Proof the Economy Never Recovered from the Great Financial Crisis
To rescue the U.S. economy from the Great Financial Crisis, the Federal Reserve, or Fed, engineered the greatest monetary experiment in the history of the world. At face value, it appears the Fed’s experiment was successful: The stock market rose, real estate values rose, and unemployment fell. It’s taken nearly nine years for the American public to regain their confidence in the economy, but instead of creating prosperity for all Americans, the Fed blew the biggest asset bubble in history. This asset bubble, which the Fed is attempting to deflate, caused stock prices and real estate values to rise.
During the Great Financial Crisis of 2008-09, our banking system was on the brink of failure. Banks lent against inflated real estate values and as property values plummeted, banks quickly found themselves unable to meet their reserve requirements. In response, the Fed, or the lender of last resort, stepped in to the rescue the financial system. The Fed instituted a vast number of programs to remove the toxic assets from the bank’s balance sheet and replaced them with high-quality assets. Once the banks were stabilized, the Fed instituted an experimental program called Quantitative Easing to reignite the U.S. economy.
The Fed believes they can encourage consumers to borrow and banks to lend by lowering interest rates. To quickly lower short-term interest rates, the Fed needed to boost bank reserves. Banks are required to hold ten percent of their asset in reserve but generally, hold little to none over the required amount. The Fed used Quantitative Easing 1-3 to increase the amount of excess reserves, or reserves over and above the required amount, then paid the banks interest on those excess reserves to keep them from lending against them. The net effect was short-term interest rates fell.
The first indication the Fed’s policies weren’t working is the Fed’s initiation of three Quantitative Easing programs. The term “quantitative” implies the Fed knew the exact amount required to fix the economic problems, so by implementing three of them, the Fed clearly had no idea how much money was needed to fix them. The three Quantitative easing programs increased the monetary base, or commercial bank reserves held on deposit with the Fed, by nearly $4 trillion. Part of the $4 trillion is considered excess reserves, which jumped from zero to nearly $2.8 trillion. With interest rates at zero and the banks flush with money, the Fed was hoping lending demand would spur an economic recovery which would lead to an increase in inflation. Unfortunately, this didn’t work either.
Banks multiply money when they lend, which is expressed in the M1 Money Multiplier. The M1 Money Multiplier shows how much the money supply increases for every $1 increase in bank reserves. In the 1980’s, the Money Multiplier peaked slightly above 3, during the 1990’s it fell from a peak of 2.7 to 1.7, in the 2000’s it averaged around 1.7 and following the Great Financial Crisis, the Money Multiplier fell below 1. Since December 2008, the Money Multiplier has remained below zero, meaning for every dollar increase in reserves, less than one dollar enters the economy. This is proof the Fed failed to reignite the economy.
The Money Multiplier falling below one indicates several problems:
- There is too much debt at all levels of our economy.
- Banks chose to increase their reserves over lending. The lending data validates this, as bank lending growth is below where it was in the prior business cycle.
- Banks are having trouble finding creditworthy borrowers, which is why most of their lending has been to corporations. Rather than put the newly borrowed money to productive use, corporations are using it to buy their stocks back which enriches their executives whose compensation is based on the appreciation of the stock price.
- Quantitative Easing failed to stimulate the economy and instead led to the creation of the largest asset bubble in history.
- Future Quantitative Easings, if they are done, will not be stimulative.
- Inflation, as defined by prices increasing due to an increase in the money supply, is non-existent. Inflation cannot occur when the Money Multiplier is less than one.
- The Money Multiplier will fall during the next recession as lending demand dries up and banks cease to lend. This will cause interest rates to fall to new all-time lows, just as they have during past recessions when the Money Multiplier collapsed.
- The Fed may be unable to save the economy from the next recession.
We know asset prices are highly correlated to bank balance sheets because a simple chart of excess reserves against the S&P 500 shows a very high correlation between the two. This means as excess reserves fall, so too will asset prices, including stock prices. So far excess reserves have fallen approximately 30% from their peak, to where they were in 2014, while stock prices have only fallen about 8% from their peak. Stock prices and real estate values will eventually fall, because asset prices are sensitive to an expansion or contraction of the monetary base, regardless of how it happens.
The problem with falling asset prices is the amount of debt and leverage behind those assets. Take the stock market, where there is a record amount of borrowed money, or margin debt, that has been used to buy stocks. To make matters worse, Wall Street allows investors to leverage their stock holdings by borrowing against the value of their stock holdings, which is also at record-high levels. As stock prices fall, investors either must add money to cover their debts or they must sell their stocks. Due to the rapid speed at which equity markets move, computer programs now automatically sell stocks to prevent investors from getting a margin call. As selling begets selling, equity prices will plummet as they have in prior Bear markets.
The same thing happened with real estate during the Great Financial Crisis. Property values fell, and owners rushed to sell. This accelerated the fall in prices, leaving the banks holding underwater loans. Banks were forced to sell assets to meet reserve requirements, which meant they ceased to lend. The corresponding fall in property values, along with a drop in lending, led to a massive contraction in the monetary base and a recession.
The reason economies experience large boom and bust cycles are due to easy-money policies instituted by central bankers. The longer the expansion, the greater the ensuing contraction. As central bankers tighten the money supply, asset prices fall which triggers a wave of selling as investors flee for the exit. Today there are bubbles in equities, corporate bonds, some commodities and real estate – all courtesy of the Federal Reserve’s policies.
Those hoping the Fed will rescue the stock market will be in for a huge disappointment. Due to the extreme over-indebtedness of our society, there is a lag between the Fed acting and the economy responding. In the last two recessions, the lag was about a year and a half, but the next recession will likely see a lag of two years or longer.
The last twenty-one recessions were due to a tightening of monetary policy, a deceleration in the money supply, or both. Today, the Fed is tightening, and the money supply is rapidly decelerating. After two financially devastating recessions in the past eighteen years, one would think investors would learn their lesson, but they haven’t. With history as a guide, the massive debt and leverage under the stock market will be unwound, leaving many retirees in an unrecoverable financial situation.
For those who do not watch the weekly video or review the separately linked charts (in PDF format), the charts discussed in this week’s update will be included in the chart pack, and along with my commentary, in the video.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
After starting out the day up, most of the market closed in the red. The S&P 500, DJIA, Nasdaq-100 and Russell 2000 are all exhibiting major topping patterns. Sellers are clearly taking advantage of those who like to buy at the top. Trading volumes remain low as liquidity continues to dry up.
Treasury yields resumed their fall from last week and are moving back into strong buy zones that go back several years. Over the weekend there were many comments on FinTwit (the financial subsect of Twitter) about buying bonds to squeeze out the record shorts. Bond owners also got some help from weaker than expected economic data.
Even the sectors I was looking to trade in tomorrow for the Legacy Portfolios all fell. While I want to buy the dollar, I don’t want to buy it alone. Trading volume on the dollar is very low compared to most other sectors, so our position in it will also be very small. It will get bundled in with the other trades when we get a green light.
Agricultural commodities continue to push higher with a prior overhead “Sell Zone” as the next destination. If that holds, agricultural prices are headed much higher.
- What happened to the stock market on Tuesday?
The Bears pushed prices down early, but the Bulls pushed back a couple hours later. There is a clearly defined trading range where the Bulls are buying and the Bears are selling. As markets neared close, buyers bought Apple in advance of its earnings which pushed the major indices and other stocks higher.
Bonds sold off a bit after the ISM factory data came out showing growth in the factory sector slowed a bit. While New Orders and Employment slowed, Prices Paid rose. Inflationists seem to be hyper-focused on any news to justify their short bond positions, even though a decelerating money supply will lead to a rejection of higher prices. I expect yields to rise tomorrow in advance of the Fed meeting which concludes tomorrow. There isn’t a scheduled press conference, but the Fed will release a statement following the meeting.
Agricultural commodities are starting to break out, lead by the grains, which posted the biggest move of the day. I expect this trend to continue.
The Consumer Staples sector is fast approaching a very strong buy zone that was established in 2014 and lasted for two years before prices broke higher. I expect this to be a strong area of support and I’ve made the necessary adjustments to add it to the model. Momentum hasn’t flagged it yet, but I expect it will within a week.
Momentum is an interesting concept because it finds consolidation zones and attempts to identify the direction prices will move from a consolidation zone – either higher or lower. Based on all my models, momentum can lead price by two weeks or more. Momentum becomes an exercise in patience while waiting for prices to move.
The U.S. Dollar rallied up to a Sell Zone where it ran into a wall of sellers. What normally happens is sellers overwhelm buyers in an early breakout. This sends prices down to the prior Buy Zone, where if held, sends a message to the sellers that the buyers are coming. I fully expect the dollar to make its last move down before a proper buy signal is flagged. I’m hoping it comes with a signal for some other positions because the position in the portfolios will need to be small due to the thin trading volume on the dollar ETF. It is worth noting that professional money managers tend to wait until a security, or in this case, the dollar has signaled its breakout before buying. Few tend to buy on the first leg down, but I believe that will make the best entry point if the current Buy Zone holds.
Gold appears to be setting the stage for its final leg down, which I was expecting several months ago. If it does, then I expect the gold mining stocks to make their final move down to the bottom of their two-year Buy Zone. This would be an ideal price point to make our move in.
- What happened to the stock market on Wednesday?
The markets were mostly muted in anticipation of the Fed ending their two-day meeting. The minutes really didn’t say much other than it appears the Fed is comfortable letting “inflation” run as it is right at their 2% target. This will likely be a mistake later when they are forced to increase the pace of tightening to curb the effects. By the close, equities sold down, as if liquidity is drying up.
The bond market dipped a bit on the news, but what is interesting is bond flows or new money into bond funds, has been strong. With speculators holding a record short position, it’s only a matter of time before yields rapidly fall. The Treasury announced today the size of future bond auctions will be increasing. Massive deficits lead to liquidity drains.
The U.S. Dollar tried to move over an identified sell line but got pushed back after the Fed statement and surprisingly pushed a bit higher before close. Once some of the other signals trip, I can easily add it to the mix. Otherwise, it will have me rebalancing much larger positions at a time I’m not ready to bring them in.
Agricultural commodities pushed back down against the bottom of a “Sell Zone,” which is expected. This zone can flip to a “Buy Zone” if it holds. The crop reports, which I am covering in this week’s update, suggest ag commodity prices are heading much higher.
My momentum “buy” signals on a couple sectors broke down, meaning prices are moving back down. We are on hold but poised to move.
The bigger issue is the massive topping patterns in the major indices. Given the current price action, this could lead to a much larger correction in the near term.
- What happened to the stock market on Thursday?
Markets slid in early trading as the “Smart Money” continues to sell at a rate not seen since late 1999 and mid-2007. By midday, volatility fell and stocks rose, which is an indicator corporation may be buying their stock back again. There’s a blackout period during earnings season where corporations who are buying their stock back, temporarily stop.
The S&P 500 and DJIA both broke below their 200-day moving averages, and the story on the street is the 200-DMA is a spot where the public believes it is a safe point to buy. Once again, the 200-DMA was defended, for now.
Bi-annual momentum on the S&P 500 and DJIA are within weeks of turning negative. A break in bi-annual momentum doesn’t spell certain doom, but they have been a predictor of larger sell-offs when they occur at the end of a long economic expansion.
Bond yields ticked down a little and bond funds experienced strong volume, which is likely an indicator of buying activity. As I mentioned previously, bond flows have been strong, but speculators have been stronger. With yields holding despite historic record bond shorting, speculators aren’t likely to hold their positions too much longer unless yields start rising again.
Agricultural commodities now have a “Golden Cross,” which occurs when its 50-day moving average passes up through its 200-day moving average. This is generally perceived as a bullish signal. Ag commodities also closed over a critical support level, which should be enticing to traders who want to buy.
Annual momentum flagged again for the Utilities and Telecommunications sectors, which a few days ago turned back down. They are on the countdown again.
- What happened to the stock market on Friday?
Today’s equity rally was brought to you by Apple, who disclosed Warren Buffet is now the third largest shareholder. It is worth noting that Warren bought 75 million shares last quarter when Apple was trading around its all-time highs. Investors believe Warren won’t sell, so his large purchase, in addition to Apple buying its shares back, will put a floor on price. As if stock prices are based on who is buying or selling! Investors should focus on Apple’s growing inventory problem.
The April Nonfarms Payroll report was a miss, but the excitement over Apple was enough for market participants to ignore the report. Stock prices finished higher after breaking through a block of short sellers before stocks reached a spot where sellers have been strongly selling. The major indices are stuck in a relatively tight trading range, but neither the Bulls or Bears have a decisive advantage at the moment. The continued liquidity drain favors the Bears.
Bond yields jumped higher with stocks but traded down by market close. The key to understanding bond yields is there is strong buying from the large commercial market makers. While the public is being told to sell bonds and speculators are shorting bonds, the market makers (the big money) is buying up the entire supply. These big money investors are nearly always right, so if they are buying bonds, it means interest rates are headed lower.
Agricultural commodities ticked down to the bottom of the current “Sell Zone.” This is expected because this zone can’t switch to a “Buy Zone” until the buyers win out. Based on the crop reports that I am covering in this week’s update, the buyers are likely to win out.
The U.S. Dollar dropped slightly, but this is expected. Rallies rarely start out like a rocket, so I expect a pullback next week. If bonds can pick up steam, I can bring cash in and add the dollar to the portfolios at the same time.
Based on technical analysis, the charts of the major indices continue to show the big money is selling in a big way. They are selling in the same way they did before the last two recessions. While I’d like to add an equity position, I expect everything to sell off if these technical levels are breached. Will it be a week, two weeks or more before this happens? Unknown, but with the Fed draining liquidity, it’s only a matter of time before we find out.
Gold it struggling to find footing, which suggests it will fall to the lower “Buy Zone” that I mentioned in last week’s update. The miners barely moved today.
Trading volumes on the major indices were still below average. Any time there is a big price move on low volume, it means those do did buy, paid a big premium. Large price moves on low volume generally get reversed, as we’ve seen over the past couple weeks.
- Why aren’t you implementing your new strategy today?
Good question – the new strategy is a long equity strategy that hedges downturns by moving to bonds when annual momentum turns negative. Annual momentum for the S&P 500 is +13% and for the Nasdaq-100 is +24%. If we bought into either index today, we’d ride the market down an equivalent amount before the strategy will recommend we move back to our current position.
The more technical rule, which I cannot build a formula against, states when annual momentum breaks its uptrend line (it has), move to bonds. Again, where the legacy portfolios are today.
- What is the risk in the next couple months?
The Fed meets again in June where it is expected they will raise the Federal Funds rate +0.25%. In addition, the Fed has stated they will continue unwinding their balance sheet, which over the next two months is -$60 billion. A $60 billion drain of the balance sheet is equivalent to another +0.25% rate hike. Not to mention heavy government borrowing which repositions liquidity out of the economy and into the Treasury’s bank account.
Liquidity is being drained and equity investors are forewarned.
- What are the long-term risks?
Foreign central banks will have to tighten their monetary policy to match the United States. This happened in the late 1920’s when the Fed started to tighten and money flowed (along with gold) into the United States. As money left foreign shores, they had to hike rates to attract capital bank. Over easing followed by global monetary tightening led to the Great Depression.
- Does this mean lower or higher bond yields?
Bond yields are a function of monetary policy. When conditions are tight, yields fall. If the dollar rises, and I believe it will, then foreign investors will start buying U.S. Treasuries in a big way. This is how the bond short squeeze will be triggered – from a stronger U.S. Dollar. Much lower yields are ahead.
- What surprises you the most?
With the exception of traders expecting inflation as the money supply decelerates, it’s the relative calm of the Fed unwinding their balance sheet. I expected the public to learn by now that when the Fed tightens, you should sell, but they continue to buy. I’m also surprised the Fed’s unwinding hasn’t caused bigger shocks to the equity market – at least not yet.
Video Topic of the Week – Nonfarm Payrolls
Payrolls missed expectations, but stocks rallied. Underneath the report is showing continued signs of weakness. Tune in this week to find out my thoughts.
Chart of the Week –
Will bonds rally if the dollar rallies? Will equities fall if Bitcoin falls? Check out this week’s charts to find out!
Portfolio Shield™ Update –
Portfolio Shield™ remains fully invested in the S&P 500, Nasdaq-100 and Russell 2000. I anticipate the bond hedge showing up next month. The latest investment detail report is attached.