Thursday, December 17, 2015

Back to the Future...

It's been nearly a year since I've posted anything here so I thought I'd make a couple of observations to keep the blog alive.

A number of people reached out to me yesterday in the midst of the "historic" Fed hike to better understand what the implications are for the economy.

1) Why is the Fed raising rates?

The Fed has painted themselves into a corner by failing to act in 2011, 2012, 2013, 2014 and most of 2015.  They have sent the message that the US and global economies are still in near crisis mode.  These extreme low rate conditions have also encouraged a great deal of undesirable financial risk taking on the part of consumers (auto and student loans) and corporations (taking out debt to buy back their stocks').  At this point in the cycle with unemployment around 5% there was no way the Fed could look at anyone with a straight face and say that we are still in the midst of an economic crisis.

Also, it's important to note that the Fed Funds rate has averaged about 5% for most of the past 50 years.  Since 2010 it's been 0% and we're moving to 0.25%, it might be worthwhile for everyone to take a moment and let that sink in.

2) Shouldn't higher rates be bad for stocks? Why did they soar yesterday?

Here is where logic gets you in trouble.  Yes, if interest rates rise and banks increase the cost of lending (many banks instantly moved up their prime rates yesterday) then, yes, this would imply that earnings could go lower and stocks should discount that fact.

However, that is a very 1998 way of thinking. There are two principal factors that the few remaining human traders have to keep in mind as it relates to the markets.

a) if everyone expects A, then B will almost assuredly occur and
b) the presence (or lack of presence) by the computerized trading firms rules the markets.

On Sunday it was clear that EVERYONE thought the Fed would hike and that would crash stocks.  Thus, it was clear to me that one or both of those assumptions were wrong.  I still expected the Fed to hike rates, so I was of the opinion that we wouldn't crash right away.  The second factor in yesterday's melt-up was vanishing liquidity. Right before the big announcement liquidity in the market (people placing quotes to buy or sell) evaporated to nearly nothing.

Think of the market like a water hose - when thing are going fine water pour out at a steady rate.  When liquidity evaporates as it did yesterday it's like covering the hose with your thumb - even if the amount of water is slowed to a trickle you can still make it seem like the hose is blasting water.  Yesterday one of the market commentators that follows liquidity told me "someone with very little money could swing the market 1-2% in an instant right now".  I believe this is what happened.  A few small traders moved the market substantially to their benefit.

3) So what's next?

This is the really big question on everyone's mind.  I would expect choppy trading from here to the end of the year but there are some very large traders that need to finish on a positive note so be aware that they may try to move thin markets when no one is looking.

However, the bigger question is regarding the timing of this move.  I believe that based on the old tools that the Fed uses they probably should have started this hiking cycle in 2011.  We likely would have interest rates at 4% and a lower stock market and while that would make it hard for some people to buy a new car or home, it would give the Fed policy tools if the US and global economies started to decelerate.

I believe that we are in the midst of this deceleration right now and some of the world's biggest economies are probably already in a recession.  This is what's most troubling for me - the Fed's obsession with keeping the banks and stock prices afloat has prevented it from position itself to act when the next crisis hits.  The Fed's balance sheet has grown from basically 0 to $4.5 trillion (yes, trillion with a T) in the past 8 years.  The only policy tools they have to spur investment - low interest rates and buying debt - are tapped out and they've not really spurred any productive investment in the US.

When you couple these factors with the global rout in commodities that is ongoing I think the Fed is in a very difficult spot (much of it of their own doing).

I know I've promised more frequent postings in the past, but my current prediction is that 2016 is going to be a year of fireworks in the markets (think 2000 and 2008) and I think there will be lots to discuss.

Thanks for continuing to check in on the blog even when I take a year off :)