The Decession Stock Market: A Yogi Bear Market Rally . . . ?

Keep an Eye on Your Pic-a-nic basket! The recent stock market rally has brought good cheer and radiant sunshine to the budding Spring of this Decession* (TM). It’s a nice picnic basket of stock gain goodies for a pleasant outing after a long winter of extreme discontent . . . Government bond prices fall (and interest rates thereby rise) in the credit market, though, whenever money heads out of Treasury securities into riskier investments like equities. Lately, the prices for longer term Treasuries are falling (in concert with the U.S. dollar), with the upturn in Treasury yields especially noticeable in the longer maturities (as the chart below indicates). In normal times, the falling Treasury market and its uptick in rates is part and parcel of an expanding economy and coexist nicely with a rising stock market – investors are confident and choosing riskier equity investments over the safety of government bonds. For a number of reasons discussed below, the “normal” picture is not necessarily the correct picture and the consequences may not be bright for the future of the stock market rally; friendly bear markets can still get ugly. That we’re in “uncharted territory” economically is today’s commonplace observation, so as Yogi Bear taught my generation: keep an eye on your pic-a-nic basket. (No, not that Yogi!)

* Decession – coined here, signifies an economic collapse of greater depth than the worst American recession but lesser depth than the Great Depression. For example, at its worst a decession will cause unemployment greater than 12% but less than 20%.

The chart above reveals the results of the Federal Reserve’s Decession program of driving short term interest rates to nearly zero via its earlier monetary policy; now they’ve nowhere else to go – as the old saying goes, they’re “pushing on a string,” meaning they can get no further traction economically with that policy. Normally, remember, the Fed would push us out of recessions by using this time tested method – they’d lower short term rates until economic activity picked up. It worked quite well throughout the Greenspan years, yet now a basic tool of central bank tinkering is literally used up.

So much for short rates, now notice the higher rates of the long term “side” of the yield curve above. The Fed has begun so-called quantitative easing (QE), the next arrow in its quiver to complement the normal monetary policy discussed above. Through QE it purchases Treasuries outright using money created with a stroke of Mr. Bernanke’s keyboard, and only a central bank can do this, so don’t try it yourself. The Fed’s creating $300 Billion of “keyboard money” for QE this Summer alone.

QE – importantly these days – backs up the sale of Treasury securities coming to market in historically enormous dollar amounts to fund both the Republican era deficits and the necessarily huge Obama deficits needed to revive the economy. When the Fed carries out its QE operations by purchasing the Treasury’s notes and bonds it adds to demand and thereby keeps Treasury security prices and resultant long term interest rates stable. This is necessary today when demand for our paper may decline (something we can ill afford), particularly since it appears that the dollar has begun another swan dive, a “canary in the mine shaft” warning that the world has less trust in our our creditworthiness. In sum, with our nation’s immense financing needs and the simultaneous political and humane need to stimulate the real economy of Main Street we cannot afford, literally and figuratively, a sustained and meaningful rise in interest rates. That’s a big part of what makes this a Decession, and not a garden variety recession, and is what makes this bear market in equities more likely to snatch our picnic baskets.

What’s in the Picnic Basket? Well, the Fed’s QE – as well as the other activities undertaken by various earlier programs like TARP, etc. – does indeed put “new” money into the banking system, or, more correctly perhaps, it puts the possibility of new money into the real economy through subsequent bank lending via the fractional reserve system. Here’s the problem though. Thus far, most of this potential is locked up in banks as excess reserves to shore up their balance sheets against their phenomenal losses due, in part, to a variety of those goofy investments made in years past that we all are far too aware of . . . For a dramatic reading on this bank hoarding see the Fed’s most recent report on excess reserves held by depository institutions. Look at their required reserves and the amount of reserves they now have on hand. Wow! That’s a measure of how much lending capacity is “locked up” in the banks. It’s a measure as well of the fact that:

1. Banks are looking at the same charts presented here and anticipating more write downs of mortgage assets, etc. (Note that not all mortgages were securitized, so many mortgages are still held by banks – so-called “unsecuritized mortgage loans”.) In effect, they’re shoring up their capital positions in anticipation of later needs; they’re stuffing their TARP and other money into the “mattress” of excess reserves.
2. Banks are therefore not lending the very money they were given to lend. Not a formula for economic expansion and the subsequent corporate earnings needed to propel the stock market. Yet, who would banks confidently lend to? They see the same unemployment and underemployment numbers everyone else sees. They see the dramatic decline in net worth throughout the economy. They see the rising default rates on credit cards; they see the foreclosure rates still rising; they anticipate commercial real estate mortgages collapsing; they do not want to be – cannot be – on the wrong end of these transactions again.

On the stock market front, the CNBC cheerleaders are euphoric and the economic data lately have been relatively upbeat. Retail sales, new orders for durable goods, and others have improved. All of us who have craftily stashed some money lately in the stock market or are recouping our losses have fingers crossed. Maybe the fiscal stimulus is, well, stimulating. As mentioned above, the yield curve’s recent steepening is generally a sign of economic recovery, and the present advance is viewed that way by many.

The Bear in the Campground. However, deficit borrowing at the level we are attempting will, I believe, lead to higher long rates and fairly quickly, perhaps by end of Summer, and will push us deeper into Decession. Already, the dollar is falling sharply again – and that’s not a sign of an economic recovery that’s going to be pain free this time. Why? Although a cheaper dollar benefits our country’s exporters and punishes imports, any decline in the dollar threatens you-know-who: our Chinese financiers who have a policy of keeping the yuan weak so as to benefit their own export binge. Here’s another immediate result of any sustained rise in rates: a dramatic rise in mortgage rates (already underway, see below). Moreover, credit card rates are closely tied to interest rates, and they are rising too for a variety of reasons related to interest rates and card issuers’ race to cash in before the effective date of the recent credit card legislation. Any continued rate rise would push credit card expenses for consumers higher, and quickly. Those two effects alone would be more than enough to squelch a consumer recovery, and the stock market rally? Far more than enough as any hopes of earnings collapses in another round of decline in spending power.

Moreover, unemployment and underemployment continues to grow, leaving many who have adjustable mortgages already facing the nearer prospect of larger monthly payments amid their declining incomes. And note, here we’re not talking about subprime mortgages. Any sustained rise in interest rates threatens to reverse the gains made thus far in the housing crisis and extend it to those who were considered credit worthy borrowers in 2003. Additionally, although pending sales of homes are rising in volume (and will be reported again tomorrow morning by the National Association of Realtors) rising rates may “kick out” certain buyers who have not “locked in” a rate, and when rates rise, they will be pushed out of their home purchase, others will put off a purchase. In short, should the rate rise continue due to increasing government financing needs we cannot escape and not, as I fear, due to old-fashioned cyclical effects of economic expansion, then equities will suffer another mighty decline this Fall.

(Note that many argue, on the contrary, that due to these pressures and the Fed’s enormous expansion of the monetary base which is rising dramatically again after a brief break (chart below), we face a burst of inflation, or, worse, the “stagflation” of the ’80s, or worst, hyperinflation. This is indeed possible and would bring about a possible commodities led stock market rocket shot. I’ll write about this next week).

Finally, significantly, Treasury Secretary Geithner has been super-schmoozing our Chinese benefactors with assurances that President Obama will address the multi-trillion dollar budget deficits in the near future. They hold about $1.6 Trillion of our paper; do you think they believe him? Do any of us really think this Decession is anywhere near a bottom, or that more rounds of deficit financed stimulus will not be required, particularly in the event of another housing crisis caused by increased interest rates, and the concomitant mortgage payment resets and recasts, credit card defaults, and increasing unemployment? The chart below indicates the resets that are coming down the pike based upon interest rates remaining level, i.e. low. In fact, the chart below has already been moved to the left due to the uptick in interest rates just within the last week or two (see preceding chart); in other words, the reset “calendar” has been accelerated. Don’t even look at the potential resets farther out into the future . . . (Recasts, represented by the yellow bars in the graph below, are subject to other rules and may or may not be as affected by rate increases. See this for information, particularly the comments section.)

At some point – I believe this Fall – despite the near universal belief that U.S. Treasuries are “the only game in town,” our financing needs will overwhelm even the staunchest Treasury purchasers, and other currencies may replace ours to some extent as safe harbors. This turning away from the dollar and our bonds does not, by the way, need to be exceptionally dramatic to bring about panic in the Treasury market. Also – and this rumor alone may spook the bond market – there is talk of further QE by the Fed, well beyond the $300 Billion planned already. How will that sit with Treasury investors, particularly the Chinese?

We cannot escape the financing requirements of the United States government. This has likely changed the rules of the road. “We are the world’s reserve currency,” some say, and this, they go on, inoculates us from most of the economic consequences that would face other countries running enormous deficits while simultaneously stimulating their economy with further deficit spending. That “world’s reserve currency” slogan has many merits, and it has worked quite well for us. Thus far. However, we have never – nor has the world – tried to manage the deficit financing requirements that we now face, except in World War II.

Bears Like Honey. As I wrote above, a wave of interest rate hikes that is not tied to normal economic expansion is a true risk to the stock market rally and the economy in general. However, if rates remain lower than I expect, and a recovery is given some air to breathe through reasonable bank lending, etc., among the hidden dangers to a stock market rally and a true and robust recovery is something we believe to be a virtue: saving. Americans are beginning to save money as we have not saved in many years. We’ve not merely cut back spending in reaction to a normal recession, we’re paying down debt as well. Americans are trying to rebuild net worth lost in their declining home values, pensions, etc. We’re spending less, and we’ll not stop anytime soon, both out of necessity and, most importantly, out of choice. Stock markets like earnings for their energy, just as bears like honey . . . So, banks aren’t lending as they once did, and consumers are not buying as we once did. Show me the honey.

No Bees, No Honey. More than that, economically – in Main Street terms where we worker bees reside – there’s a mass psychological and cultural change occurring unlike anything in my lifetime, including, I believe, the momentous socio-cultural changes of my youth in the “fabulous 60s.” In fact, this may rival those changes in the generation of the Great Depression, and, ironically, may bring to an end those positive outcomes of its aftermath. We’re facing no less than a loss of the carefully rebuilt trust that Americans gained from the New Deal, a trust in “safety nets,” not merely those offered by governmental programs but those built up through regulation of the financial industry as a whole, both governmental and industry-inspired regulation. This financial catastrophe has laid waste the second of these pillars, and threatens the first. Our belief that if we work hard and well we can expect to enjoy a reasonably comfortable and safe retirement is threatened as much as in the era of the Great Depression. Pensions? Quo vadis? Guaranteed investment vehicles? Quo vadis? Social Security? Quo vadis?

Presently, we simply do not trust as we once did – even just a few years ago – the words “guaranteed.” We don’t trust the vaunted historical averages and stock market cant that used to push us relentlessly into equity investing. Can we anytime soon believe that “$1,000 dollars invested today in the S&P will turn into $100,000” in 10 years, or 20 years, or . . . ever? Thanks to the Madoffs, the ENRONs, and others, how many younger Americans – our children – will, for perhaps a generation, believe the old Wall Street adages or trust the brokerages to protect our money, much less grow it? How long will it be before we feel assured enough by changes in federal regulations and regulators to believe that “investing” is anything more than an unprotected bet like roulette?

I’ll take the risk and use the oft disproved phrase “this time it’s different.” I hinge this belief on a sense that we’ve learned from the debt bacchanal of the Wall Street quants and thieves, indeed, from our own weighty debt loads, and have begun to return to the savings values of a bygone era. I think, too, that we also are beginning to value simpler pleasures and turning away from many of the material “things” produced by many Fortune 500 companies. And why not? We’ve seen how ephemeral these items can be when we lose the ability to pay for them, or have to run as fast as we can just to stay out of bankruptcy. We may be on the verge of realizing that we not only can wait longer for certain things, we can actually do without them. Again, this mass psychological and cultural change that’s afoot does not bode well for fast and furious gains in the traditional stock market. Americans today are both land poor and cash poor at the same time, and our government, as I’ve argued, may not be able to mass produce money enough at a reasonable price to do much to change all that anytime soon. That’s the essence of this Decession and what makes it a . . . BEAR.

But for Some Needed Comic Relief, When It Comes to Eatin’ Yogi Can’t Be Beaten.