/what-g20-will-not-discuss-this/410156#comment410272). Humans want to linearize and extrapolate trends. But the truth is, they are just not very common. The world is built on cycles, and not surprisingly, our stock market also exhibits cycles. Humans on average are pretty bad at seeing and understanding cycles, especially if they last longer than a year.

Further, in the stock market, we know from history that bull markets are always slower and take longer than bear markets. From a 10 year chart to a 10 minute chart, we always see trends that take a long time to build up to the upside and then get erased to the downside in a fraction of the time.

Think about it even from recent history

1995-2000: Bull Market (5 years)
2000-2002: Bear Market (2 years)
2002-2007: Bull Market (5 years)
2007-2009: Bear Market (2 years)
2009-20xx: Bull Market

Why are we expecting this bull market to be so much shorter? Why are we expecting this time that it will be different?

Maybe this time it will be different. But when I step back, and I clear my head of biases, and I read the cyclical lessons that the market teaches us and I think about the ebb and flow of trends, the logical conclusion is: 'this time it *won't* be different'.

This bull market will continue. It will take it's time and eventually slow down. It will crush bears. And at the top, everyone will be a bull, and extrapolating a new secular bullish trend, even though we know from history that this secular bear market is likely not done.

Cyclical markets have to run their course.

So this brings me to gideon's comment. I do think that corporations are healthier now than they were 2 years ago. And I expect them to be relatively healthy during the next cyclical bear market (the one that I believe will end this secular bear) sometime in the next 5-8 years. The difference will be that P/E's will compress. They will go to single digits, just like they have done in every single secular bear market that we have records for.

That will be when we find the real values. Not here with the SPX over 1300. The 2009-20xx bull market's purpose was to get rid of much of the unhealthiness that got trashed from 2007-2009. Corporations are by and large doing much better, and the next cyclical bear will be about margin and P/E compression. There will be a lot of babies thrown out with the bathwater.

In the same vein, because corporations will largely be healthy during the next cyclical bear, I expect many of them to use their balance sheets to pay out dividends in higher rates than we have seen in the last many years. The markets will be crushing stock prices, and to return shareholder value the companies will increase payouts. In fact I expect very good yields before this secular bear is done. (see here, the signal of major secular ends will be when the Div Yield on the S&P approaches the P/E).

There are many lessons that I am sure we as market participants and as a nation won't learn, but I think the purpose of this secular bear will be to remind us of many of the ones we have forgotten.

So until then, it is best to not be either a permabear or a permabull, but rather a permafrog. Mean reversion is a powerful thing (which the permabulls don't understand). As are cyclical deviations away from a secular trend (which the permabears don't understand). As biased as I have been in the past, I am interested in letting the larger cycles unfold as they want to, as history has shown us that they are likely to do, rather than trying to impose my view on the markets. I will try to ride the large trends and hop on to the next when it is ready to turn, and not try to anticipate too much ..... ribbit :)

Tuesday, February 8, 2011

Impulsive vs. Corrective

Is the wave since July 2010 an impulse wave, or a correction?

Us Ewavers are trying to answer that question. And the answer is: it is not clear cut at all.

I have done quite a lot study regarding impulsive waveforms and how they manifest beyond the standard textbook definitions (see Not All Five-Wave Moves Are Impulses: A Short Treatise on Elliott Wave, Another Impulse Wave Study: A Look at the 1974-1975 Low and Rally, Historical Count: 2002-2007 and Five-Wave Structures Revisited: The Identification of an Impulse Wave)

I understand the impetus for wanting to count it as an impulse. People want to count it as a 5-3-5 zigzag for P2. Or even a 1-2, 1-2 up for a new bull market. But quite frankly, I think both of those counts are bogus as I discussed here.

Here are a few thoughts regarding the degree to which the July 2010 - now wave exhibits impulsive characteristics.

The July 2010 - now wave is a better fit for an impulse than the Mar 2009 - Apr 2010 wave is. .... And that is about as strong as the argument gets (i.e. not very).

- Two is a deep retrace wave. (Ideal)
- Alternation in both form and severity between 2 and 4 (Ideal)
- Minor 3 accelerates relative to Minor 1. Not overtly so however (Acceptable)
- The internal wave structures of both Minor 3 and Minor 5 are not clearly impulsive (Non-Ideal)
- If Minor 3 were "lazy" (which it is) then Minor 5 should be very strong and cleanly impulsive. That is not occurring (Non-Ideal)
- Clear deceleration as the Minute subwaves progress (Non-Ideal)
- In the Minute subwaves, there is clear overlap in the middle of the wave right where the 3rd waves should be extending, or at the very least the most impulsive (Non-ideal)
- First wave are the strongest Minute subwaves in both Minor 3 and 5 [see relevant observations here] (Non-ideal)

So how does this stack up as an impulse wave? I would give it maybe a 4 or 5 out of 10. .... Far from a ringing endorsement.

I was reserving judgement on the impulsive vs. corrective call because I wanted to see how Minor 5 played out. If Minor 5 turned out to be a clean impulse, then some of my observations above would have turned to support for an impulsive count. But Minor 5 has turned out to be very similar in character to Minor 3, with the same mid-wave deceleration and overlapping.

In short, I don't buy the wave as an impulse.

I think the corrective option is a much more compelling fit.

Either way, I don't much care. I still do not think that whenever this wave ends that it will be the 'top' before a major downleg / crash. I think there is still more in the tank of this cyclical bull (even though there will be increased volatility in the coming years) before the secular bear market resumes.

I continue to think that this secular bear market is far more complicated than most are assuming

See more thoughts here: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market? and here: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'

Monday, February 7, 2011

The VIX and Market Tops and Bottoms

The VIX (as a measure of implied volatility which is an indirect measure of nervousness/sentiment) has been often used as a measure of sentiment and looking for divergence has often given a clue to market moves.

I examine this occasionally in my sentiment charts: Sentiment Chart.

I wanted to do two things in this post: take a longer look back, and to plot the "inverse VIX" (1/VIX) to pick out the divergences more obviously / intuitively.

When looked at in this manner, there is obvious divergence between market tops and market bottoms, which is what we expect.

But based on the last two major tops (2000 and 2007), the VIX had very obvious divergence with the SPX. That isn't exactly what we are seeing now.

The VIX is making essentially a double bottom (or as shown below, the inverse VIX is making a double top) when measured on the timeframe of a year.

I would be very hard pressed to call this divergence 'obvious', especially compared to the last two major tops.

This is another market measure that leads to the conclusion that I reached a few months ago: Whatever top we find here will not be a 'major' top. For more discussion on my long term thoughts, see here: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?

Friday, February 4, 2011


Triangle breakout on AAPL? If so, that should be good news for the AppleDAQ next week.

Thursday, February 3, 2011


Is the 'Charlie Brown' (lots of rectangular continuation 'blocks') market going to continue?

Tuesday, February 1, 2011

Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability

This is a Follow up to my last post QE is not Inflationary, Thoughts on Risk Asset Instability - http://marketthoughtsandanalysis.blogspot.com/2011/01/qe-is-not-inflationary-thoughts-on-risk.html / http://caps.fool.com/Blogs/qe-is-not-inflationary/531743. I received a lot of good comments that allowed me to make clarifications to my argument. I would like to consolidate those clarifications and add a bit more to my observations. This will be a more complete post than my last one, and I think will be a useful exercise.

*** The Federal Reserve buying and selling Treasuries is a Monetary Operation, not a Financing Operation

I have gone through this in detail here (The Matter of Deficits, Sovereign Default, and Modern Monetary Theory) and here (The US Treasury and the Federal Reserve: Redundant Institutions). Both of these pieces were influenced heavily by The Pragmatic Capitalist who I believe understands the current reality of Fed / Treasury operations better than anybody.

Here is the highly simplified and shortened version of the two posts above:

Treasuries do not fund anything. Once upon a time (prior to 1971) they did. But they are no longer a fiscal (financing) tool. They are a monetary tool. Treasury auctions are the mechanism by which the Fed maintains its overnight rate. The Fed purchases or sells Treasuries in order to add or drain excess reserves. That's it.

Open Market Operations (see here) are how this process is carried out. Sometimes this involves new Treasury issuance to cover the amount of reserves the Fed needs add, and sometimes this involves only existing Treasuries which could come from banks, Primary Dealers, or an authorized Government Securities Trading Desk. The main point being that Treasury auctions and purchase or sale of treasuries by the Fed is a completely co-ordinated activity (by design) simply done to maintain control of their target rate, and as such will never be under-subscribed (again by design).

Note: This is different than 'Government Spending'. As I said above, Treasury issuance is entirely a monetary operation, it is not a financing operation (not since 1971). When the US Government wants to spend, it simply spends. More specifically, the Treasury credits bank accounts directly. This is exogenous to the banking system and has been termed 'vertical money creation', as opposed to 'horizontal money creation' which happens completely in the banking system. For more on this, see here. This also illustrates why the US Government is not revenue constrained. It must first credit accounts so that money can disseminate through the economy, one use of which is to pay taxes. Neither Taxes nor Treasury Issuance 'funds' Government activities.

... [ However government spending *MUST* be in some proportion to private sector productive capacity otherwise inflation will ensue. There is no 'free lunch' here. But the point of this section is to discuss the specifics of monetary operations, which is highly relevant to this post ]

*** Excess Reserves and Bank Lending

Under neo-classical economic theory, a large amount of excess bank reserves will lead to an increase in bank lending via the Money Multiplier Model. The very abbreviated version goes like: In a Fractional Reserve Banking System the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves. Which means the higher amount of reserves, the more loans / credit money can be created.

However there are a number of issues with the Money Multiplier Model in terms of being the driver of forcing monetary policy. It basically is a 'supply side' theory in which the bottleneck is the banking system. By increasing the reserves in the banking system, more loans will be made because there is a higher capacity to create loans. This does not hold up with empirical observations (see here).

Operationally, banks are never really reserve constrained. Reserves only need to be met against a 14 day average, which means if you are a bank you can make a loan absent the required reserves at any point. Reserves can be acquired either through interbank lending or the discount window. Moreover, reserves need to be carried against demand deposits (checking accounts). Sweeps have been routinely implemented to move demand deposits into a special purpose savings account (a savings account is not a demand deposit) obviating the need for higher reserves.

In a fantastic paper by Austrian Economist Vijay Boyapati (see here) observation has shown that bank reserve creation by the Fed actually lags banking sector lending

Given that commercial banks are effectively operating without a reserve requirement and that loan issuance is not constrained by reserves, it would be sensible to reconsider the temporal causality posited by the money multiplier theory of lending. If the causality were correct, one would expect changes in reserves to precede changes in the issuance of credit, ceteris paribus. Citing an empirical study on business cycle statistics conducted by the Federal Reserve, Steve Keen explains that the opposite is true:

…rather than [reserves] being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and [reserves were] then created about a year later.

From an Austrian perspective, an empirical argument based on a temporal correlation is not definitive proof of an underlying causality — although it may be illustrative and suggestive of that causality. An explanation for the counterintuitive temporal sequence is provided in a Federal Reserve study of the institutional structure of the US banking system since 1990, conducted by Carpenter and Demiralp. They demonstrate that “reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source of funding, either.” Their point is that when a bank makes a loan, the matching liability used to fund the loan does not need to be reserves created by the Fed.

These are particularly relevant points, because the size of the monetary base exploded by over $1 trillion in 2008 (see http://research.stlouisfed.org/fred2/series/BASE) and we have not seen any commensurate explosion in bank lending since 2008 (see http://research.stlouisfed.org/fred2/series/TOTBKCR?cid=49). Also broader monetary measures like M2 and M3 (see http://www.nowandfutures.com/key_stats.html) show the still disinflationary / deflationary monetary trends.

The problem is not a 'supply side' (bank reserves) issue, rather it is a 'demand side' (unwillingness to borrow) issue.

For inflation, which is a persistent increase in money supply and credit resulting in a persistent increase in prices, to take hold and become a problem the US private sector needs to borrow. And since the private sector remains in a balance sheet recession, this significantly reduces the inflationary potential in the current environment.

*** Why Quantitative Easing is not Inflationary

Quantitative Easing is an asset swap.

At the end of the day, it is nothing more fancy than that. The Fed takes excess reserves and purchases Treasuries. This is exactly the same type of operation that the Fed undertakes when trying to maintain the Fed Funds Rate as described above.

Under normal OMO, the Fed buys the short end of the yield curve. Under the Quantitative Easing 'Two' program, the Fed is mainly targeting 4 to 10 year securities (see http://www.newyorkfed.org/markets/lttreas_faq.html).

The main goal of Quantitative Easing, as stated by Chairman Bernanke in August 2010 during his speech at Jackson Hole was to lower long term interest rates, which will stimulate borrowing and then eventually stimulate the economy. (see http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm)

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed's earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC's recent decision to stabilize the Federal Reserve's securities holdings should promote financial conditions supportive of recovery.

The problem is QE-I and QE-II happened in completely different environments. The crisis of 2008 was primarily a deleveraging crisis. QE-I added liquidity to the banking system when it needed it after the Lehman collapse. I have discussed that previously here: Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR.

However, as discussed above, the current environment is different. Excess reserves and the monetary base are at unprecedented levels. Banks are not reserve constrained. There is no liquidity crisis now. So if bank lending has not increased substantially with $1 trillion in reserves, why would an extra $600 billion make much difference? ($600 billion is the amount of Treasury securities to be purchased - http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm)

This makes the stated intentions of Quantitative Easing suspect. But let's put that idea on hold for a minute and focus on the mechanics of Quantitative Easing to show why it is not inflationary.

The Fed wishes add reserves to the banking system (recall at the beginning of the post, the Fed purchasing Treasuries adds reserves to the banking system). It also wishes to change the structure of bank balance sheets so that banks are holding less Treasuries themselves and will take on more reserves (which presumably will make then more inclined to lend, ... which as was discussed above is not the problem). So in this case, the Fed does not want to buy Treasuries from the Treasury, it wants to buy the Treasuries on bank balance sheets.

In this case especially (as is often the case in OMO) the Treasuries already exist. They are already a part of the financial system. When the Fed buys these Treasuries and transfers them to its balance sheet, it gives the financial institutions an equal amount of reserves. At the end of the transaction, there are no new net financial assets in the banking system. The structure of the assets are different, but the amount of assets are the same. It quite literally is an asset swap. For a more detailed description of this process, see here

There is no increase in money supply. The mechanics are not inflationary.

QE is actually deflationary since it takes an interest bearing asset away from the financial sector and swaps it for reserves (which currently pay only 25 bp).

The only way for Quantitative Easting to be inflationary is if all of these new bank reserves spurred an increase in lending, and that is not happening.

The current environment is disinflationary and borrowers are not willing to take on more debt. Increasing bank reserves, based on the argument I present above, doesn't seem like it will make much difference (at least not an inflationary one), and so far that looks to be the case.

*** Who exactly are the buyers and sellers in QE-II?

Yet, since the end of August after Chairman Bernanke gave his speech at Jackson Hole, almost every risk asset class has gotten a bid, and big time.

Is there some causal (yet hidden) inflationary activity occurring here?

I argue the answer is 'mostly' no .... and a lot more dangerous over the long term than an outright 'yes'.

First, addressing the Fed's stated reason for Quantitative Easing, which was to lower long term interest rates (by buying that part of the curve), we see that in fact the opposite has happened:

Longer term yields have increased since QE-II began.

So, we have an increase in long term yields (opposite of the stated intention) and we have a decrease in lending (opposite of the stated intention).

Bank reserves have increased, but bank reserves cannot be used for speculation. Bank reserves are on account at the Fed and can be used to purchase Treasuries, MBS's, or loaned interbank to those that need it for reserve requirements. This is true for all commercial banks, investment banks, primary bond dealers, or other government securities dealers who have an established trading relationship with the Fed.

..... Hmmmmm. We seem to have found a dead end in our analysis.

We have a terrific rally in all kinds of risk assets since QE was hinted at by Chairman Bernanke at the end of August, which continued with gusto when QE was officially announced at the beginning of November.

Since I have shown above the QE is not inflationary (no increase in the overall money supply), then there are three reasons for this rally.

1) "Animal Spirits" only (used intentionally pejoratively)

2) The majority of all investors mistakenly believe QE is inflationary and are simply front-running the Fed based on improper understanding

3) Something about the structure of QE is changing the liquidity in the system

I suppose we could just assume idea 1 (Keynes famous "animal spirits" idea, which basically says that anything that doesn't fit into his economic theories is just irrational behavior). While potentially the whole story, it's not a very compelling story and I would be a lazy analyst if I just left it there.

I also suppose idea 2 might work as well. But there are very smart people in the market, and I think if I could figure out that QE was not inflationary (at least highly unlikely at any rate) others much smarter than me and in control of more money would also. The flip side is that maybe they are playing off the misconceptions of others and 'front-running the front-runners'. And while I think that is part of it, that is still analytically unsatisfying and I don't think comes close to describing the sheer size of the rally the last 5 months.

I will spend the rest of this section focusing on idea 3.

Fair warning: this train of thought is my own pet theory. It may or may not hold up to scrutiny, but I believe the logic to be sound.

First lets return to the Treasury purchases. The Fed is purchasing these Treasuries through Open Market Operations. Ideally the Fed wants only banks to participate in these auctions, but they are Open Market. Which means that any Government Securities Trading Desk can bid at the auction. But lets operate under the theory that most of the Treasury sales are coming from banks. If that were the case we should see a decrease in bank holding of Government Securities starting in November (QE-II POMO is ~$75 billion per month from the FOMC statement).

This does not jive with the data:

There is a drop in November, but is not $75 billion (only about $20 billion)

Now I would like to return to the observation about bond dealers. Primary dealers are often very connected with investment banks (here is the Primary Dealer list from the NY Fed: here). These institutions obviously have ties to the large bond holders (funds and institutions) in the world.

So while a Primary Dealer or any Government Securities trading desk can trade with the Fed, they get paid in reserves which stays on account with the Fed, and can't be used for speculation. But there would be nothing stopping a Primary Dealer buying Treasuries from the bond community (say an Investment Bank who might be a seller based on QE) and in turn selling to the Fed. This could be accomplished through the repo market via a term repo (see http://wfhummel.cnchost.com/repos.html).

But just thinking like bond holder for a second, if a large institution (such as the Fed) with a huge amount of reserves was able to soak up a large amount of Treasury selling, then why not sell some now and purchase later? Think of it like this, if all the long term Treasury holders go to sell at the same time, prices will plummet and yields will skyrocket. But if a party steps in and says 'I am buying half a trillion or so of long term Treasuries', then why not sell part of your position and book some profits (or speculate if a large buyer is putting in a partial floor)? If a number of people think think this, and it is larger than what the Fed is purchasing, then prices will drop based on the selling pressure. But it would be less than it would otherwise be since the Fed has announced that it is a large buyer. And since you are a bond investor, and you are smart, and you understand that QE is deflationary (from the observation above), then likely you will get a chance to repurchase your Treasuries at a better price sometime in the future (from the current selling activity and the fact that it will likely trend for some time) and prices will likely recover.

This idea jives with both the observation on the yield curve (Treasury prices are falling, not rising) and the fact the most of the Treasury selling is not coming from banks.

*** A Speculative Increase in the Price of Risk Assets and the Fed's Third Mandate

So let's assume for moment that my bond market theory is correct. Is it inflationary?


Again, QE does not change the amount of net financial assets in the system, it only changes the composition. But what I have described above is a way for more liquidity to be available to chase risk assets.

It is something like a currency carry trade. An investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used. In a carry trade, no currency is created. Traders hold the positions on their own balance sheets and then eventually unwind them. (The primary dealers would be the carry traders in my above example).

So even though this scenario is not inflationary, it would explain how additional liquidity could be made available for speculation.

But let's say that my idea is bunk. That there are no bond sales freeing up liquidity for speculation purposes.

It would then mean that (since I have shown there is no inflationary impact from QE) that either 'Animal Spirits' (again, I think this is ridiculous as a going-in assumption) are out in full force or everybody is front-running the Fed in a mistaken idea about the nature of QE.

My main point here is that in all three of these cases, there has been a sharp increase in risk asset prices across the board (many different asset classes) with no commensurate increase in the money supply

Both the nature (severity) of this rally and its timing scream 'speculation' to me.

Now please, don't misunderstand what I am saying. Excess liquidity and/or the urge to speculate does not guarantee a rally. There has to be some basis for speculation, and with stocks in particular, all of dominoes did in fact line up:

a) There had to be actual GDP growth occurring (which there has been)
b) Earnings has to be growing (and they have been)
c) Corporate balance sheets had to be improving (and they did)

There are some legitimate reasons for investors to be bullish right now, and I am saying that part of the rally is for that reason. But how it has manifested, and how the market reacted in all risk assets, not just stocks, to the QE hints and then the official announcement has a speculative stench all over it.

With respect to the Fed, having failed at their primary reason for QE-II (lowering of interest rates and the stimulation of more lending) could be for two reasons: i) They did not understand that this would happen (unlikely) or ii) This was not in fact their primary reason for QE-II.

In retrospect, the real reason for QE-II was so that the Fed could add a Third Mandate:

To keep risk asset prices higher than they would otherwise be

So while I think that the next few years will likely see a continuation of this cyclical bull stock market (P/Es are in another expansion cycle right now, and the market is getting a goose from excess liquidity [potentially] and certainly excess speculation), this gets at the heart of why I think this is unstable over the long term.

I talked about many of these thoughts here: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?

Over the long term, as economic fundamentals cannot support the revenue streams to generate the earnings that artificially inflated stock prices expect to keep growing, then we have crashes. The 2000-2002 crash was based on the unsustainable dot-com valuations. The 2007-2009 crash was based on unsustainable consumer spending due to the housing bubble bursting as well as deleveraging of financial assets tied to the housing bubble. The next bubble will likely form (and pop) due to excess liquidity or excess speculation (or both) in risk assets that get completely divorced from sustainable fundamental economic drivers.

This makes this wave a bubble in motion, but I don't think it is at it's popping point yet.

Here are John Mauldin's thoughts on the FED's Third Mandate (which I completely agree with): (see: http://www.johnmauldin.com/frontlinethoughts/thinking-the-unthinkable)

The Fed has two mandates: keeping prices stable and creating an economic climate for low unemployment. I am sure I was not the only one to listen to Steve Liesman's interview of Ben Bernanke this week and shake my head at the spin he was giving us. First, let's set the stage.

In a paper with Alan Blinder early last decade, Bernanke made the case for the Fed to target a specific inflation number, and the number that came to be accepted as his target was 2%. In his famous helicopter speech in late 2002, he assured us that inflation could not happen "here," even if the short-term rate was zero, because the Fed would move out the yield curve by buying large amounts of medium-term bonds. This would have the effect of lowering yields all along the upper edge of the curve. This became known as quantitative easing. In Jackson Hole last summer, he made very clear his intention to launch a second round of liquidity-injecting quantitative easing (QE2). In that speech, in later speeches in the fall, and in op-ed pieces he said that such a program would lower rates.

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, "In theory, there is no difference between theory and practice. In practice, there is." It's got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip (link below) about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben's answer (paraphrased):

"We have seen the stock market go up and the small-cap stock indexes go up even more."

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed's target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes?

Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they're making up the rules as they go along, it's because they are.

Here is the clip: http://www.cnbc.com/id/15840232/?video=1742165849&play=1

The Fed wants a risk asset rally, and it got it. And it wants the cyclical bull market to continue, and I think it will do that too. It's primary goal is to create a 'wealth effect' from a rising stock market. While that might have some short term impact, it has a very dubious long term impact: http://pragcap.com/robert-shiller-debunks-stock-market-wealth-effect.

But keeping asset prices 'higher than they would otherwise be' will create instabilities. Which means before this cyclical bull market is over we will see another very volatile period like 2010.

Make no mistake however, excess liquidity and speculation does not equal economic activity. It will amplify stock market signals (rallies) based on economic growth (which there is), but will also amplify downturns when said growth stalls (and it will). Feedback works both ways, as any signals engineer will tell you.

QE, while not inflationary, potentially creates excess liquidity (see my scenario above) and certainly creates excess speculation which acts like an amplifier. Which means that there exists the increased potential for instability. And I don't think many people are appreciating that fact.

For some thoughts on how that could manifest, see this: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'