The stock market, QE and the psychology of asset bubbles

The stock market, QE and the psychology of asset bubbles

U.S. Federal Reserve's DC HQ. (Via Wikipedia)
U.S. Federal Reserve's DC HQ. (Via Wikipedia)

WASHINGTON, October 16, 2014 — Has the stock market’s Day of Reckoning arrived?

The occasional dips in the mild amusement park ride of the Dow’s climb from 7,000 to 17,000 have not had any effect on investors until now. The reason was that the big money — the institutional investors — followed the Federal Reserve’s interventions in the market — quantitative easing, or QE.

QE is the policy whereby the Federal Reserve pushes money into the banking environment by purchasing securities such as U.S. Treasury bonds. They buy the bonds with money they print — “electronic cash,” The Economist calls it. The premise is that if banks use this money to lend capital for commercial, industrial and personal credit, the economy will pick up, jobs will come back and the country will grow out of the recession.

That’s the story. Paul Gambles, managing partner of MBMB Group, outlines the Wall Street narrative of QE:

QE is seen by its adherents, such as former U.S. Federal Reserve Chairman Ben Bernanke, as both the panacea to heal the post-global financial crisis world and also the factor whose absence was the main cause of the Great Depression. This is in line with their view that central banks create currency for commercial banks to then lend on to borrowers and that this stimulates both asset values and also consumption, which then underpin and fuel the various stages of the expected recovery, encouraging banks to create even more money by lending to both businesses and individuals as a virtuous cycle of expansion unfolds.

However, Gambles doesn’t buy it, and aside from the insider mouthpieces of the Washington/Wall Street Axis, the majority of economists don’t buy it either. What has actually happened is that the major banks have backed their trucks up to the Fed Discount window and loaded up on zero interest money. That money, except for a trickle, hasn’t gone into loans and liquidity. It has gone into equities.

QE has added a minimum of $4 trillion to the Fed’s balance sheet. If you look at the QE charts from 2009 and the major market indices since then, they follow a parallel track, which led the Dow to 17,000, the NASDAQ from under 500 to over 4,000 and the S&P 500 from 700 to percolate right around 2,000.

QE has held interest rates near zero, making the stock markets the default destination for investors looking for yield in a zero interest playground. The resulting asset bubbles are driven by this and partially by the herd mentality, supported by deceptive reporting on the economy by the corporate media.

So here we are on October 16, 2014, having just witnessed a tumultuous market drop in the Dow Jones Industrial Average (DJI or DJIA) of over 460 points in just one week. What is causing the tumult depends on which financial Oracles you are consulting. To some, it is accounted for by external factors such as negative economic reports from Europe and China.

“The economy isn’t as strong as perhaps everyone thought,” says Bruce Bittles, chief investment strategist at Milwaukee-based RW Baird & Co., which oversees $110 billion. The concern here is that the weakness in Europe and Asia is going to be exported to the U.S. and our economy is going to be negatively impacted.

Is the “everyone” Bittles refers to the drones in the corporate media falsifying the true nature of the “Obama recovery”? Others point to flagging consumer confidence. Retail sales numbers have dropped 0.3 percent in September — and softening in the manufacturing sector.

Then there is the Ebola scare, which investors correlate to reduced demand for air travel and all of the market factors associated with it, e.g., the tourism economy and so forth. Rounding out the explanation for the volatility and the market jitters are some disappointing 3rd quarter earnings reports that have begun to emerge, with the latest being dismal numbers from retail giant Walmart.

All of this can be neatly summed up as the “turbulence” narrative. There is a confluence of factors all converging at one time. But the market will settle down after a correction. Nothing new, say the carny barkers for the Wall Street thrill ride attractions.

On the other hand, what is not being disclosed in these reports suggests that what we’re seeing may be the restlessness of the herd before a full on stampede breaks out. The bulls may be about to magically transform themselves into bears.

The run up of the markets was led by banks tied to the Fed, followed by institutional investors. Running behind them were small investors, or ‘retail investors’ — the kind of folks targeted by all those “lifestyle” financial brokerage ads run during golf tournaments.

The process is now reversing itself. Large investors, institutional investors — the so called “smart money” — are dumping their stocks. Warren Buffett’s Berkshire sold roughly 19 million shares of Johnson & Johnson, and reduced its overall stake in “consumer product stocks” by 21 percent. Berkshire Hathaway also sold its entire stake in California-based computer parts supplier Intel. John Paulson disposed of 14 million shares of JP Morgan-Chase, and George Soros has 86’d large holdings of JP Morgan-Chase, Citigroup and Goldman Sachs.

Jim Fitzgibbon estimates that in less than a year and a half, institutional investors have offloaded $50 billion in stocks, while the smaller investor has come on board, based on the ludicrous puffery of mass media financial reporting about the economic rebound that doesn’t exist.

Hofstra University’s Dr. Jean-Paul Rodrigue, of the Dept. of Global Studies and Geography, wrote an excellent outline of the characteristics of the phases of a stock market bubble. He had this to say about the ‘Mania’ phase:

This phase is however not about logic, but a lot about psychology. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Fairly unnoticed from the general public caught in this new frenzy, the smart money as well as many institutional investors are quietly pulling out and selling their assets. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going.

Here is Rodrigue’s chart illustrating the psychological stages of an equities bubble.

 photo Stagesofmarketbubble_zpsd266cdef.jpg

It is interesting that Rodrigue mentions the value of unbiased opinion, meaning experts on market factors that are not dependent upon clients’ participation in the equities markets. Immediately after the big drop on Wednesday, many investment strategists are giving the sales pitch to “stay the course”.

Merrill Lynch’s chief investment officer, Ashvin Chhabra writes, “While some technical signs point to further downside for equities, we still believe it makes sense to favor stocks over bonds over a time frame of 12 to 18 months.”

Another rah-rah for riding out the volatility exhibited by yesterday’s plunge is Ric Edelman, the CEO and founder of Edelman Financial Services. He says the company’s clients “know that current market activity will be short-lived and is nothing to be concerned about. Most of those who are calling are expressing an interest in adding to their accounts, to take advantage of the lower prices while they last. We concur completely with their sentiments.”

Just one problem. If the market is now a house of cards waiting for the slightest gust to bring it down, the only people who are going to be ruined are the people still in it — and history shows us that they are the retail investors who got swept up in the mania cycle.

As further proof that the artificial stimulant QE has been the only thing driving the market — except for the mania phase investors — and the only element that is keeping this overvalued market from imploding, is a Bloomberg News report noting that U.S. stocks recovered from an early plunge today when St. Louis Federal Reserve Bank President James Bullard said policy makers should consider delaying the end of bond purchases to halt the decline in inflation expectations.

This doesn’t mean that the Fed is going to delay the end of QE. It is merely a speculative statement, a kind of lullaby that, it is hoped, will serve to calm the restless herd.

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