Bernanke’s Bubble in Stocks and Bonds


Six years after the height of the financial crisis, we may be living in one of the most prolific financial bubbles in recent history.  Under Dr. Bernanke’s guidance the US Federal Reserve system expanded its balance sheet to about 4.3 trillion dollars, with asset purchases creating a disproportionate wealth effect in equities and debt-based financial instruments.

Despite this massive injection of liquidity, by and large the US economy has not significantly recovered. Yet the US stock market (with the exception of the NASDAQ) is at all time highs. This disconnection in equity prices vs. measurable economic recovery is the primary reason that I believe a bubble exists. In addition, the artificially low interest rate environment (see: ZIRP and QE) has also created an enormous bond market bubble as reflected in US treasury bond yields.

LFP Participation

The US workforce is languishing 

A quick glance at the US Department of Labor’s recent U3 unemployment data would have us believe that almost as many Americans are employed as had been before the Great Recession.  Unfortunately the Department of Labor’s U3 unemployment rate is based on the amount of Americans currently on unemployment benefits — not the number of Americans out of work.

The US Labor Participation Rate is at its lowest levels since 1978, indicating that US job creation is not sufficient to support widespread employment. In addition, the quality of new jobs being created is equally deficient, with lower pay being a prevailing theme.  One of the Federal Reserve’s mandates is maximum employment.  A mandate they seem to be failing to uphold when utilizing more objective measures of employment.


Raw materials are rolling over

While equity markets re-test all time highs, commodities are sinking fast.  Traditionally weakness in industrial commodities and energy prices signal global economic weakness.  Since July we have seen that weakness accelerate as the sell-off in commodities prices took the CCI (a broad measure of commodities prices) to multi-year lows.  This is a powerful sentiment indicator.

Optimism about global growth would be expressed in higher commodities prices — as more orders for raw materials would increase demand.  Another mandate of the Federal Reserve is stable prices.  A cursory glance at the above chart shows we certainly don’t have stable prices.


Stronger dollar, weaker world?

Part of the recent decline in commodities prices has been attributed to recent strength in the US dollar index, which is in its most basic form, a measure of the dollar’s spot value vs. the Euro, Yen and GBP.  There are other currencies in the basket, but none are quite as influential.  In essence, the US dollar currently signals that it is more favored than the Euro, Yen and GBP through its ascent towards 87.

As commodities are priced in dollars, it is expected that some weakness will occur if the US dollar strengthens, especially under the back drop of softening global demand.  But one must also question the utility of the current US dollar index structure — and whether or not such an index is relevant in a world that seems to be increasingly moving away from the dollar as the primary trade currency.


Stocks surged on stimulus. Now what?

With the S&P 500 back above 2,000 and optimism among fund managers back to similarly lofty levels, it may be time to examine the US stock market with a degree of skepticism. There exists a very high probability that we are in a bond and equity bubble that was fomented by the US Federal Reserve system. And traditionally these bubbles deflate when policy makers begin to head for the exits.

With QE3 over, and no immediate sign of further stimulus in sight, as well as the Fed signaling that rates are going higher in 2015, perhaps we are closer to seeing this bull market mature.  After all, it’s been largely driven by liquidity injections and those have since ended.


A direct connection: Fed assets and stock prices

The correlation here is uncanny. QE’s various incarnations have an incredibly potent effect on boosting US equity prices to all time highs.  Just about every dollar the Federal Reserve has injected in to the US bond and mortgage market has found its way in to US equity markets directly or indirectly.

Now that QE3 has ended, what policies will be utilized next?  Is the Japanese QE-to-infinity program going to be enough to generate a new carry trade that pops US equities higher?  Or are we finally witnessing the tail end of one of the biggest financialized bubbles in US history?  One that has brought bond yields to the lowest levels in decades whilst simultaneously inflating mortgage-backed securities (lowering interest rates) and equity prices.


Is this bond bubble ready to bust or is it signaling something worse?

Bond yields are an inverse indicator of the underlying asset price. That is to say, the lower the bond yield, the higher the paper price to buy that bond.  This chart illustrates US Treasury bond bubble in no uncertain terms.  With US government debt exceeding GDP, whilst simultaneously at all time low yields, there is something wrong with this picture.

Typically the higher the debt level, especially as it exceeds the GDP of a country, the worse its debt outlook becomes.  The only exception we’ve seen to this rule has been Japan, which has ‘enjoyed’ a 25 year economic malaise that was culminated by their very own real estate bubble.  The deflationary forces at work there have been keeping bond yields and economic activity pinned down for a quarter century.

Reading the tea leaves of macroeconomic data

Signs seem to be pointing to an intermediate term deflationary bias.  It’s likely that this situation will be greeted by more quantitative easing from central banks of developed countries around the world. Signals include a rocketing dollar, collapsing commodities, the Bank of Japan already engaging in record QE and the weaker EU countries slipping back in to recession or worse.  In addition, China’s miracle growth story seems to be concluding with a not so happy ending.


Velocity of money sinks to lowest level on record

Worse yet, with all of the Fed’s easing and stimulus, the velocity of US money has been collapsing.  This is an indication of economic activity insofar as how fast money is changing hands. Generally during periods of strength the velocity of money will increase.  What we’ve seen since about 2002 has been just the opposite.  A marked decrease in the velocity of money across all measures to the lowest levels ever recorded.


Leverage and levitating stock prices

Margin debt on the NYSE (see above chart) is at record highs, and similar leverage is being employed across many equity and bond markets around the world.  That means that the level of debt-based risk taking now exceeds what we saw during previous bull market peaks and as such a reversal in psychology would be even more dangerous to stock prices.

A replay of 2008’s volatile panic selling of various asset classes is quite possible.  The level of complacency and leverage in financial markets is similar to where we were in the fall of 2007 before the financial system began to collapse.


Watch these trends carefully.  Further deterioration of M2 stock velocity, commodity prices and increased dollar strength will signal the increased potential for a renewed deflationary global recession.  If such a situation unwinds, and if equity prices are dragged down in sympathy, then I do believe the Federal Reserve will begin to reinvigorate its stimulus programs and we could see the pendulum swing back towards a more inflationary bias.

What remains a mystery is how the Fed will do so when it already possesses the biggest balance sheet in its history — and has largely failed across many metrics to remedy the economic problems that face the US.  Alternatively, if Bernanke’s Bubble is allowed to burst, the consequences will be catastrophic, not the least of which for the Federal Reserve and its balance sheet.


Fedflationary fabrications

These press conferences with Federal Reserve Chairman Dr. Bernanke are becoming more amusing as of late:

“We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation [..]” – Ben. S Bernanke

Really?  On what basis of calculating inflation can one say with a straight face that over the last 30 years inflation has been tame or for that matter stable?  Let’s take a look at the 30 year chart of the CRB index, which represents a broad view of commodities as priced in US dollars.

30 year CRB index chart showing high inflation and unstable prices

30 year CRB index

Clearly inflation is not under control.  However, if the above chart is not enough to make one skeptical of the Fed’s latest remarks, then here’s a 30 year chart of the US dollar index, the currency in which prices are set for all the items we purchase in the United States (and other countries using or pegged to the US dollar).

30 year US dollar index chart

30 year US dollar index

What one can gather from these charts is that we’re experiencing 30 years of a weakening dollar and extremely volatile commodities prices.  Our central bank has the audacity to tell us that inflation is under control, and that in essence one should ignore gas prices, food prices and the prices of other goods which have surged over the last few decades (because all of the official inflation statistics ignore said prices).

I’ve always been a skeptic of the Fed’s press releases and these conferences, but this statement alone is enough to make one’s head spin when put in to context with the charts above.  I believe instead that the Fed is claiming inflation is under control as a guise to give them the flexibility to perform more easing should the European contagion come home, or if our own sovereign debt issues begin to become more apparent to bond investors.

Without quantitative easing, twisting (and lots of shouting) our markets would likely have higher Treasury yields, lower equity prices — but people would be enjoying lower prices on food and energy.  With the labor market stagnating and the overall economic picture still quite dismal, one has to wonder whether the Fed’s dual mandate of encouraging employment and maintaining stable prices has been abandoned in favor of recklessly supporting the financial system at large, and more specifically US Treasury bond and equity prices.  It certainly seems to be the case when objective data is reviewed from a macroeconomic perspective.

Why fixed income investing is on life support

The current financial paradigm is crumbling beneath us.  This is not a temporary disruption, it is a meltdown.  All of the mechanisms that drive paper markets are being eroded, and more and more market participants are being, quite literally, robbed — and without consequence.

Income generation through investing comes down to a troubling set of problems, because revenue comes from the interest yield on various debt-based instruments.  Which debt does one buy during a credit crisis?  Obviously not European debt.  Corporate debt is suspect — and when the market is this high if it takes a turn for the worse corporate debt could easily take a 30-50% haircut overnight.

US debt has incredibly low yields and has been in a 30 year bubble, suggesting that it could collapse if inflation becomes a problem.

Other countries currencies seem dangerously manipulated by central banks, so it is hard to build a portfolio of high yield currencies without risking a monetary crisis wiping a large portion of the value out.

That leaves high dividend stocks, which are, just like every other paper asset, overvalued, dangerously dependent on the stock market continuing to move forward — and what would cause the stock market to continue to move higher here?  The only thing that could is a large scale global bailout which would be highly inflationary and bad for all debt (income) instruments — with the exception of a select few Euro bonds.  Bonds so toxic that they blew up MF Global and caused a global liquidity vacuum.  And let’s not forget about Dexia, who also had a lot of Euro debt exposure.  This highly rated European financial passed all its stress tests and subsequently collapsed, needing a bailout.

Any investment in ‘income’ instruments is highly speculative and dangerous.  Look at the charts for varying income instruments: sovereign bonds, corporate bonds, junk bonds, high dividend stocks, high yielding currencies — then tell me if based on just the technical analysis, they seem like good investments.

Then add to it the macroeconomic foray.  The likelihood of either a global banking system disruption or a highly inflationary bailout are both negative for most income instruments.

If we have a disruption, income instruments will crash in value very, very quickly.  No stop loss order will adequately protect against a waterfall collapse.  If instead we have a global bailout, money will rush out of income instruments in to speculative assets.

Most retirement age Americans are struggling with this problem.  Millions are unable to get yield, which forces them in to dangerous assets.  Investors have to be patient and wait for the opportunity to come — rather than get destroyed by the rush to the exits that is almost certain at this point.

Caution! Market crash could be imminent

With growing uncertainty surrounding the European debt crisis, and the contagion spreading to much larger sovereigns, such as Italy, we now see risk aversion back on the table.  US markets are down over 3%, the headlines seem to be getting progressively worse and many fear that the situation could deteriorate much further — giving up much of the gains achieved in October.

Growing concern as market whipsaws

This kind of volatility, both up and down, is historically an indicator of very large market moves.  With the bias largely negative, it seems that a market crash could be coming if no resolution is found for the EU debt implosion.  Alternatively, should a large scale bailout ($2T+) occur, we could see a significant rally, especially within precious metals spot prices and miners.

For investors and traders, this type of price action is stressful.  Seeing fluctuations of multiple percentage points in indices and nearly 10% in stocks can cause forced position liquidation because of stop loss orders being triggered.  For traders, who generally capitalize on multi-day moves rather than moves within a single day, this type of action can cause significant losses should one be caught on the wrong side of the market action.  High frequency trading machines may capture gains, but are not providing liquidity or improving market efficiency, especially during periods of intense market moves.  Instead, evidence seems to be growing that the machine-based traders are making the market less stable and more prone to large price swings.

World view deteriorates

Global markets plunged as well, with Italy down over 9%, Poland down nearly 9%, Germany down over 7% and other European markets leading weakness as stock prices bleed, especially within the financial sector.  The lackadaisical response out of the EU, ECB and IMF leadership seems to be draining confidence and sparking fear in the markets.

US banks have hundreds of billions of dollars worth of exposure to European sovereign debt, banks and other related instruments.  Many have written credit default swaps, a form of insurance that has no capital reserve (see AIG implosion circa 2008) against European debt, exposing them to significant risks should the EU situation worsen.

Broken bonds from backwards economies

Many Western countries now face the prospect of sovereign debt problems, as their economies continue to slow, while investors fear that they will not be able to pay back the debt.  The United States is no exception, as its official debt reaches 100% of GDP, and by some estimates, their total outstanding unfunded liabilities have reached $75 trillion.

Japan has a 200% debt-to-GDP ratio, which is only made possible by the fact that most of their debt is held by Japanese banks and pensioners, but the situation there is deteriorating with growing political and economic instability.  Even China is no exception, as their economy is slowing down and the yield curve on Chinese debt has inverted for the first time — causing serious concern for those that felt China would lead the world out of recession.

The coming crisis

What happens next is not clear, but what is evident is that the world is changing.  Slowing economic growth, the bursting of the largest credit bubble in history, significant deterioration in debt-driven consumption and resource depletion all leads to a potential crisis.  All of the new debt that has been created to attempt to stem the last debt crisis has only exacerbated the underlying structural economic problems we are facing.  Papering over large amounts of fraud within the financial system and ignoring the peril of main street has divided the Western world.  Growing civil unrest and lack of available employment, especially for the young, has created the potential for large scale disruptions (think of the “Occupy” movement, but on a global scale with a significant percentage of the population participating).

I feel that unless we start seeing accountability within the financial sector and governments of the world, prosecution of the enormous fraud, transparency within the political and electoral process and erosion of corporate personhood in so far as money is considered free speech, as well as more regulation of over the counter derivatives, we will look back at the 2008 crisis and think of it as a relatively calm and orderly time within the financial markets compared to what could happen next.

News recap for Monday, Oct 3rd

Today was an exciting day for global markets.  Below you’ll find a recap of today’s most important news.  We are not anywhere near out of the woods, yet.  In fact I think equity markets are bound to get much worse.

Global equity markets are tumbling:

Banks are getting hit the hardest:\

Many EU banks have serious liquidity problems:

The yield curve is flattening, which usually happens before it inverts, signaling a potentially deep recession:

Protests in NYC are spreading:

And more protests are being planned:

I’ll have more posted as I digest and research the events that are transpiring in global markets.

Silver’s scary sell-off

Silver and silver-related assets were smashed across the board on Friday as the World Bank and IMF met in Washington, DC to discuss the worsening global crisis.  Other commodities saw sharp declines as well.  More silver was traded that day in any given hour than silver is available on the market for an entire year.  It was an electronic sell-off.  Physical prices now command a 10-20% premium to spot paper prices, the highest in years.  Gold to silver ratio is now over 1:50, the highest in a very long time.

Predictably news comes out after the trading day (but we must assume the large insiders knew the whole time) that COMEX was raising margins by 15.6% on silver.

The problem is the COMEX does not have the silver to deliver, so forced liquidation is the strongest tool they have to bring prices down and take parties who would seek delivery out of the equation.

Silver is still up 46.31% on the year and has strong support in the $30.00 area.  I think we need to see what the price action is when buyers step in and shorts cover.  It could very well move up as fast as it did down (and higher) if we see ECB rate cuts, a Greek bail out, good earnings in the US, emergency Fed easing or other central bank policy movements as well as any geopolitical or event risk scenarios playing out.

Given that even though silver fell to $30.00, but physical silver commands a price of $33-35.00, there is evidence of a growing paper vs. physical price discovery bifurcation.

As far as my strategy goes, I don’t see any change in the situation for the dollar long term.  The recent strength has been more of a liquidation panic in Europe and foreigners buying dollars because it’s the least bad currency for the moment.  There’s even some rumor of weaker central banks liquidating gold and silver holdings to raise liquidity.

I saw the same pattern of behavior in 2008 and 2009, yet gold and silver are much, much higher now despite the occasional (and sometimes violent) correction.

Over the last 11 years silver and gold have outperformed all sectors of the S&P 500 by many multiples.  There is no paper asset class quite as trusted during times of crisis, either. (three year chart)

Now, given the potential for further easing by the Fed, ECB, BOJ, BOE, SNB and others, the need to monetize debt in the US to keep the government open (i.e. the necessity for QE3) — without debt monetization the government will go in to a crisis mode where their ability to spend will be limited as interest rates rise because treasuries are sold more than bought.  But we’re not the only country that has to monetize debt.  Keep in mind the US government has over $75 trillion in unfunded liabilities and there’s no ‘economic growth’ scenario that allows these debts to be funded from revenues.

QE3 from the Fed at this point seems like a foregone conclusion once we see a sovereign debt or large bank collapse.  The ECB is also monetizing debt in the Euro zone for a few of the larger PIIGS, the BOE has QE’d in England and there’s a good chance the BOJ and SNB will continue to print money to artificially devalue their currency.

These actions will create a short to intermediate term burst in global money supply — and hot money seeking a high return.  These types of inflationary pressures lead to booms for precious metals.

Greece’s default is all but inevitable, and that is going to rock the world and create the need for much, much more liquidity.  This situation will spread throughout Europe and spread here and to Asia.  Lower rates and more stimulus will follow.

Many shops sold out of their silver bars and coins on Friday because the appetite for physical silver was so strong at $30.00 (even though customers gladly paid the $5.00+ premium making purchases $35.00+ per ounce).  In fact I still saw online stores selling silver for $45.00 to $50.00 per ounce.

I believe that the bifurcation in physical and paper prices is important to note because it indicates that there are two markets.  A real market and a phony market.  The phony market is being manipulated downward to an artificially depressed price.

This happened in 2008, too.  But from that low price of $8.00 silver quickly rose to $48.00 in the course of three years, a 600% increase or averaged to 200% per year.

Gerald Celente, one of the best trend forecasters of our era is now buying physical silver.  He made the announcement on Friday, so I believe that will mean something to the many that follow his advice and watch his investments closely.

One year silver chart

Tonight silver is testing the 350 day moving average.  Some continuation selling was to be expected after Friday’s drop, but we’re looking for some consolidation or even a short term reversal due to the very, very oversold condition, combined with the support of the 350 day moving average at 29.57 as well as the appetite that should be present in Asia during this season.

We’re also dealing with price move that is over a four standard deviation event — i.e. something that is extraordinarily rare and it’s punctured the bottom bollinger band, leaving a reversion to the moving average around $37.00-40.00 quite possible if technical buyers come in.

24 hour silver chart Right now silver is trading at $29.83, having found some support at the $29.57 area.

Volume is light as to be expected, but once Sydney and Hong Kong open we’ll get a better idea of what the Asian appetites for metals are after last week’s discount.

Personally, I am tempted to buy silver and silver-related assets given these discounts.  Even if prices are weak short term, I know they will be much, much higher in the intermediate and longer term.

Twist, but don’t shout

(Updated at 4:25 p.m.) The Federal Reserve announced that it will begin selling shorter term US Treasury securities and use the funds raised to buy in to the 6 to 30 year space.  They also indicated more easing in the mortgage-backed security market.  Stock and commodity markets had a knee jerk reaction lower, selling off on the statement’s release.  The total size of the program is expected to be about $400 billion — but there is no balance sheet expansion, just swapping of securities.   Notably the Fed did not reduce interest rates on bank reserves, thus there is no expectation that banks will lend more when they are poised to make even less because of the yield curve compression.

I believe that this is the beginning of more aggressive approach that the Federal Reserve will implement to lower borrowing rates for consumers on both fixed-rate mortgages and revolving lines of credit.  Whether this action has any material impact on the ailing economy remains to be seen, but I am highly skeptical as I don’t believe the Federal Reserve is capable of doing much more than delaying the deleveraging that must happen in all sectors of the economy.

Fed causes sell-off of equities with twist

Traders are apparently not enthused by Fed's maturity "twist."

Because of the renewed pressure on equities and the lackluster reaction to the policy release, I now expect the head and shoulders pattern to play out on major US indices.  These stock market indices have decisively broken down below the 10 day moving average, indicating a loss of upward momentum.

A sell-off down to the 10,000 area on the Dow could occur within the next week or two, and if that area does not provide technical support to markets, additional downside pressure could bring markets to the 9,750 to 9,500 area in relatively short order.  If frenzied selling occurs, perhaps as a result of news-driven events in Europe or more bombshells being revealed in the American banking sector we could see the 9,000 area give way to much lower stock prices.

Curiously silver is outperforming gold today, with gold weaker and silver spending much of the trading day in the green.  Even more interesting, however, was the difference in action in the paper and physical markets.  SLV and silver futures took a hit after the announcement and did not recover, but PSLV (the Sprott Asset Management physically-backed silver fund) saw selling and then filled the gap almost immediately, albeit temporarily.  Does this bifurcation in trading indicate that investors are more confident in the real thing or is it only a blip that will be arbitraged by the quants?  At this point it looks like an aberration as the gains have been given back, and then some.

Overall I think this monetary policy shift should be bullish in the long term for hard assets, especially gold and silver, as the maturity “twist” diminishes the interest rates on long-dated fixed-income securities and provides less “safe havens” for investors to seek returns in the paper markets.  In the short to intermediate term a longer period of consolidation and possibly a correction across the commodity spectrum is growing more likely.

Full Fed statement here:

Fed Wednesday – Policy Outlook

I don’t want to be right about my of my dire predictions, but all signs point to a significant global slowdown:

The Fed is coming out at 2:15 pm to announce the results of their policy meeting.  Many expect a variation of the 1960s “Operation Twist” where they sell their short-dated maturities and buy long-dated maturities:

If they were to do this, it would actually hurt the large and regional banks because they would be borrowing at a higher rate and lending at a lower rate — but it may help the consumer, at least short term, buy making mortgages and revolving debt less expensive:

They downside is that any more monetization of debt will likely be perceived as inflationary and send speculators in to commodities (including energy and agriculture) which could cause a rise in consumer prices.

I think they may even have to perform some more aggressive monetary policy measures given that the US dollar money market funds in Europe are drying up — and the EU banks are in bigger trouble than our banks:

If they announce nothing new, which is in my opinion extraordinarily unlikely given that this is a longer than usual Fed meeting (something we hadn’t seen since the last rounds of QE) I think there will be a significant market sell-off and a head and shoulders topping pattern may play out:

Whatever is done by the Fed is only a short term piecemeal solution to a broader, more structural problem with bank and sovereign balance sheets — and in my opinion it only delays any real resolution.

Cautiously waiting for the Fed

The Fed’s two day meeting wraps up tomorrow and markets are eagerly awaiting the release of any policy changes or revisions in the economic outlook from the central bank.  Many pundits expect a variation of the 1960s “Operation Twist” where the Fed lets shorter term US Treasury bonds mature and buys longer dated treasuries to reduce the interest rates on the end of the yield curve.   Others expect another bout of Q3-like monetization of debt.  If the Fed doesn’t do anything substantial I expect the weakness in the markets to accelerate and the head and shoulders pattern discussed in the previous article to play out.

Head and shoulders setup on major indices?

Could the Dow Jones and other major indices be setting up for a head and shoulders style technical-driven sell-off?  It will depend on what the Fed has to say next week, but also on the rate of deterioration in Europe and other news-driven event risk.

For the pattern to play out, some more upside may occur, but not further than about 11,600.  The downside target, should the Dow slip below 10,600, would be approximately 10,000, but if the sell-off accelerates we could see a dip to the 9,600 to 9,800 level.

Which way the market goes is uncertain, but on the weekly charts the recent technical damage has created the potential for further downside risk.  I began aggressively taking equity positions off the table in July, with the exception of some silver and gold miners.  I encourage all readers to exercise extreme caution in the coming weeks and months as the global equity markets are extremely volatile, illiquid and therefore less volume can create much larger percentage moves.