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June 22, 2010

Trouble in Equity Land

The stock market is in trouble. I've recently been describing to Members how the violation of February's yearly cycle low is a huge warning sign regarding the viability of the cyclical bull, and that the break of the yearly low implies that the market should not be able to recover to a new high. There is corroborating evidence from various economic and technical data that the market faces strong headwinds.

baltic dry index

A declining Baltic Dry Index would certainly have to dampen the spirits of those counting on recovery. Less goods being moved around shows about as clear a picture of a stifled recovery as one can get. In fact, the demand picture shown by the BDI is substantiated by commodity price trends:

CRB Index

An economy in decline does not, in and of itself, imply lower stocks prices so much as create hindrances to advancement via lower earnings expectations. In fact, there is a long-standing myth that the stock market discounts the economy six months in advance. Statisticians point to decades of evidence showing how stocks began rallying a couple of quarters before economic growth was recorded. However, these statisticians, who are supposed to be professionals, ignore one of the most basic concepts in statistical analysis: multicolinearity. Simply put, the concept of multicolinearity recognizes that multiple factors may effect an observed outcome. So, despite finding a supposed correlation between two data series, the true causal relationship may be with a completely different factor. (The food industry loves to abuse multicolinearity, by the way).

The point here is that the stock market rallies these statisticians observed were not caused by any expectation of economic recovery. They were caused by easy money. It just so happens that in most cases easy money also leads to higher economic activity (multicolinearity). The 2009-10 stock market rally plainly reveals this causal effect, as a monster 80% rally did not lead the economy out of recession (don't believe the government stats). The market was reacting simply to the amount of new money being pumped by the Federal Reserve.

But we now have a problem: growth in M3 (as computed by the Fed does not publish M3 data anymore) has been plummeting for two years and, in fact, began contracting as we entered 2010:

M3 money supply

The Fed simply has not been printing fast enough to counteract debt deflation. Personally, I don't think they should attempt such folly (actually, I don't think the Fed should even exist), but when money supply contraction starts taking its toll on financial assets... which it will... this misguided cabal will put the printing presses in hyperdrive. The only problem is that their attempts will not have the desired effect... they never do... and we will likely see a stock market sliding down a slippery slope regardless of Fed efforts, much like we saw in 2001-02.


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