BERNANKE HELPS FUEL AN INCREASINGLY EXPENSIVE MARKET

As the market continues to grind higher each and ever day it’s useful to gain some perspective on just how much Bernanke is impacting valuations and generating disequilibrium in the market.  In order to do so we’ll review a number of long-term valuation indicators.

The first is Warren Buffett’s self proclaimed favorite valuation tool (see here for more).  He uses the total market cap of the US stock market compared to GNP.  He has generally maintained that levels below 80% are bullish.  The latest reading of 106% is well below the levels seen at the last two market peaks, but well above the historical average levels.  You will notice that the permanently high valuations coincide with the Greenspan Put which has now morphed into the Bernanke Put.

John Hussman’s latest piece succinctly describes the current market environment in which Ben Bernanke continues to encourage speculation and malinvestment.  As we all know by now it is Bernanke’s goal to keep asset prices “higher than they otherwise would be” in an attempt to generate a self sustaining economic recovery through asset prices.  This is the insane notion that nominal wealth will lead to real wealth.  In fact, Ben Bernanke has this quite backwards.  Fundamentals drive real wealth – not nominal price increases.  But two bubbles in one decade doesn’t teach this man a lesson.  Hussman elaborates:

“Last week, the S&P 500 Index ascended to a Shiller P/E in excess of 24 (this “cyclically-adjusted P/E” or CAPE represents the ratio of the S&P 500 to 10-year average earnings, adjusted for inflation). Prior to the mid-1990’s market bubble, a multiple in excess of 24 for the CAPE was briefly seen only once, between August and early-October 1929. Of course, we observe richer multiples at the heights of the late-1990’s bubble, when investors got ahead of themselves in response to the introduction of transformative technologies such as the internet. After a market slide of more than 50%, investors again pushed the Shiller multiple beyond 24 during the housing bubble and cash-out financing free-for-all that ended in the recent mortgage collapse.

And here we are again. This is not to say that we can rule out yet higher valuations, but with no transformative technologies driving the economy, little expansion in capital investment, and ongoing retrenchment in consumer balance sheets, I can’t help but think that the “virtuous cycle” rhetoric of Ben Bernanke is an awfully thin gruel by comparison. We should not deserve to be called “investors” if we fail to recognize that valuations are richer today than at any point in history, save for the few months before the 1929 crash, and a bubble period that has been rewarded by zero total return for the S&P 500 since 2000. Indeed, the stock market has lagged the return on low-yielding Treasury bills since August 1998. I am not sure that even members of my own profession have learned anything from this.”

Using his expected returns methodology Mr. Hussman is looking for annual returns of just 3.15% in the coming decade:

Dshort brings us the Q Ratio which has now hit “nosebleed” territory again.  This is consistent with the other metrics which all showed relatively stable ranges until the Fed began its unusual policy of propping up markets following the 87 crash.  The latest reading of 1.17 is well below the Nasdaq bubble peak, but is higher than any other historical peak.  “Nosebleed” could be an understatement.

As I mentioned in December, we have to ask ourselves if any of this matters as long as the Fed is directly involved in promoting speculation.  It’s now clear that the Bernanke Put is well ingrained in every investor’s head.  Never has the Federal Reserve been so explicit about propping up asset prices and it has created a speculative frenzy that has every investor trying to front-run the Fed.  The problem for the Fed will be letting their foot off the gas.  They have created a beast that they likely no longer control.  When and if the Fed ever ends QE it is likely that markets will begin to revert to the mean.  This will likely force the Fed’s hand to stabilize markets.  So what we’ve created with this explicit backstop is a positive feedback loop.  Can the Fed ever get out of the market now?  And if they don’t it’s likely that markets will spiral higher until they cannot control the inevitable collapse.

The foolishness of current Fed policy cannot be downplayed.  Let’s hope for the sake of US citizens that they are as quick to take credit for the inevitable market decline as they have been about taking credit for the rally.  For once they admit to having contributed to malinvestment and misallocation of resources we can likely begin mounting a case that closes this horrible chapter in American history where the Central Bank attempted to turn our economy into a financialized ponzi scheme.

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Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Derfem

    “Faith in the FED is the last bubble”….

  • JH

    I thought this was the last bullet in the chamber,QE2, but now I realize there are no bullets left after tech bubble, Greenspans put, Glass/Segal,CMO,Housing bubble. Its really to stop the bleeding.

  • Brandon Ferro

    No bullets left? What’s the chart show? The Fed has been capable of engineering permanently high valuations. Their bullets are infinite and history now proves they can indefinitely keep the ball in the air. Additionally, there is ZERO political will to stop them…

  • Bellwether

    Brandon the charts, or at least the GDP v S+P and CAPE charts, show the market collapsing at lower high valuations over time, suggestive of the Fed policy having reduced impact over time.

  • http://Instigator928.blogspot.com Instigator928

    Why blame Bernanke? It’s the American peoples’s fault (along with the leadership that the few that vote elected). All of a sudden everyone cares now if he inflates everything so the people can continue to drive around in their rented cars, live in their borrowed houses and complain on their computers. The USA mindlessly achieved one of its most important goals…to export capitalism and democratic ideals. The communists fell apart (a la Karl Marx) and their people are adopting our ways. Soon they will be eating plenty of meat (a la McDonalds) while driving their rented cars back to their borrowed houses. The rest of the world won’t be able to afford the buns for the burgers…but the USA and most of its people never cared anyway…

  • Mikie

    Its an alarming picture!

    The Bulls will argue that the graph is meaningless as “Margins” are considerably higher than the average over the period of that graph and that interest rates are also alot lower than the average, affording higher valuations etc etc

    Naturally, they ignore the following;

    Margins are cyclical. Aided with cost cutting / job cutting etc. But at some point one companies costs becomes another companies revenue. That isn’t obvious now with all the stimulus spending papering over the cracks

    So I guess

    if you are bullish you say we have reached a “permanent plateau of higher margins and lower interest rates” allowing us pay a higher % of GNP than before. This time it is different!!

    If you are bearish, you argue that Margins are cyclical. Govt stimulus will hit a brick wall at some point… you cant have ever growing deficits and low interest rates forever. Once the stimulus rug is removed (either by choice or by the market), GNP, Margins etc etc are all vulnerable to serious correction…Thats when stocks markets halve

  • apj

    “Soon they will be eating plenty of meat (a la McDonalds)”

    …you have a vey loose definition of “meat” I see…..:)

  • boatman

    we have the DOW bubble, next the gold bubble.

    ride the bubbles in a bubble world.

  • Anon

    I thought QE was largely ineffective, both because of the reasoning you have posted before (Treasuries are “near money” and therefore in a low interest rate world, asset swaps don’t increase M2) and because of the subsequent real world experience where interest rates have risen. Unless you are talking about the Fed successfully changing inflation expectations through moral suasion.

  • AWF

    Simplistic analysis

    What are earnings reduced by (1950) Dollar value.

    What are earnings reduced by Gold prices.

    If earnings are reduced by the gold price could we be mildly overvalued??

    American’s think that US dollar is the only money.

    Around the globe people think Gold is money–

  • wh10

    This is my issue as well, with Cullen placing blame on the Fed.

    He has taught me why QE2 does nothing to fundamentals.

    In a recent blog he has admitted Ben has never said “go buy stocks because I said so.”

    In recent Fed press releases, I have not read language that would be any reason for investors to be so bullish. If anything, the opposite.

    So I still am wondering what the rhetoric is that Cullen speaks of. Though he may think the markets are so unthinking in this environment that they interpret any Fed action as proof enough for a future recovery; and thus the only good Fed policy right now is no policy.

  • MDR

    Will you please explain the transmission mechanism from QE2 created reserves to asset price increases? If QE2 is not creating “money” then where does the capital come from to raise asset prices? Is it all self-fulfilling – investors believing that it will raise asset prices so they behave that way?

  • wh10

    Per your last point, that would have to be based on the assumption that the market does not properly understand QE2 as Cullen explains it. Which is possible, but partially difficult to believe. Then again, it seems most do not understand MMT. But I join you in asking this question.

  • http://www.pragcap.com Cullen Roche

    Is it having a fundamental impact on the economy? I see zero evidence of that. Is it helping fuel another speculative boom. Yes.

  • http://www.pragcap.com Cullen Roche

    No fundamental reason. This is an important distinction. It’s psychological. When you tell people one of your goals is to increase asset prices then you’re explicitly saying that the Bernanke Put is a good idea.

  • chris

    hey mikie, i’ve liked your posts in past. with this one, i would simply say that context should matter to an investor. hussman is a little too rigid.

    of course the shiller pe will look high when you come out of a recession. but the period when you come out of a recession is the time to buy (context) as opposed to the time to sell or hold.

    so when hussman says, “We should not deserve to be called “investors” if we fail to recognize that valuations are richer today than at any point in history, save for the few months before the 1929 crash, and a bubble period that has been rewarded by zero total return for the S&P 500 since 2000″, he is talking like an academic, not an investor.

    what would he recommend, wait for valuations to increase so the shiller pe goes down and then invest?

  • http://www.pragcap.com Cullen Roche

    I am not sure what you guys have been reading. Bernanke has taken credit for the equity rally in numerous recent speeches….

  • chris

    oops, replace valuations with earnings.

    my point is that if you wait for earnings to increase to lower the shiller pe, you are already on the sliding slope of the cycle.

    if you wait for valuations to decrease, then that’s ok is suppose, that just puts you on the bench until the next cycle, and there is money to be made in the interim.

  • http://www.pragcap.com Cullen Roche

    Uh, I have never said that Ben didn’t want higher stock prices. That has been his goal for months now and his commentary has been consistent for months on end.

    http://www.nytimes.com/2010/11/07/your-money/07stra.html

  • Dave

    The point is that QE2 does not add “net financial assets” to the system, but it does change the mix of assets. With fewer treasuries to hold, the choice for investors is to either hold cash and get no return (or negative real returns) or buy riskier assets a la commodities and equities.

  • Mark

    Considering that a great many businesses are private (especially the very profitable ones) and therefore are not reflected in the U. S. Stock Market Cap. – folks should really pay attention to this.

    The very profitable businesses have increasingly gone private in the past dozen years and this trend will continue.

  • chris

    mark, i wonder whether, with the financialization of america, the raito of private businesses value to total business value has actually gone down over the past, say, 50 years.

  • B Ferro

    No fundamental impact? With all due respect Cullent, how can you say this? Didn’t you read the WSJ article this morning that highlighted the fact that for the first time in this recovery, investors can feel confident that the one thing that wasn’t in place for the bulls previously, that being revenue growth, has emerged with reckless abandon? To wit, revenue growth for the SPX actually increased QoQ in 4Q10. Why? Accelerating consumer confidence and purchases. So, while it may have no true mechanical impact on the economy, QE, as your intelligently point out, does in fact have a psychological impact. And as Soros so succintcly coined it, “reflexivity” is all that matters sometimes in financial markets and the economy.

    I keep hammering away at this and luckily price action continues to confirm it for me, but we are so knee deep in the $hit now with respect to market/economic dependence on the Bernanke/Fed psychological put thing that they CAN never and will never extricate themselves from what’s going on.

    Bernanke tells us every chance he gets now that 1) he wants higher stock prices, 2) he’s getting them because of QE, 3) inflation, according to his metrics is nowhere to be found and 4) unemployment is still too high. All four of these things add up to one important reality – there will be MORE QE coming.

    And because markets take illogical policies to their logical extreme (call it Ferro’s version of reflexivity) the only logical thing for everything to do is go up in price every day (almost). This is such an important distinction – we all can sit around calling the market irrational because it looks like a bubble again but in reality, what it’s doing is the most rational thing it could be doing – taking the illogical to the logical extreme, just like in sub-prime housing when politicians/Fed implied all people should own a home regardless of credit/income – sure enough, bankers made sure it happened.

    And most ironic of all, people look at this price action and banker-fueled sub-prime as the markets and capitalism failing when in reality, they are working to absolute perfection – profit maximization through playing by the rules they’re given to play with.

  • rhp

    Cullen, Dave.

    OK, here’s my question. I understand that QE2 is just an asset swap, changing the nature of the reserves. But if the banks cannot use reserves to lend, and all the Fed is doing is changing the term structure of reserves being held, then how can the banks use reserves to invest in equities, commodities, etc??

    Thanks,

    rhp

  • http://www.pragcap.com Cullen Roche

    Brandon,

    So now we’re attributing higher revenue growth to QE? Explain to me how that could be? There is no evidence that shows QE is having a fundamental impact on the economy. None of the transmission mechanisms through which QE works are actually positive. And if you want to say that equity prices are making everyone feel better then the logical question is how about rising commodity prices and falling home prices. Or do you conveniently ignore those in your analysis like BB does?

  • http://www.pragcap.com Cullen Roche

    Banks as a whole can’t “get rid” of reserves. This is exactly the same as the cash on the sidelines myth. Your cash doesn’t disappear when you sell stocks. So, if BAC wants to run out and buy stocks then they always have the right to do that. Just like they did before QE when they owned the bonds. They sell the bonds, buy the stocks, presto changeo! Someone else owns the bonds, BAC owns the stocks. They would do the same now. Sell the reserves, buy the stocks, presto changeo! BAC owns the stocks, someone else owns the reserves.

    It’s really that simple.

  • wh10

    I never said you said that. I said exactly what I said. Word for word from a post a couple days ago (http://pragcap.com/three-things-i-think-i-think-21):

    “You’ve clearly misinterpreted how the Fed intended to raise equity prices. The goal is to reduce int rates and increase the relative value of equities. Bernanke described this several months ago:

    “Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration.”

    So the channel through which QE works is the int rate channel. Bernanke never said: “I am going to talk up equity prices with the hope that people will just buy them”. Although that has likely occurred to some extent it’s clear that he was targeting lower rates. Anyone who denies this does not really understand how QE is supposed to work.”

    Emphasis Added: “Bernanke never said: “I am going to talk up equity prices with the hope that people will just buy them”.”

    Latest press release from the FOMC: http://www.federalreserve.gov/newsevents/press/monetary/20110126a.htm

    I just don’t see the rhetoric that should be so terribly convincing to the market. Furthermore, scant articles and speeches coming months after the beginning of the rally isn’t strong proof of causation.

    Let’s say the Fed never did QE2. Then what do you think would have happened? It seems the Fed could have still caused a market rally, according to your perspective, simply because they exist and express hope for an improved economy, as that’s part of their mandate. How can you fault them for that? They’ve run out of tools and fiscal policy isn’t kicking in as MMT would like it. It’s damned if you do and damned if you don’t and seems to be more a case of stupid market participants than an irresponsible Fed.

    Or do you really think we wouldn’t have this market bubble without QE2, controlling for whatever language the Fed would have used in absence of QE2?

  • Mark

    Good question.

    I know from my own experiences these 60 odd years – I see most truly profitable businesses not at all interested in the “Wall Street Dance.”

    But we do see lots of public companies taken private, leveraged up to the hilt and then spun out to the marketplace again.

    The end result of this is further and further concentration of wealth in fewer and fewer hands.

    Ultimately – this will not end well.

  • rhp

    Thanks Cullen,

    I’m getting hung up on “banks cannot lend reserves”. So my question is, if they cannot LEND reserves, how can they SPEND reserves?? Do they lend AGAINST reserves, but not the reserves themselves?

    rhp

  • http://www.pragcap.com Cullen Roche

    I think investors are convinced that QE is really fueling inflation. You wouldn’t believe how many people can’t understand that it’s just an asset swap. So, they think that the POMO’s and other operations are really helping bolster equity prices. And they’re putting their money where their mouth is. It’s changed the psychology of the market even though the transmission mechanism through which it was supposed to work has failed.

    It’s impossible to say how much of this rally is due to the Fed, but it’s clear that he’s emboldened investors and helped to generate a “buy the dip” mentality. I think it’s clear that the vast majority of this rally is due to real fundamental improvement, however, it’s foolish to say that QE is having no psychological impact and at the end of the day, that is what drives equity prices – the eagerness of investors to buy and sell.

  • http://www.pragcap.com Cullen Roche

    So the trillion dollar question is – how do we reverse it?

  • http://www.pragcap.com Cullen Roche

    Loans create deposits. Not vice versa. Banks are capital constrained. Not reserve constrained.

  • rhp

    I’ve read that statement above 50 times now over the last 4 months. I understand that (I think I understand that). But some how, your statement above doesn’t help me understand being able to lend versus not lend “reserves”. Sorry for my density. I’ll try at another time…….

  • http://www.pragcap.com Cullen Roche

    The point is RHP, that banks don’t need reserves in order to lend. They can find the reserves after the fact. Does that help?

  • B Ferro

    I hear you on your push-back; no doubt rising commodity costs and housing hurt the consumer. But let’s play sociologists for a second and not market participants. Do consumers get a statement each month telling them their housing went up or down X% like they do equities? Nope. The market, and Bernanke knows this, is a lighting rod in consumers’ minds – they derive all of their confidence from those statements and the nightly news. Is the market up or down? That’s all they care about. I consider my Dad an extremely smart man. That said, no matter what type of factual analysis I show him about where we stand with respect to economic structural problems, valuation issues, blah, blah, he always comes back to me with the following: “Everything I read and hear on TV and the bankers I work with are pretty bullish, so what gives in your analysis?”

    And, per the blow ups in stocks like KFT, WHR, PG, etc., we’re finding that only in the rare case are commodity costs actually being passed on to consumers with most so far being eaten entirely by the staple companies.

    It is madness indeed, no doubt, but it appears to be at least temporarily working.

    I would add for you the following data point I ran today – on Friday the Dow was up for 93 / 155 trailing trading days, or 60% of the time. Other points through history where that has happened inlclude August 1929, August 1987, June 2006 into the correction, October 2007 and late March/early April 2010. To be sure, it has happened at other points in history and the Dow has continued to climb, such as the mid 90s or has only consolidated, but all of history’s great declines (i.e. dramatic, fast crashes or panics) have had this overbought condition associated with them…FYI.

  • B Ferro

    I’m trying to think like a sociologist and not a market participant. Clearly, the consumer accelerated in 4Q10. But why? PI and HEG were weak. I think it was entirely psychological. None of us get a statement every month detailing the value of our house investment, but the same is not true for equities. Even my father, who I consider a very intelligent man, scratches his head at all I show him analysis-wise and suggests instead to me that “everybody I talk to and everything I hear on TV seems to be pretty bullish, what gives?”. The market is the most important confidence building/destorying tool in this country. And, so far, per the blow ups in consumer related stocks like KFT, PG, KMB, etc., commodity costs are not really finding their way to the consumer.

    Food for thought – I ran some historical conditional formatting today as on Friday the Dow was up 93/155 trailing trading days, or 60% of the time. To be sure, this has happened plenty times in the past where the market just consolidated or even trade higher (mid 90s) but all of history’s great crashes/fast panic declines were immediately preceded by this condition’s existence. To wit, we had it as follows:

    – Aug 1929
    – Aug 1987
    – Jun 2006 into a 6% correction (10% SPX)
    – Oct 2007
    – late Mar/early Apr 2010

    Just saying, FYI…

  • B Ferro

    No idea why I am commenting 2x on stuff now…weird. Doesn’t go through at first but shows up later.

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    I’m not sure what the argument is here – unless I’m losing my mind.

    You’re right, banks don’t need reserves in order to lend, but in order to BUY stocks all they have to do is sell their bonds to the Fed when Mr Sack shows up at 10.15 every morning – correct? When you say it’s just an ‘asset swap’, this is presumably what you’re referring to? In which case, although the total value of assets in the system remains unchanged and the money supply does not increase, the value previously held in bonds is flowing into stocks & commodities etc. creating asset price inflation.

    The impact on markets of QE is therefore not merely a psychological phenomenon – though that is part of it – it is real money being re-allocated by the banks from bonds into stocks. Or am I going insane??

  • http://www.pragcap.com Cullen Roche

    Net financial assets are unchanged following QE. The banks sell bonds, get reserves. What they do after that is up to them. But it’s nothing they couldn’t have done before. They might be more eager to change their portfolio allocations, but there is nothing fundamentally different following the Fed’s purchases. The net financial assets are the same.

  • MDR

    Is it possible that some of the increase in asset prices is from loans made by the banks to prime brokers who in turn lend it to hedge funds, CTAs, etc? I believe the leverage levels in hedge funds has been rising and the primes are much freer with capital to hedge funds than they were in 2008 when they nearly squeezed a number of funds out of business by recalling leverage. Perhaps this is one way that bank loans are working into asset prices.

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    So my understanding of the mechanism is correct – yet you’re saying you’re not sure if that money is going into stocks??

    If the banks ARE buying stocks, that explains the historic momentum, the clockwork entry of money into the market during the first hour of trade, the meaninglessness of major sell signals from numerous reliable technical and sentiment indicators etc – not to mention the fact that stocks only fell in any meaningful way since March ’09 in the gap between the end of QE1 in March ’10 and Ben’s Jackson Hole wink to markets in August.

    If the banks aren’t buying stocks, we’ll need a pretty good explanation for where that extra $600billion is going! Any ideas..?

  • Dan Dell

    “Margins are cyclical.”

    I agree, but that depends on your view on why margins are so high today. If we assume as a base case, that the economic situation is structural and not cyclical, and that margins are due to lack of capex and hiring, one could argue that until structural issues are ironed out and growth in demand occurs, capex and hiring will remain low and margins high. That is, unless inflation hits margins. But then again, that depends on both your view of inflation and of the pricing power of companies you are investing in.

    Put simply, either this is a cyclical recovery or not. And if you view the situation as structural, margin can stay rather high without total “reversion to the mean.”

  • http://www.pragcap.com Cullen Roche

    Yes. It could certainly be due to leveraging.

  • Obsvr-1

    1) Make fraud a crime again … remove, punish those that are corrupting the financial system.

    2) End the TBTF doctrine, let the market operate such that losers lose with their owners/investors taking the hit. This would constrain the wild speculation and leveraged positions as the risk would be retained by those taking the risk.

    3) End the corpratocracy which entangles the gov’t (supposed policing org) with the banks and big business. What we have is the criminals are the cops and move seamlessly through the revolving doors.

    otherwise the boom/bust/BAILOUT cycle continues … and unfortunately the amplitude continues to expand. I suspect if the system is not “fixed” then we will ultimately reach a point where the ‘straw that breaks the camels back’ moving the 99%-ers to a history making event.

  • http://www.pragcap.com Cullen Roche

    There’s no net new buying power is the point. If the banks had wanted to do this before they could have. There was nothing stopping them. But you could argue that investors are more eager to buy stocks now that they know there is a Fed backstop. That’s the point.

  • FDP15

    Cullen, I was following along with you at Lee Adler’s website. Looks like you really got him riled up. The surest way to lose an argument is to start calling people names like a little kid.

    I don’t know how you maintain your patience with people like that.

  • Obsvr-1

    The banks can lend, but only if there is someone willing to borrow or borrowers that meet the banks renewed conservative underwriting requirements.

    Also, if the banks are effectively loaned up to there capital requirements (leverage limits) then they would be tight on lending.

    so it comes down to

    If the bank has the capacity to loan, but can not find a borrow that meets their condition to loan results into the “liquidity trap”.

    So the question is do the banks really have the capital to support new loans, we don’t actually know this because of the suspension in MTM FASB rules.

  • Dimm

    TPC also ridiculed Krugman for the thought that the FED can talk up the market and change expectations.

  • nottpc

    Why do you say it is money we don’t have. I put 100K in netlfix in seo…bebernanke QEs us to the moon. I sell netlfix today and I have a lot of very real money. I can go buy farmland or a mercedes or 10 vacations. It is money. He has created it for me.

    Yes it will crash someday because its unsustainable but if it crashes from bernanke sp 2200 rather than no bernanke sp 1275 we still win and ben created wealth

  • nottpc

    Amen look at steve schwartzman and freescale semi

    I hear now this LBO which blackstone bought 4 yrs ago and larded with debt while PE lined their pockets for doing this “service” is set go IPO now as a bloated pig. With Bens easy money and a dearth of alternatives it will work and The boys at BX laugh all the way to the bank with their 15% tax rate.. Ibanks make their fees for helping to take it private and now back public…just a circle jerk.

  • http://www.pragcap.com Cullen Roche

    It’s nominal wealth. Not real wealth. Ben can’t make companies more valuable by changing the pool of financial assets in the pvt sector.

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    ‘If the banks had wanted to do this before they could have.’

    Excuse me, but with what resources? Who else would buy their bonds in such vast quantities? The point, surely, is that without a ready buyer of their Treasurys they don’t have the liquidity to buy up stocks in the way they plainly have.

    You’re clearly correct that the Fed is providing a psychological backstop – but it is also providing the pure green liquid cash. Of course the NET buying power in terms of asset value is no different, but the argument is purely academic since they now have that buying power in liquid form.

  • http://www.thompsoncreekwealth.com Lance Paddock

    Chris,

    Your criticism applies to traditional P/E ratios, not Shiller or Hussman. Those ratios are specifically designed to adjust for the business cycle.

  • http://www.pragcap.com Cullen Roche

    Are you denying that tsys are one of the most liquid assets on the planet? You can buy and sell tsys on the open market easier than just about anything in the world. I dont even know what you mean when you say that the banks could not have sold their bonds before QE….That’s illogical. That’s like saying that you can’t sell a share of AAPL tomorrow morning if you want to….That’s entirely incorrect.

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    A share of AAPL? We’re talking about $600billion – two-thirds of China’s entire treasury holdings – in the space of six months. Of course Treasurys are liquid, but what we’re seeing here is exceptional.

    While the Fed’s back-stop has made it psychologicallly ‘safe’ to pile into risk assets, it is clear that the massive, guaranteed flow of liquidity from Uncle Ben has made such purchases possible at a hugely accelerated rate.

  • http://blogfirstrider.blogspot.com/ first

    Don’t forget to sell some for dollars before you do your groceries.

    Gold his not money its a metal. Its up so what… so is oil and platinum and everything. Even Iron is up more than 100% in the lats year. Any thing can be called money but it would be kind of stupid to waste energy extracting a and storing a commodity in order to give an intrinsic valuation to a medium of exchange.

  • rhp

    Cullen,

    “There’s no net new buying power is the point. If the banks had wanted to do this before they could have. There was nothing stopping them. But you could argue that investors are more eager to buy stocks now that they know there is a Fed backstop. That’s the point.”

    Onthemoney and I are in similar understanding-misunderstanding straits I do believe. i.e. I’m saying “yes” to his questions in his posts and “huh” to yours…. So…..

    1) I understand banks do not need reserves to lend, and that they can find the reserves after the fact.

    2) I understand that the net financial assets are unchanged and there is no new buying power in the system after QE2.

    3) i DON’T understand some terminology, like….Is the bond the bank held before the Fed bought it a “reserve”? If not, then is it just convention to call an asset a “reserve” when it is a zero term instrument (cash) versus a termed instrument (trsy)??

    4)”But you could argue that investors are more eager to buy stocks now that they know there is a Fed backstop”………….

    What exactly IS the Fed backstop, since you argue that QE2 is a non-event? Seems like the only “backstop” is a shifting of term structure that is influencing asset allocation (speculation in equities and commodities) based on psychology or trying to chase some kind of return more than trsys and more than cash (thus, the rising trsy rates as no one wants to buy trsys, which is paradoxical to what the Fed expected).

    From what I understand from reading your site, there IS no backstop!

    So, could you clarify your position on whether there actually exists a backstop or if it is all psych and perception??

    Thanks Cullen. Your insights and replies are always much appreciated, even at what I consider my “junior” level.

    rhp

  • http://www.pragcap.com Cullen Roche

    I don’t really see your point. Turnover is greater than $500B in the US bond market every day. There was nothing stopping the banks from selling their highly liquid tsys and buying stocks before QE happened…..

  • http://www.pragcap.com Cullen Roche

    Think of reserves as overnight loans earnings 0.25%. Banks don’t get rid of them.

    Here is what happens before and after QE. Banks buy bonds from govt. After QE2, the govt comes back and says give me those bonds. Banks get reserves, govt gets the bonds. So, now there are fewer bonds in the marketplace. But this doesn’t mean there is more fuel to go on a buying spree. The banks always had this fuel. All they had to do was sell their tsys and buy stocks or whatever. But they didn’t get rid of the bonds and make them disappear. They would have sold them to someone else. Just like they have to do with the reserves. If one bank wants to sell their reserves and buy stocks then they do it. But then some other banks owns the reserves and not the stocks. There is no net change in the amount of outstanding financial assets.

    What is the backstop? Well, it’s the govt telling investors they can’t lose with stocks. Do you not think that’s a pretty solid backstop?

  • chris

    “The net financial assets are the same.”

    indulge me, let’s play this out a bit. this point is a little besides the point.

    assume there are two private banks in the universe, bank a and bank b, and the fed.

    suppose that bank a has 50 of assets, 40 of liabilities (assume these liabilities are assets of bank b), with an equity of 10.

    suppose that bank b has 50 of assets, 40 of liabilities (assume these liabilities are assets of bank a), with an equity of 10.

    total net assets of the system is 20. one can assume that the other 20 of assets in this system are home mortgages or some such, but that doesn’t affect this analysis.

    assume the fed has no assets or liabilities.

    also assume that both bank a and bank b are having a tough go of it, they can’t sell their assets to anyone else. also, given their b/s, they can’t issue CP or other loans very easily, and all of the homeowners who have mortgages held by banks a and b are keeping their money under the mattress.

    the fed says to itself, let’s do QE to help out the banks.

    the fed buys 25 assets from each bank (assume it was not the mortgages), issuing to each bank 25 of fed reserves.

    banks a and b each still have 50 assets, and still each have equity of 10. the fed’s b/s has 50 of assets and 50 of liabilities ( which reserves are held by banks a and b).

    now banks turn around and start issuing CP and the homeowners start to give the banks their money because their confidence has been restored (!), which enables banks a and b to make new loans.

    is it stimulative for the fed to substitute its riskless reserves for bank liabilities as assets of banks a and b? yes. inflationary? perhaps. have to wait and see.

    now you might say that in QE2 the substitution involved is treasuries for reserves, in effect something of a like kind exchange.

    but of course in QE1, it was reserves for dog doo like bear stearns cdos.

    and i would posit that the more the fed purchases treasuries, rather than let the unaffected market set the price, the more likely will the treasuries eventually resemble dog doo. $600B over 6 months is not a drop in the bucket.

  • http://www.pragcap.com Cullen Roche

    I agree that QE1 was effective in restoring confidence and helping to establish a market in unmarketable securities. That was very important in getting the credit markets unfrozen. But where your example goes wrong is in assuming that this should all generate more consumer demand for loans. Consumer demand for loans is weak because the consumer balance sheet is upside down. Not because they lack confidence. And certainly not because the banks didn’t have the ability to lend….

    If the Fed can convince consumers to take on more debt then we haven’t really solved anything….All that does is re-leverage the consumer….

  • Coolidge Low

    Great post & comments!

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    Er no, not particularly. Isn’t the actual backstop the govt in effect ‘telling’ the Primary Dealers to buy stocks?

    I concur that for every other player out there, it’s a confidence game. But for the PDs, they’re swapping a modestly-performing asset for cash with which to make an almost certainly far greater return. The words ‘no’ and ‘brainer’ come to mind.

    It seems TPC you’re suggesting the backstop is mere smoke and mirrors, but the banks clearly think (along with just about everyone else) it’s made of pretty solid stuff. Apart from some external shock, the only thing I can imagine could change their thinking is trsy yields reaching levels which start to make stocks look less interesting – and I don’t see any evidence we’re there yet.

    If not, the inevitable bear picnic may have to wait ’til Ben turns off the taps this summer.

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    To clarify: the essential point I’m making is that the Primary Dealers know – and so do the rest of us – that THEY MOVE THE MARKET. That has always been the reality. THAT’S the backstop.

  • http://www.pragcap.com Cullen Roche

    They haven’t added net new financial assets. I am not sure how else to explain it. You are just rehashing the cash on the sidelines argument over and over again.

    I am not denying that the Fed can influence asset prices. I am denying that they are doing anything that truly fundamentally changes the economy. Who cares if you bid AAPL up to $500 tomorrow? If it’s not backed up by its fundamentals the market will correct lower. That’s what we’ve seen over the course of 20 years of Fed tinkering….

  • gb

    I applaud you all. I wish I had the time to read the whole thread. The discourse is that good.

  • billw

    Cullen,

    Great post and follow-ups. The reason we are where we are is that the MSM and the financial community have not stood up to BB. Basically they have allowed him to dig us into a much deeper hole. My only point of disagreement is that I believe that without all of this liquidity the economy would not be looking very good at all. I still believe as I know you have said that you do also, that we should have allowed the insolvent banks to go bankrupt. All of this money spent by BB and Obama has been poorly allocated trying to avoid the inevitable. So much for human hubris.

  • Matt C

    Yes, ride them…. for small amounts of time, and disembark before the ‘POP’

  • http://jamesgoodeonthemoney.blogspot.com/ OntheMoney

    You don’t have to explain it, Cullen, I understand it. Net financial assets remain unchanged, there’s no ‘cash on the sidelines’. The Fed’s actions can’t save the economy. I also agree with you entirely on the ultimate outcome – a market which eventually corrects on fundamentals, probably violently.

    But, barring an exogenous shock, that’s almost certainly not going to happen before the PDs stop buying and they’re happily buying now courtesy of Fed largesse. No it’s not new money, but that’s irrelevant. If buyers bid up the price of my house with money they’ve made from the sale of their own, there’s no ‘new’ money involved. It’s just motivated demand meeting limited supply.

    Motivated demand is, in this case, the PDs rampant in a stock market in which sellers are not yet motivated to sell and shorts are utterly terrified. This is an irresistable combination, so the backstop is not an illusion – it’s real. When the buying stops or slows, most likely in June unless the economy soon begins to tank, the market will finally become vulnerable, as per last summer.

  • http://www.pragcap.com Cullen Roche

    More motivated – we agree on that. It’s a psychological change. That is my point.

  • rhp

    Cullen, Thanks. I think I’m getting “it” a little bit better. Your statement below got through to me (I think!)

    “Think of reserves as overnight loans earnings 0.25%. Banks don’t get rid of them.”

    Although you did not directly answer my question about bonds being “reserves” or not, I believe I can infer from the above statement that only CASH can be considered “reserves” since it would be impossible to earn another 0.25% on a trsy. (Hope that right!??) And I understand that the “cash” is simply an electronic entry at the Fed.

    Now, about another one of your statements……..

    “What is the backstop? Well, it’s the govt telling investors they can’t lose with stocks. Do you not think that’s a pretty solid backstop?”

    I did utter a hearty guffaw at that one, considering all the things the gummit has told us…… “Weapons of mass destruction” and “Chicken in every pot” comes to mind……… You shoulda put a smiling emoticon on that one!!

    thanks! (for the explanation, and the humor, intended or unintended…)

    rhp

  • Matt C

    Where have BB and OB supposedly allocated it ( the idea that they’re working together is numptitious- a word I just made up based on the scottish slang ‘numpty’)? The way that BB (the Fed) buys or sells tsys has no immediate result upon how OB ‘allocates’ the same (factually he allocates nothing comparable to what BB ‘prints’, they’re not related or correlated).

    Its purely ridiculous. They are not compatriots in strategy (sadly). If they were we’d be in a different situation. The policy maker (specifically OB et al) have no idea what they’re doing in this respect. They’re fighting a popularity battle, not a success war

    If you arguing TBTB and MT at the same time, you’re confusing MMT with our government’s policy by combining them, they are wildly different.

    It took me a while to grasp MMT and how it does (or even better does not) connect to our Gov’t policies despite pundits’ routinely if not always connecting these two things. But, please realize that one must fundamentally understand the channels that affect these change as well as what they do or do not accomplish; CNN nor Fox will help with this.

  • http://blogfirstrider.blogspot.com/ first

    Net financial assets are the same. As bonds are sold for cash, cash goes right back in to assets except that there are less assets by the same proportion = price increase which move all the way in to different asset class including stocks. This not only psychological or neutral.

  • http://www.pragcap.com Cullen Roche

    There is no cash going “into” anything. You’re still not conquering the cash on the sidelines myth….

  • Michael Covel

    Nice writing CR. It will end as expected. The only issue, and it is no small issue, when.

  • http://blogfirstrider.blogspot.com/ first

    Is this why the Fed is now the biggest owner ?
    Why is there goal to prevent rate from going up if there are so liquid.
    Any one who sold in the last few months can say thank you to the Fed and is certainly not using the money to buy more. That money as moved in to other assets and that is exactly what BB wanted. It was never meet to be neutral. Rates moved up despite the intervention imagine if BB was not the Bid of last resort.

    What if the Bank are getting out of the longer maturities thanks to a bid from haven so they can exit the free ride of borrowing a 0% to purchase T Bonds.
    BB is not taking long term bond down his he ? but he is certainly helping investment Banks exiting there internal carry trade.
    When he is done short term rate will start moving up despite what BB said.

  • http://blogfirstrider.blogspot.com/ first

    Correction: BB is not taking long term “rates” down his he ?

  • rhp

    “There is no cash going “into” anything. You’re still not conquering the cash on the sidelines myth….”

    OK, I’ve read Hussman’s take on this and it seems to correspond to yours (or vice versa). Yet, I DO have a disagreement or comment. The “sidelines” implies a playing field with boundaries, and it seems to me that “there is no cash on the sidelines” sets a VERY wide playing field as including all financial assets that are in play. Thus, all cash is in play at any time; it is simply a matter of asset allocation.

    HOWEVER, many people cut up the total asset playing field into separate playing fields and denote these playing fields as having their own sidelines. So, the stock market has a “sideline” as does the bond market, as do commodities, housing, etc. It all depends on the field of reference and money flows across these boundaries according the the risk/reward appetites of the players………which field do they most want to play in.

    From the point of view of equities or commodities, cash is flowing out of munis and trsys and INTO THEIR playing field……crossing a boundary or a “sideline”.

    “In the market” and “out of the market” are very common expressions that denote a boundary. And most people on the street would assume “market” equals “stock market”, though I would expect bond traders might have a different definition. But I think yours and Hussman’s emphasis on “there is no money on the sidelines” could be softened by taking a different reference point which would avoid the head one battles that I’m seeing precipitated by this statement.

  • http://www.pragcap.com Cullen Roche

    The point is – there is a buyer for every seller. An exchange of every asset. Sure, the total size of the playing field could change (there can be less bonds for instance), but that doesn’t change the transactions. There is still a buyer for every seller. The only thing that potentially changes is the eagerness of the buyers and sellers. QE attempts to force a portfolio rebalance by reducing the number of bonds. But it does not fundamentally change the economy or the underlying assets.

  • wh10

    I may have to review my cash on the sidelines myth, but even if no fundamentals change, is it not possible for psychology to come into play, causing investors desperate for yield to irrationally drive up prices of other assets after they swap their bonds for cash?

    Sorryyyyyyy…..

  • http://www.pragcap.com Cullen Roche

    YES! That is what I keep saying….It’s psychological. Not fundamental…..

  • rhp

    true (re QE attempts to force asset allocation choices and no fundamental change in econ or underlying assets).

    My point is the “languaging” and the needless arguments (hmm, this seems to be a theme of mine looking at the language of econ from the outside).

    From the viewpoint of the equities market with “sidelines” around it, money IS flowing from the outside onto the playing field (of the stock market) due to the eagerness of buyers more than sellers. The bond market has less cash in ITS playing field, the stock market has more cash in ITS playing field.

    It doesn’t have to be called a “myth” or a “non-myth”, the parameters of the playing field just need to be agreed on by all participants. You and Hussman have the boundary as all inclusive of all markets and asset classes. A lot of commentators are more interested in a specific market and set their boundaries/sidelines accordingly.

    OK, bedtime for bonzo. How the h*** do you answer all these posts!!!! go to BED!! lol

    r

  • http://www.pragcap.com Cullen Roche

    I don’t sleep much :-)

    Sidelines is a bad term, but it’s created by the CNBC crowd so…..zzzzzzzzzzz

  • Anonymous

    And beleieve it or not, the fundamental improvement is due to the psychological improvement as a result of QE. It’s all a question of faith in the Fed.

  • Anonymous

    I also think that the marginal buyer in this rally are the hedge funds (which are the carved out prop desks now) and some other prop desks. There is no public mania from retail investors like in 2000 and mutual fund inflows were weak until recently. Maybe private investors are now in ETFs. But I guess the rally goes on until the hedgies / bank prop desks unload to retail investors at lofty prices.

    So Bernank does not need to buy SPX futures, he lets banks do the bidding with their new liquidity, while keeping the temporary profit and Bernank gets his “wealth effect” and acknowledgement that he “saved the world” and “QE2 works”. And of course QE1 worked – it was a direct gift to banks (unconstitutional).

    InvestorX

  • Anonymous

    Cullen,

    there are in aggregate $600bn less of Treasuries in the private sector, which do not need to be sold to the private sector to get cash, so there is (marginally) more liquidity. (Clearly they could have done this via FRL as well.) And then, now they have less income, so they need to look for substitutes. So the attractiveness of risk assets rises.

  • Anonymous

    On the money’s point is also what I am trying to make. The PDs have a shift in their portfolio and they bid the equity market steadily high.

    The NFA argument for me is either irrelevant (i.e. PDs are a big driving force with direct tailwing from the Fed) or fallacious due to its failure to differentiate between money and Treasuries and because it does not look at the aggregate private sector level, but always uses a single bank as an example as opposed to the aggregate private sector.

    And finally the initial pure psychology has led to consumer releveraging and a “fundamental” improvement to back up the purely speculative initial QE effect. (“relfexivity”).

    So this is not a capitalistic free market, it’s a managed market as the Chinese peg. No point of fundamnetal analysis or technical analysis until the PDs stop the game. And they most of the time risk OPM for bonuses based on unrealized P&L.

    InvestorX

  • AO

    Higher valuations could be justified by some arguments (to be verified) in addition to a supportive Fed:

    – higher participation in the equity markets due to the growth of mutual funds, the expansion of the internet etc.

    – low returns from alternative asset classes (bonds…)

    – the search for liquidity (vs. real estate investments for example which badly crashed…)

    Maybe there are more reasons. My point is that not necessarily mean reversion should happen, and that each historical period brings with itself its own rules that are different from those of the past.
    This is to get to the point that historical analysis is useful in understanding what worked in the past and COULD work in the future.

  • Mitch83

    The point is: As a bank there is nothing you can’t do with treasuries that you can with reserves (or as you say “pure green liquid cash” = Dollars) in financial terms.

    Regarding the operational realities involved in QE2 treasuries are “money” the same way reserves (“cash”) are.
    Of course you as an individual can’t go to the grocery store and pay with treasuries. You have to have cash.
    But banks don’t go to the mall with “green liquid cash” and buy stuff, they do their “payments” and other operations in a different way:

    First, as Scott Fullwiler explained, if banks want to buy, they just buy, no matter if they have the same amount of reserves (a.k.a “cash”) or treasuries on the asset side of their balance sheets. If necessary they clear an overdraft with the Fed and later get reserves on the interbank markets from other banks, use their treasuries in the repo market (treasuries get leveraged), borrow at the discount window at the Fed (using the treasuries as collaterals) or simply sell the treasuries on the bond market to raise the needed reserves (“cash”).

    Second, if banks lend, they just create deposits (“out of thin air”) and corresponding debt claims by expanding their balance sheets (and that of their customers).
    Banks don’t lend out reserves or deposits from other customers.
    They even don’t have to have reserves on their balance sheets to create loans, meaning they are only capital constrained in lending (with ratios of 10% you see lending is also a form of leveraging), not reserve constrained. If a country has reserve requirements (RR), then the banks get the reserves they need afterwards (if necessary) to meet these requirements.
    But in fact RR are completely unnecessary (many countries even don’t have RR).
    Reserves play a predominantly unimportant role in bank lending.

    So you can see banks / HFs etc. could do/buy the same things without restriction before and after QE2, as QE2 just replaces treasuries with reserves (the Fed buys in the secondary market, not in the primary market -> no debt monetization, QE2 = asset swap).
    The “spending power” of the private sector is exactly the same before and after QE2, meaning no net financial assets are added.
    The only difference is that an interest bearing asset (treasuries) is replaced with an almost non-interest bearing asset (reserves), reducing private sector income, which is in fact slightly deflationary.

    The hope of the Fed is the releveraging of the private sector by impacting investors/consumers/lenders psychologically.
    As Scott Fullwiler said monetary policy is all about increasing the leverage of the private sector (horizontal level), whereas fiscal policy deleverages the private sector by actually adding net financial assets (vertical level).
    The Fed thinks that if confidence of the private sector is restored by QE2-QEn the releveraging game will continue, no matter how the balance sheets of the private sector look like.
    I think with QE1 the Fed as lender of last resort/”market maker” succeeded in restoring confidence in and of the credit markets and partly the “shadow banking system” (although as I see it it didn’t recover greatly or started relevaraging in a big way, I think this is part of QE2-QEn).

  • Pod

    Chris,
    Understand the methodology before commenting. The shiller p/e uses a normalized earnings construct to smooth out cyclical peaks and troughs. there is no cyclical component to the “e” in shiller, only secular. hussman’s point is academic but it is also correct. he is arguing that most of a stock’s value is in the “terminal value”, which by definition is based on a sustainable, perpetual, normal earnings, not based on a spot-earnings at some point in the cycle. the excess earnings during the peak, and the deficient earnings in the trough, are minimal contributors to overall firm value.

  • Mitch83

    No question that the PDs have a shift in their portfolio due to QE2.
    The question is: Why should they invest more eagerly in riskier assets when QE2 doesn’t change anything fundamentally?
    Answer: Risk assets become slightly more attractive compared to non-risk assets.
    This I guess is the psychological effect of QE2: PD’s get risk affine because of their portfolio allocations, but without preceding fundamental reason. This increased risk appetite raises asset prices (“asset prices higher than they otherwise would be” -> “wealth effect”).

    So could QE2 be the spark that ignites releveraging of the private sector through borrowing? With messed up balance sheets, I think the Fed solely bets on the “wealth effect” bringing confidence back.
    Remember, for releveraging there have to be not only creditworthy borrowers (creditworthiness judged by banks, meaning the more confident the banks are the more creditworthy borrowers are), but also confident enough borrowers that want to relevarage rather than deleverage.
    If releveraging took place we had the fundamental reason for rising asset prices (reflexively).

  • http://www.thompsoncreekwealth.com Lance Paddock

    AO,

    I disagree that your points hold. However, for Cullen, Hussman and Shiller’s points to hold it does not really matter one way or the other. Such factors might explain why prices are higher than otherwise, they might explain why they will not collapse through vicious reversion to the mean (though it has been the story of the past ten years despite the argument being trotted out over and over.) It does not eliminate the point that returns looking forward will be low.

    Especially point two, which through variations of the “Fed Model” has been used to argue that equities are not expensive repeatedly (and to disastrous outcome.)

    My response repeatedly has been that “Maybe equities are more attractive than bonds (though they have not turned out to be so) but that doesn’t mean they will return any more.”

    If the return of stocks (and this is an accounting identity) is inflation/deflation + yield + real earnings growth/contraction + multiple expansion/contraction then none of the factors above can raise returns over time at all. The yield is what it is, inflation doesn’t count, and real earnings growth has reliably been below 2% over longer periods (10 years or more.) So real returns have to be low moving forward over time frames of 10 years or more unless one posits ever increasing multiple expansion.

    I’ll gladly put money against the idea that the Shiller P/E will move up enough to add 5% a year to returns over the next 10 years and make any “bull” move from here profitable on an investment basis. Riding it out and trading it profitably is another thing, power to you. On an investment basis there is no merit, and after inflation investors will have little to show for any advance from here even if we accept your arguments. More likely they don’t hold, mean reversion will raise its ugly head and we will all get the opportunity to actually invest at a level of 750 or below (adjusted for inflation) on the S&P 500 sometime in the next few years yet again.

  • Anonymous

    Mitch83, this is a good summary of the MMT take on QE, no doubt. But it seems that the MMT explanation of why “Treasuries = money” has nothing to do with the Fed or the vertical aspect of money creation and everything to do with the bank’s ability to do whatever they want on the horizontal level (maybe with the exception that also the Fed accepts Treasuries as collateral).

    So on the one side MMT argues that QE has no effect on the vertical level, but then MMT argues that MMT works in its described way because of (a single bank’s) activity on the horizontal level. And when people say that QE has effect because of the horizontal level, MMT is quick to say that QE has no effect because of the vertical level. See the irony here?

    Then I have 2 further questions for you:

    1. Is the market wrong in its inflationary trade? Or is maybe MMT good only on theory, but not in practice?
    2. Please explain the exact mechanism in which QE is supposed to increase confidence within the private sector, if it has no real effect. Is it just hoping to exploit people’s misconceptions about the money multiplier? Or is it something else?

  • Mitch83

    I’m no MMTer, but I’m curious and eager to understand the monetary system. I have to say I learned a lot here that confused me before (great thanks to Cullen, Scott etc.).

    MMT simply describes reality.
    To describe this reality precisely and accurately, you can’t simplify important things or don’t understand their meaning. As I can see it, MMTers do, all others do not (which is ridiculuous).
    One thing for example is the term “money” (e.g., treasuries are sometimes “money”, sometimes not, again depending on your definition of money. Regarding QE you can’t deny the fact they are “money” as it is commonly used), another e.g. is “Fractional Reserve Lending”, which, as some say (I completely agree), should better be called “Fractional Capital Lending”.

    So QE2 doesn’t increase liquidity (as treasuries in this case are “money” just like reserves), QE2 is not “money printing” (adds no net financial assets) and it doesn’t directly improve/affect the real economy (e.g. by increasing lending).

    BUT: It ignites speculative behaviour of big participants (by making riskier assets slightly more attractive) -> rising asset prices -> increasing “wealth effect” (see my reply to InvestorX). This is all psychological.

    In other words: QE2 is speculation at its finest. From beginning to end.

  • Mitch83

    To add another important thing where MMTers I think are spot on is the sectoral balances approach (and its meaning) and to emphasize the accounting identities.

  • http://blogfirstrider.blogspot.com/ first

    “Bank reserves are similar as an asset class to T-bills; both are risk free and both pay 0.25% annual interest”. But the Fed has been purchasing the longer maturities and the price of those security holdings has and is declining as interest rates rise. On the other hand Banks have reduced there interest rate risk by a corresponding amount and are moving the money in to different securities including stocks.

  • Pod

    This conversation is boring. Meanwhile, our (USA) human capital wastes away, the Socialist-in-Chief continues to develop new and creative ways to destroy economically-motivating incentives, our companies allocate more capital investment abroad, and we (USA) in aggregate continue lever-up in order to CONSUME trinkets and trash from Asia.
    The USA is like a deranged junkie destroying his body and his health, ultimately ending up dead in some back alley. So pathetic…

  • http://blogfirstrider.blogspot.com/ first

    “there is nothing you can’t do with treasuries that you can with reserves”

    If the the security treasuries holdings where the same as reserve why do they need to buy them ? Pushing or trying to maintain longer rates down does not make for a wash trade. On the book it does but its not a market bid its a back stop and the loses are transfer to the fed.

  • http://www.pragcap.com Cullen Roche

    If only it were that easy….

  • http://www.pragcap.com Cullen Roche

    Why do risk assets become more attractive? What did QE do to improve the fundamentals of the other assets? This is the part no one who supports this argument can actually explain…..Shiller debunked the equity market wealth effect. Besides, you can’t talk about the equity wealth effect in recent months while ignoring the commodity increase and housing decline….

  • http://www.pragcap.com Cullen Roche

    The onus is on you to provide real evidence that QE has resulted in real fundamental improvement. I have done thorough work showing it’s not true and now many experts are coming out agreeing after the fact….

  • http://www.pragcap.com Cullen Roche

    Agreed 100%. Speculation, in my opinion, is not a recipe for economic growth….

  • Mitch83

    Hi Cullen,

    I try to explain:

    When buying bonds from the PDs on the open (secondary) market the Fed can’t force the PDs to sell bonds for a specific price. So the Fed has to bid up the prices till the PDs are willing to sell (making bond prices “higher than they otherwise would be”).
    Why do the PDs sell their bonds at all as they can always use them as collaterals etc. (bonds = “money”)? Because at a certain price level they see the chance that in say 3 months bond prices are significantly lower again. So they dispense with the interest earned in that 3 month period in order to get higher yields in 3 month.
    Now to the psychological effect:
    The fact that PDs make a not anticipated profit with their bond selling (Fed bid up the prices) combined with the feeling of having to “put the money to work” they get more risk affine and are more eager to buy equities e.g., meaning they find risky assets more attractive.

    This all has nothing to do with fundamentals, but only with psychology.
    It seems illogical at first sight (because fundamentals of the economy didn’t change) but this is how I see it.

  • http://www.pragcap.com Cullen Roche

    Mitch,

    Thanks for clarifying.

    Allow me to agree and disagree.

    The first part is not necessarily true. The PD’s do the Fed’s bidding because that is the mandate in being a PD – you HAVE to make a market for the Fed. Granted, the Fed overbids, but how important is this? As I’ve previously described, these are small potatoes in the grand scheme of things. In order for the PDs to make a profit on these QE transactions the Fed would have to bid over the rate of lost interest. The Fed removes 3% int bearing assets. How much are they overbidding? And does it really matter? At 3% we’re talking about the displacement of $18B. That’s certainly not a meager amount of money, but it’s also not moving the needle much….

    As I’ve previously shown, I think it’s damn near impossible to say that QE is having a dramatic impact on the broader economy. Even the positive psychological impact of the equity market increase is likely nixed by the rise in commodities and continued decline in housing. The latest retail sales data is consistent with that….

    I am fully onboard with your psychological impact. I definitely agree that QE entices investors to take more risk. But I have posited that any added premium from QE is merely speculative and not fundamentally based. That is, in large part, why I believe we are merely rehashing the bubbles of old….This is not the foundation from which sustained economic growth is built.

  • Eric F.

    I question the comments concerning banks buying stocks/equities.
    My understanding has always been that this asset class could comprise
    only a small portion of their (banks) balance sheet. Can anyone
    clarify what % of bank assets can be invested in equities?

  • Pod

    Ahh, Earth does have intelligent life. Yes, Eric, that is correct. Bank assets are categorized according to risk, and riskier assets require more capital. It is a populist myth that “banks” are “loading up” on stocks using “ZIRP funds from the Fed”. Only the morons at Zero(Value)Hedge think that is reality.

  • Everyman

    Cullen, I was wondering the same thing. I read your posts and usually do not agree with your take. Maybe that is perspective, however clearly you stated that Bennie HAS taken credit for the recovery via POMO and QE.

    I have to support you on this one, and the article is what I have been seeing for a year. Put it together with the inflation in food and energy (which is not in the normal calculations) and the coming problems with city, state budgets and the cutting of the education budget…………

    I expected this sentiment a year ago. THAT is why I disagreed with your previous posts. UE is a mess and things are looking “real” again, and usually that is a bad thing.

    But, NO, you have been pretty consistent.

    I just get very irritated as what passes for “economic and financial” intelligence and am deeply offended at our national economic and financial policy.

  • http://www.pragcap.com Cullen Roche

    A little disagreement is good.

    I think people get confused by my position on QE because I say it won’t do anything for the real economy. I have never said the government couldn’t make equity prices go higher if they really wanted to. In fact, I think it’s foolish to believe otherwise. That doesn’t mean they’re in there buying equity futures, but then again they don’t have to. All they have to say is “buy stocks everyone, we’ve got your back”. And that’s what BB has done.

    It works until it doesn’t. And when the tide goes out we get to see who’s been swimming naked.

  • Anonymous

    Cullen, there is a mismatch between MMT’s prediction and the market’s reaction (inflationary trades, which are not fully explainable with “growth”). So I do not see that I have to prove anything, but MMT. Two simple questions (again):

    1. Is MMT right and the market wrong?
    2. Exactly what is the psychological channel in which QE boasts confidence?

    InvestorX

  • Greg

    Yes nottpc

    You CAN sell netflix for a profit provided you find a buyer. This is just like the housing market was. Once incomes cant support the debt levels in the housing market…. Boooooooom! At least with housing we created some new jobs via construction AND ended up with real wood, brick and drywall structures at the end of it all. With this bubble we are only further enriching stock brokers, providing no fuel for real economic growth and simply creating a nationwide casino game.
    Pathetic.

  • Greg

    I think part of the problem is that when Cullen is talking about the consumer being squeezed he is talking about a different group than the people the WSJ are talking about feeling better. To the WSJ crowd the ones who are feeling better because their stock portfolios are becoming higher priced are the only ones who matter to the economy, they are the producers the supply side that needs to feel “certain” before they will spend their money on such trivialities as “labor”.

    Cullen actually recognizes that the group that needs better conditions in order to meet their debt obligations and to become consumers again is actually being made worse off by the present stock mania. As long as the champagne and caviar class can make money simply calling their broker and making winning bets, without actually contributing to real economic improvement, they will. This is not a formula for a strong American economy however, its the seeds of gilded age or banana republic dynamics.

  • JH

    The only thing the Feds can do now or control is asset prices mainly the stock market, with QE1and2 the cash went to banks and from there they plowed it into the stock market hence the “charts”. Can you imagine if the Dow flatlined at 7000, for the last 3 three years, we would be done. There are trillions of dollars on the sidelines i.e. not in the stock market, to stop us from bleeding to death here was to artifically inflate aka stimulate, the market, aka economy, as they have done for the last ten years in the various ways as stated in my first blog.