What Is Behind The Rally?

Optimism has returned to the markets.

The New York Times is telling us that "The Markets Sense a Turning Point."

Ben Bernanke "... continue[s] to expect economic activity to bottom out, then to turn up later this year." But adds, "an important caveat is that our forecast assumes continuing gradual repair of the financial system..."

To which Tim Geithner adds, "I think the results [of the stress tests] will be, on balance, reassuring [for the financial system]."

Unfortunately, anyone who had listened to the NYT, Bernanke and Geithner over the past few years are swimming red ink at best, living in a tent city at worst.

The confidence men have succeeded in talking the markets higher and are using their success as evidence that all is well. Of course in order to believe them, one would have to concede that the problems in the first place were a simple "lack of confidence" rather than a fundamental shift social preferences, a revulsion of debt accumulation and a ponzi scheme of derivatives that has already collapsed.

It is no secret that the stock market typically bottoms 4-8 months ahead of the economy. However, most major economic cycles experience many "bottoms" before the last one signals the coming recovery. That is, every recovery is foreshadowed by a stock market bottom, but a stock market bottom does not necessarily foreshadow a recovery.

So in order to determine whether an economic bottom has actually been put in, one would need to look at some other indicators. Since this is a credit based contraction, it would make sense to take a look at some of the major credit indicators that were experiencing such distress on the way down. Indeed, the major benchmarks (LIBOR, Agency Spreads, CMBS, etc) have improved. However, looking at just a few of the most-watched indicators would not be giving one the full story. As it turns out, the massive expansion of the Fed balance sheet has gone towards "plugging holes" in precisely these indicators. If one were to dig a little deeper and look at the far larger corporate bond markets (for example) they would find little to no improvement, and in many cases serious deterioration since autumn of '08.

Brian Pretti of the Contrary Investor has a great article documenting exactly this, appropriately titled, "Of Fingers and Dikes." From the article:

The concept of perception versus reality is an extremely important distinction in the current economic cycle and circumstances of the moment. And remember, it’s not that potential misperceptions being priced into financial assets at any point in time are somehow bad, but rather THE issue of importance is making sure we are in touch with factual reality at all points in time so that we hope to make a judgment about whether what markets are discounting is correct or otherwise. Trying to make an informed judgment about this distinction is an exercise literally crucial to ongoing investment decision-making and risk management. You already know financial markets are not moved by reality 100% of the time. Far from it. Human greed, emotion, fear, distress, etc. all get to take turns driving the financial market pricing bus. We all just hope to be smart enough to know when a reckless driver has the wheel.

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Before jumping into some data and historical relationships one more quick comment. A very cursory and superficial glance at a number of key credit market relationships could indeed lead one to believe that the healing process for the credit markets has also begun. But as we look at the facts underlying a number of headline credit market indicators a different picture emerges entirely. A much different picture. The bottom line is that the Fed has all of its fingers stuck in the holes of the macro credit market dike. At least up to now, this multiple fingers in the dike approach by the Fed and friends to dealing with very meaningful credit market issues can indeed create the superficial perception that the initial rumblings of healing are upon us. But a number of these “managed” credit market indicators have created a misperception about the supposed recovery of the credit markets in the broader and more important sense. Although I’ll walk through the data piece by piece, the credit markets are far from healthy and not recovering as per the perceptions embedded in the current run in equities. If there is to be an Achilles Heel in the equity rally of the moment, it’s the reality of the US credit markets.

Pretti goes on to show a number of very nice charts of the various credit markets and outlines the amount of impact the Fed has had on the "healing" of them. In many cases, the previous markets have disappeared and the Fed has become the market. Pretti concludes:

In summary you understand what is happening here. The BIG bottom line message is that the Fed is creating the impression or perception of healing in pockets of the US credit market. For those not willing to or literally unable to understand what is happening behind the scenes, many a headline credit market perception is actually a misperception when a light is actually shown on the facts of these various market segments. Where the Fed is involved, the perception of healing or stabilization can be created. Where they are not involved (corporate markets), continued stress is still plainly visible. In the endgame, credit market investors are smart. They are less emotional than equity investors. We believe many know exactly what is going on and the true character of supposed healing that has taken place with the Fed sticking all of its fingers in the US credit market dike that has cracked and has certainly not been repaired.

Alternatively, equity investors caught up in the momentum of the moment need to keep a sharp eye on exactly what is happening in the credit markets. After all, the Fed/Treasury/Administration is compelling us to do so as they constantly focus on “unfreezing” the credit markets. Absent the influence of the Fed, these markets are not yet recovering. Absent the Fed, the credit market patient is unable to get out of bed and walk on his/her own. Let’s just hope equity investors have it dead right in their happy anticipation in recent months. For if what they are discounting is correct, especially in financial sector issues, the US credit markets should very soon be involved in a Lazarus event – an immediate rising from the dead. But for now, it’s really the Fed holding up the credit markets, from which they cannot have a current exit plan by any stretch of the imagination. The credit markets ARE the issue for the current cycle. We need to keep this firmly in mind.

The whole time I was reading this article I had the funny feeling that I had already come across it. But long ago. The story sounded so familiar. Then it hit me:



Minyanville's "Mr. Practical" has come to a similar conclusion.

If people really did hard analysis on the current environment they would take a much different view. The Fed's balance sheet is not only irreparably massive, it is a mess with credit risk. When you hear people saying credit is improving, it can clearly be shown that the only areas of improvement are where the Fed has stepped in and become the market. The Fed has reduced transparency, not increased it.

Take any category where credit has improved and you will see that the Fed has taken and retains massive positions: Bank Credit Reserves increased over last year by $1.3 trillion, Agency Securities $70 billion, Mortgage Backed Securities $356 billion, Term Credit (LIBOR, the real headliner) $456 billion, Commercial Paper $238 billion (this market has shrunk dramatically so the Fed is basically the whole market), SWAPS (inter-dealer lending) $256 billion, and credit to AIG (AIG) $45 billion. These are the holes the Fed has stuck its finger in. If the Fed takes the finger out, the damn will bust.

These are both guys I have read and trusted for many years. Somehow I get the impression that they read each other as well.

It is clear that the Fed is distorting certain parts of the market. Nevertheless, the underlying reasons for the credit market contraction remain. Job losses continue, even though they are slowing. The number of Americans "underwater" on their mortgages is still rising. Mistrust in the financial system is building. And social willingness to further indebt themselves for short-term indulgences is diminishing. There is nothing the Fed can do to reverse these trends.

Ever since the crisis began in 2007, I have criticized the Fed's interventions as a futile attempt to cure the symptoms rather than the disease. Cough syrup will not cure pneumonia. But it might stop the person from coughing for an hour or so. Meanwhile, the patient's lungs are filling with water. When the drugs wear off (the Fed stops its interventions) the patient will deteriorate again. Either that, or an unforeseen symptom (pension funds, perhaps) will prove immune to the other treatments and attack.

The people referenced in this article have constantly used the words "perception" and "confidence." They have been improved at the expense of transparency. Whether or not Bernanke and Geithner can continue to prop up the dead corpse longer remains to be seen. As I have been writing in my Technical Updates, I think this rally will exhaust itself by either time or price. With this morning's (Thursday's) gap higher to 930, I took the opportunity to initiate some short exposure. The vast majority of indicators I follow are suggesting we have reached an apex in optimism, and the 930 level is close enough to my 1st target area of 940-950. I remain open to the possibility that the rally simply needs to correct itself before carrying on higher and longer. But after a nearly 40% bounce in 9 weeks, I believe the odds have tipped in favour of the prevailing trend - which is lower. Much, much lower.

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