Central Bank Intervention or Real Economic Growth?

By: Money_Morning

Michael E. Lewitt writes: That was quick!

Shrugging aside concerns that a week ago sent markets reeling to near correction territory, all major indices bounced back strongly this week and made it seem as though the October 15 panic never happened….

By the Numbers

The S&P 500 soared by 4.1% or 78 points to close at 1,964.81 while the Dow Jones Industrial Average gained 425 points or 2.6% to end at 16,805.41. Although the Dow's gain wasn't as impressive in percentage terms, it may have been more notable considering that several key Dow components reported terrible earnings including International Business Machines Corp (NYSE: IBM), The Coca-Cola Co (NYSE: KO), AT&T, Inc. (NYSE: T) and McDonald's Corporation (NYSE: MCD). The NASDAQ Composite Index rose an impressive 5.3% or 225 points to 4,483.72 and the small cap Russell 2000 added 3.4% to 1,118.82.

Even the NASDAQ had to overcome weak reports from some of its largest companies.  Amazon.com, Inc. (Nasdaq: AMZN) reported its largest loss in years as its spending across its many businesses failed to produce any sign of profits. Investors sent the company's stock down by 8.34% or $26.12 on Friday to $287.16 but the company is still trading at a very high valuation on anticipation of future profitability with little evidence that it can produce.

Nonetheless, investors remain willing to give companies the benefit of the doubt. Netflix, Inc. (Nasdaq: NFLX), which just a week earlier disappointed and took a pounding, saw its stock regain 60 points from the $325/share intraday low it hit after its earnings announcement. On the week it gained $28 from its closing low last Friday of $357 to close at $385.02 as investors refused to throw in the towel on social media and other highly priced stocks. Facebook Inc. (Nasdaq: FB) also performed well, demonstrating that whatever fears sent investors fleeing a week earlier failed to spook the market's animal spirits as we head into Halloween.

What QE is Really Doing

The bond market settled down as well with the yield on the 10-year Treasury ending the week at 2.27%, a far more reasonable level than the 1.85% level it hit intraday on October 15. High yield bonds rallied strongly pushing the average yield on the Barclay's High Yield Index back below 6% (5.85% to be precise) and the average spread back to about 420 basis points. Just a week earlier these levels were about 80 basis points higher, illustrating how dramatically this market's illiquidity can impact prices. High yield has returned to being unattractive on both a relative and absolute basis as a result of this week's recovery. Interestingly enough, investors pulled more money out of leveraged loan funds and ETFs this week as well. ETFs have increased the velocity of price change in the leveraged finance markets.

The question remains whether stocks have seen their highs for the year as well as their lows.  Next week the Federal Reserve will formally terminate QE3. The last two times the Fed ended QE, the S&P 500 dropped by about 20% over the following three months. Observers are debating the causes of this month's sharp sell-off. I would attribute it to a confluence of factors – a growth scare emanating primarily from Europe, the Hong Kong protests, other geopolitical problems, concerns about the imminent end of QE3, and Ebola. There may have been another more technical factor that contributed to the sell-off as well – an inflation scare.

Inflation expectations have dropped to a level that has triggered previous sharp sell-offs in the S&P 500. Since July, the average expected five-year inflation rate has declined from 2.1% to 1.6% (as measured by 5-year TIPs), back where they were at the depths of the recession in the fourth quarter of 2009. This is the third time inflation expectations have dipped toward the 1.5% level in the post-crisis world and each of the first two times the S&P 500 sold off sharply.

The Fed responded to those two earlier sell-offs with renewed bouts of QE and Fed officials (as well as their European cousins) were ready with reassuring comments this time as well and the world was all too ready to heed their siren songs. The only problem with this picture is that they are singing from an empty song sheet.

Quantitative easing may have worked to prop up markets but it has failed to produce sustainable economic growth or inflation. Instead, both growth and inflation are flagging throughout the world with the possible exception of the United States (and it remains questionable whether U.S. growth will continue once the Fed stops buying bonds next week). European QE may provide a short-term boost to markets but faces the problem that there likely aren't enough bonds available for purchase to generate the type of growth necessary to drag the region's economy out of its doldrums. As a result, markets are rallying on a series of promises that are likely to be broken. Like the sirens in the ancient Greek myths, central banks are luring investors to disaster. Central bankers may be seeking to produce economic stability through their unconventional policies, but they are instead creating hollowed out, debt-ridden economies that exhibit sluggish growth, financial asset inflation, grotesque levels of income inequality, structural unemployment, and disguised but dangerous levels of market instability that are leading to another crisis.

This is another way of saying that investors likely got off too easy this month.

The sell-off did little to purge the excesses in valuation and leverage that have built up since the last time the market experienced a genuine correction. Margin debt was $463 billion in August, much higher than the $381 billion seen in 2007 before the financial crisis. Most likely only a small fraction of this was purged in last week's sell-off. No doubt some hedge funds and other investors were flushed out of positions and suffered serious losses as a result of being ill-prepared for well-telegraphed volatility. But investors who did what they have been taught to do and ignored the drama were barely hurt at all. And now it appears than many investors are heeding the Happy Faces on CNBC who are urging them to "buy on the dip" and pile back into equities. That would be a serious error even if the market continues to rally because the underpinnings of the markets are increasingly fragile. Instead, investors should now be asking themselves whether they should be trimming their sails as markets head into choppy seas. QE is still coming to an end; geopolitical strains are still increasing; growth outside the U.S. is still faltering and could falter inside the U.S. as well.

The only piece of good news appears to be that Ebola, despite the unfortunate diagnosis of a doctor in New York City, should be contained in the West if people use their heads (although it remains very much a threat in West Africa).

Mixed Earnings Reports From the Titans

Despite some good earnings reports late in the week from Microsoft Corporation (Nasdaq: MSFT), General Motors Company (NYSE: GM) and Caterpillar Inc. (NYSE: CAT), the overall earnings picture is mixed and still flattered by massive stock buybacks rather than sustainable organic factors. The stock market is not cheap by any reasonable measure and further gains will require a combination of strong economic growth and corporate earnings momentum. They will depend on low interest rates and other monetary support that are more likely to dissipate than strengthen in the months ahead. In truth, the Federal Reserve remains far more important than anything corporations are doing in supporting stock prices. Now the Federal Reserve is either going to remove this support or feel compelled to continue because growth is weakening, and either scenario would bode poorly for stocks over the next couple of years. As legendary investor Leon Cooperman said recently on CNBC, the stock market will be very unhappy if interest rates are as low a year from now as they are today because that would mean that economic growth has been very weak.

Last week's rally offered investors a reprieve from what could have been a very ugly sell-off. They should take advantage of this opportunity to take some money off the table rather than chase further gains in a highly manipulated and volatile market.

Source : http://moneymorning.com/2014/10/26/learning-how-to-distinguish-real-growth-from-fed-meddling/

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