Market Thoughts Post Labor Day Weekend 2013
I recently made a market call ahead of July earnings thinking that the market might crack. I have updated my SPX chart from my July Market Call posts, which you can read here and here. I am currently LONG a lot of volatility. It is currently working well and next week when the bond traders come back and we get NFP, Fed events, tapering no tapering, Syria, conference season, deficit ceiling, etc., I am happy to keep the lon vol trade on. I am also long CL1 here and some high quality large cap tech stocks on the thesis of buy backs and dividends. I have one big loser on the LONG side and that is FIO. I hope they get taken out at this point.
I was wrong about the market move off Q2 earnings in July, but I was not wrong about the market move off of the first company to report a July month. I wrote in my August Market Call post “I am looking forward to the upcoming Cisco results as they will be the first to report a July month and if their guidance for enterprise spending is positive, I will go long high beta tech growth names.” I did not go long.
When I examine the market from a macro perspective, I try to keep the thesis simple: expansion of credit, inflation or deflation and the velocity of money are what matters. I have used the FRED charts from the St. Louis Federal Reserve before, most notably in this post. Here are links to a few of my favorite FRED charts:
- Velocity of M2 Overlaid with USTs Held by Federal Reserve
- M1 Money Multiplier versus USTs Held by Federal Reserve
- St. Louis Fed Financial Stress Index
Traveling over the past two weeks afforded an opportunity to do a lot of reading and a lot of the reading was about QE. Here is a paraphrased version of some of the smart opinions I read interlaced with a few my thoughts. Banks (i.e. depository institutions) create money by making loans, they do not lend against their deposits. You can see this be the rise of capital held at Federal Reserve by depository institutions in this chart.
Deposits are created when the money from the loan is deposited into the banking system by the receiver of the funds that were loaned. This means that the private banking system can create money as long as the loans they make continue to be current. Loans not being current was the problem during the credit crisis and it was exacerbated when these loans were used to create synthetic instruments which produced all sorts of counter party risks, recapitalizations and margin calls.
The Federal Reserve can only create as much money as there are in US Treasures (USTs). The Fed worked around this technicality by granting themselves the ability to buy Agency Mortgage Backed Securities (MBS). Agency MBS are securities guaranteed by a government agency such as Fannie Mae, so the Fed is buying MBS to create money from another agency other than the Treasury. Fannie Mae creates MBS buy creating a secondary market for purchasing mortgages from lenders, which is the receiver of loans part from the prior paragraph. This is also the part that the quality of loans, sourcing of loans, buying power (i.e. how much credit you are afforded) and how much cash a buyer comes to the table with matters.
The limit to which the Fed can grow their balance sheet is equal to the amount of USTs outstanding. If the US Treasury stops running a deficit, then the only course of action for the Fed is to buy up the current float of USTs. This does not create new money, but it does remove high quality collateral from the system that the shadow banking system uses to create new money. This is bad and this is why QE does not end unless the private sector becomes strong enough to bear a bigger burden.
The result of the current market construct is that ability of the private banking system to create new money is greatly diminished by the ongoing insolvency of the banking system. It was never allowed to clear the bad loans. We would have been better off taking a bitter pill and clearing the books, but the system chose to prolong the deleveraging process for years, maybe decades.
The Federal Reserve does not have enough deficits from the US Treasury to monetize through large scale asset purchases (see this paper on LSAPs), more commonly referred to as QE, the amount of debt that needs to be cleared. The result is we will continue to slow and this will be exacerbated if the US Treasury were to cut the deficit even further, which is why we are going to take the deficit even higher and Congress should just put a 5X the current limit and push it out a few years. The other option is to default or devalue, which Russia did in 1998. As we go into September all these endogenous risks are in play and they are hugely impactful. Unfortunately, we also have a wag the dog event in form of an exogenous event in Syria to complicate matters.