As an avid fan of the science fiction genre, I am fascinated by the idea of parallel worlds and alternate realities. Lately, however, I have begun thinking that I may be living in one. In the alternate world in which I am currently living, anything resembling good news tends to have a dampening effect on the market, and bad news is reflected positively. Terrible news often leads to downright euphoria. How bizarre.
What drives markets in this parallel world, I am told, is that if the news gets bad enough, central banks will intervene and save the day. Ok, fine; central bank action has prevented a world-ending market crash. But are these levels justified? Stock markets have reached pre-crisis levels, as if nothing happened during the last 4 ½ years.
Let us return to my regular world for a moment. In this world, ignoring a problem does not make it go away. Moving a loss or a non-performing asset from one entity’s balance sheet to another’s does not will it out of existence. Shifting the burden to a bondholder or taxpayer will leave him or her with fewer funds with which to make discretionary purchases.
Oh, and one other thing – in my regular world, the fair value of an equity is the present value of future cash flows.
Last Thursday European Central Bank President Mario Draghi pledged to embark on an aggressive bond-buying program in order to boost confidence in peripheral eurozone countries. The announcement set off a global panic-buying rally in equities, metals, and foreign currencies relative to the dollar. The rally continued into Friday despite a rather tepid U.S. payroll number, which prompted fresh speculation that the Federal Reserve will announce a fresh round of quantitative easing at its meeting later this week.
Now, I understand the euro’s rally, as the immediate threat of a eurozone breakup has receded.
But what of the equity market? If the ECB, after exhausting all other options, must now buy distressed and toxic debt in order to save the banks, how can this be a positive for the stock market? Here is what George Soros had to say about that on Monday:
“The policy of fiscal retrenchment in the midst of rising unemployment is pro-cyclical and pushing Europe into a deeper and longer depression. That is no longer a forecast; it is an observation. The German public doesn’t yet feel it and doesn’t quite believe it. But it is all too real in the periphery and it will reach Germany in the next six months or so.”
When Draghi announced last week that Europe, too, can offer Fed-style intervention, it touched off a wave of euphoria. If the market is responding favorably to the ECB’s calls for unlimited intervention, then that means the market thinks it is in need of unlimited intervention. That is not a good thing.
The answer to why the market reaction has been so strongly positive comes straight out of the parallel universe, and lies with Fed Chairman Ben Bernanke. In his Jackson Hole speech August 31, Bernanke acknowledged the targeting of stock prices. From the speech:
“… the sustained recovery in U.S. equity prices began in March 2009, shortly after the FOMC’s decision to greatly expand securities purchases. This effect is potentially important because stock values affect both consumption and investment decisions.”
In my world, the Federal Reserve’s dual mandate is monetary stability and full employment. On this parallel world to which I have been transported, there is a third mandate: higher stock prices.
So there you have it. We have 56 million retirees in the U.S. Of households with children under age 18, nearly 60 percent live from paycheck to paycheck. Many others are unemployed and thus have no paycheck. Do these people really care whether the Dow was up 100 or down 300 today?
The fact that frugal savers and retirees favor safe, short-term investments such as treasuries and CDs, which have been driven to zero (and even negative in some cases), means nothing to him, nor does the fact that loose monetary policy has destroyed the purchasing power of the dollar.
I don’t like this planet. Take me home, please.