Mike Lenhoff's Market Tactics: Wall Street's underlying 'risk-on' trend
Comment of the Day

September 25 2012

Commentary by David Fuller

Mike Lenhoff's Market Tactics: Wall Street's underlying 'risk-on' trend

My thanks to the author for his latest and well considered assessment of financial developments. Here is the opening:
Writing in last Friday's Insight column of the Financial Times, Gillian Tett picked up on the Fed's latest initiative on QE3 (Beware the high costs and psychology of America's QE3) and on why several Fed Governors (and non-voting FOMC members) were less than supportive of it. She encouraged those wishing to celebrate the market action to read the speech given last week by Richard Fisher, head of the Dallas Fed and one such non-voting member - and I did.

In his talk, which was 'bold' and well worth the read, Fisher focused on uncertainty as the key in preventing monetary policy from being as effective as might be expected and thus questioned the merits of more stimulus if companies are not responding to the Fed's policy initiatives already. To quote Fisher: '... you cannot have consumption and growth in final demand without income growth; you cannot grow income without job creation; you cannot create jobs unless those who have the capacity to hire people - private sector employers - go out and hire.'

If uncertainty inhibits what would otherwise be the response to easy monetary policy, what good can more QE do? Fisher cites evidence, which applies as much to medium-size and small businesses as to large companies, as indicating that monetary policy is not an issue and that even if interest rates could be cut, this would not induce firms to alter their investment intentions.

Moreover, the concerns are broadly shared across the corporate spectrum. As Fisher put it: '… With the disaster that [US] fiscal policy has become and with the uncertainty prevailing over the economic condition of both Europe and China … it is no small wonder that businesses are at sixes and sevens in committing to expansion of the kind … to propel job creation.'

There is no doubting the uncertainty. Sir Mervyn's 'black cloud' stretches far and wide. But with one exception, much is being done about it. The introduction by the European Central Bank of a formal framework for supporting bond markets is subduing the crisis and its destabilising influence. China's landing remains an uncertainty but it is also easy to forget that the authorities are targeting slower growth and that policy is intentionally geared to stabilising rather than stimulating the economy. The last thing the authorities want is to hand over to a new leadership an economy heading for the rocks or heating up again. While the balance is fine, the objective is clear. Less clear is the outcome, an uncertainty reflected in the equity market.

David Fuller's view Sure, there are plenty of reasons for uncertainty, including the longer-term consequences of all this QE, the US Presidential Election and 'fiscal cliff', Europe's self-made conundrum over how to generate GDP growth with socialist policies, and China's edgy response to its export slowdown while the next generation of rulers lobby for power, and not always from behind the scenes.

Meanwhile, the press certainly knows that a grim headline catches the eye and a crisis scenario is more interesting than reports about all the cats (fat or otherwise) that did not get stuck up a tree (real or metaphorical) this week. Veteran subscribers know that worst-case economic and financial scenarios, although much discussed and masochistically enjoyed, are statistical outliers in a world of mostly muddle-through outcomes. Even Sir Mervyn's 'black cloud' mentioned above has diminished now that a modern era Brit has finally won a Grand Slam.

Nevertheless, the CEO parade on CNBC and Bloomberg is quick to cite 'uncertainty' whenever a moderator asks the awkward question about employment intentions. Since uncertainty has more or less always been with us, I think the word has become a euphemism for, 'I'm considering my options.' For this reason, I maintain that additional QE will have little influence on job creation, although it is a humane reason for taking one heck of a gamble with future inflation while ramping up asset prices well in advance of the next economic recovery worthy of the name.

I also think that unemployment has become a structural problem in addition to the usual cyclical factors. I mentioned this in yesterday's opening item:

I certainly do not fault Mr Bernanke for following the full employment side of his mandate, but I do not think it will work, for two reasons: 1) globalisation will continue to ensure that many jobs flow to countries where labour is less expensive, less unionised, and where government costs from healthcare to regulation are less onerous; 2) manufacturing assembly, distribution and even clerical jobs will increasingly be undertaken by robots.

In this interesting letter, Mike Lenhoff also points out that both the S&P Mid-Cap (weekly 10-Yr & daily) and the S&P Small-Cap (weekly 10-Yr & daily) Indices have rallied to new all-time numerical highs this month. This has been impressive and has no doubt surprised many a cautious investor.

I think the rally demonstrates the comparative health of many listed companies relative to the balance sheet of the US government and the soft economy. Additionally, it is also testimony to the power of accommodative monetary policy in lifting equity prices in an environment where long-dated government bond yields remain low, also with the considerable help of QE.

Subscribers will have noted that both indices illustrated above are somewhat overextended relative to their 200-day moving averages. Consequently, they are susceptible to some mean reversion during a reaction and consolidation phase which appears to have commenced. MID has not maintained the upward break and SML is likely to follow its lead as both had downward dynamics today.

Lastly, and as I said in an Audio last week, QE has created some valuation expansion, not least in Europe recently. However, QE has had little effect on the underlying fundamental factors. That will take more time. Therefore we should not be surprised if this reaction and consolidation phase for most stock markets lasts for a few weeks. At worst, I envisage a correction, not a crisis although this frank statement by President Obama at the UN today may have contributed to today's sell-off - Obama at UN Vows U.S. Won't Let Iran Gain Nuclear Weapon.

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