THREE THINGS I THINK I THINK

1) How will Ben let the market down softly?

How will Bernanke let this market down softly with the end of QE2? Mr. Bernanke has done something that Alan Greenspan always attempted, but never made so explicit – he has kept asset prices “higher than they otherwise would be”. It’s a dangerous precedent to set. It’s a lot like giving your children a treat every time they start to cry. After awhile they become conditioned to believe they will always get their treat so long as they cry long enough. The result is a child who never actually earns the treat and instead becomes spoiled rotten. Similarly, market prices no longer have to rise on fundamentals alone. So long as the Fed is there with their safety net speculators can feel confident that they will be rewarded with a treat every time the market declines and they begin to cry.

The result has been obvious – equity investors are eager to take excessive risk by buying every dip in the market with the knowledge that the market can no longer decline. It’s a lot like walking a tightrope knowing that there is a cushion just 5 feet beneath you. There is no need to be overly careful. The problem arises when too many people start jumping on the tightrope with you and create a disequilibrium in the system. At some point the rope becomes unstable and possibly snaps. Except this time your cushion isn’t a soft padding, but someone else’s head. People get hurt. You get the picture. What Bernanke has created is not all that different. It’s an environment of spoiled tightrope walkers who are conditioned to take risk and believe they will always receive their treat when they begin to cry. It might be “working” for speculators, but is it good for the US economy?

The problem for Mr. Bernanke is that he must take the pacifier out of the baby’s mouth without causing a temper tantrum. And yes, Wall Street will throw a temper tantrum when the pacifier is removed. If I had to venture a guess I’d guess that Mr. Bernanke will end QE2, continue reinvesting interest payments, thus slowly removing the pacifier. But that’s just a guess. Either way, he will tread carefully and likely remain close at hand with the pacifier at the ready just in case the baby begins to throw a temper tantrum.

In a similar note to thought #1 – there is the potential for a very frightening market development in the coming years (work with me through this hypothetical). Let’s say the Bernanke Put continues to cause asset prices to deviate from their fundamentals – the economy continues to recover (marginally), but the Bernanke Put becomes so ingrained in market perception that the disequilibrium in markets expands. This results in an imbalance so severe that market bubbles appear (could already be occurring in the commodity space). What happens to the market if the disequilibrium Ben Bernanke causes results in some sort of serious market dislocation similar to 2000 or 2008? All it would take is a minor exogenous threat to cause a global panic. It could be surging oil, a slow-down in China, a repeat of the Euro scares….The result would not only be economic slow-down (into an already weak developed market), but potentially crashing asset prices as bubbles have a tendency to overshoot on the downside. But it’s not the recession that would scare the markets. It is the potential backlash against the Fed.

After three bubble implosions in less than 15 years (all somehow directly tied to Fed intervention), I think the public would call on Congress to revisit the Fed’s dual mandate, its impact on markets and whether their actions over the last 20 years have been appropriate. The rational response would be to reduce the Fed’s role in markets. From a societal perspective I think this is an enormous long-term positive. The sooner we get the Fed out of the market manipulation game the sooner this economy can stabilize, definancialize and get back to becoming the economic growth machine that it has been for so long. For the markets, however, this would be a traumatic event. Imagine 20 years of Greenspan/Bernanke Put being sucked out of the market…it might sound far fetched right now, but I have a feeling the Fed will be far less involved in markets at some point in my lifetime. It might be wishful thinking, but I am confident that America will wise up to the destruction this institution causes by constantly distorting our markets and economy.

2) When does the market wake up to the oil problem again?

The seasonal trend in oil and gas prices appear to be moving right on cue. As I type, West Texas Crude is topping $108 and Brent is just shy of $118. While the equity market has powered higher, this headwind only continues to become more problematic. The average national gasoline price is now up to $3.65. UBS says the problems begin to emerge at $110. Merrill Lynch says $120 is the “breaking point”. Deutsche Bank has previously calculated the impact of a 1 penny rise in gas prices as being the equivalent of a $1.4B drag on consumer spending. This means the 65 cent increase since the beginning of 2011 has reallocated $91B in consumer spending. That’s almost the entirety of the positive impact coming from the recent tax cut!

The market has been able to overcome a number of overhyped hurdles in the last few weeks, however, this is one the markets cannot overlook forever. It’s only a matter of time before the market and economy wake up to the reality that higher oil and gas prices are causing severe consumer woes.

3) The plight of the working class

John Mauldin’s latest letter covers a very important question from a reader of his. Mr. Mauldin passes the question along and then dives into the answer:

I get a lot of email from readers. I recently got an impassioned letter from very-long-time reader Bill K., who asks some very pointed questions about austerity and spending cuts. It is a rather lengthy letter, so I will only quote part of it and use it is the launching pad for this week’s letter, where we look at today’s employment report, but from a little different slant. This letter will no doubt anger a few other long-time readers. I argue this week for the middle, but do so as a survivalist.

While Bill starts out by saying some very nice things about me (thanks), let’s jump to the meat of the letter:

“…. I would like to get something off my chest. I would like to know why you seem to side with those analysts who keep telling us that the only way we can sort out Western economies is by making the average guy suffer through austerity programs… You are a very intelligent guy – obviously. You can see how things work and what is broken. You can also see through the greed and excesses of Wall Street, and you can read the economic data which clearly shows that the wealthy continue to get more wealthy in America whilst the average Joe continues to see his standard of living going in the opposite direction. Capitalism today only works for the ‘have gots’. It’s been going in that direction for more than 30 years now. You saw the senseless and stupid greed of the derivative scheme which fueled the housing bubble which led to the meltdown which never melted because Bush/Obama handed out a huge welfare check to financial institutions that should have been allowed to fail.

“In the aftermath of all this, politicians in DC, you, and your guest pundits warn us that the world as we know it will end if we don’t somehow reduce the average Joe’s Social Security, pension, Medicare and Medicaid benefits. Oh and let’s not forget the budget, which is being argued in Washington as I type this. The line is that we have to make drastic reductions to spending on domestic programs, on our schools, on our infrastructure, on unemployment entitlements, on all the things that serve to give working people a chance at a dignified life. You’re a smart guy. You can recognize what is fair and what is greed and excess. When the nation is as troubled as it is today and yet the wealthy are living even better than they did 30 years ago, what does that say about America? I wonder if we really care about our neighbors anymore? I wonder why such a great country with such great natural resources cannot find a way to be just and generous and a beacon to higher ideals? Ike warned us to be wary of the military-industrial complex. Looks like he was right. We’re a nation constantly at war, spending trillions on defense, whilst at home we enrich the already wealthy and tell the average Joe that he has to pay for it. I wonder how you manage to rationalize all this away – if indeed you do?

“Thanks and with respect, Bill”

Mr. Mauldin moves into a very good description of the plight of the working class. But then the wheels come off the analysis as he begins to focus on the debt issue in the USA. I always enjoy Mr. Mauldin’s work, however, his incessant fear mongering over our “Greek moment” has reached a level of absurdity. His reader asks a very astute question and Mr. Mauldin responds with the standard misunderstanding of monetary systems by explaining that we reside in a monetary system similar to the EMU:

“The problem is that the debt is like a cancer. The bigger it grows the more threatening it is. Pretty soon it consumes its host (think interest expense).

Bill, I am worried about the survival of the country economically. Another crisis caused by the bond market driving up interest rates, because they become concerned about the size of the debt and deficits, will seriously reduce the choices we have – with none of them being good. Ask Ireland or Greece how it feels. They are in what can only be called a depression, and likely to stay there for some time. You think we have it bad now? Avoid dealing with the debt and see what happens.

To think it cannot happen here is to simply ignore reality. Yes, the US can go longer than we might think, but there is a limit. I think that limit will come before the middle of this decade. Perhaps as early as 2013, if the new incoming President and Congress do not deal with the deficit in a realistic manner. Then Bang! , we have our own Greek moment. I want to avoid that.”

I’ve said this a million times and I’ll say it again – any time an analyst compares the USA to any EMU nation – RUN. As I’ve previously described, the individual countries in the EMU are not remotely comparable to the Federal government of the USA. If you want to compare Deleware to Greece then be my guest, but when you start spreading debt fears by comparing a currency issuer to a currency user you discredit your work substantially. There are no bond vigilantes to come after the USA for fear of solvency. There is simply no such thing. The only form of insolvency the USA faces is in the form of hyperinflation and that is a very different phenomenon than the one we currently are at risk of.

Comparing an EMU nation to the US Federal government is a terrible flaw that we see day after day. It contributes nothing but fear to the conversation and exposes the fear mongerer as having a severe misunderstanding of the workings of monetary systems. Well over a year ago I warned of this fear mongering. Luckily, we have not succumbed to it (and our economy is recovering – though slowly), but that hasn’t stopped millions from trying to scare the rest of us into believing that our Greek moment is right around the corner….

Of course, Mr. Mauldin isn’t the only person making this crucial mistake day after day. The never ending debate over the debt ceiling, deficit, etc has exposed a nation whose most prominent economists and leaders do not understand this very basic difference between a currency user and a currency issuer. Over the course of the last 30 years the majority of advisors to Congress and the White House have failed to make this crucial distinction and our economy has suffered as a result. The fear mongerers have used this argument to help impose austerity on a struggling working class while giving tax cuts to their wealthy friends and freeing their banker buddies from the chains of regulation. The result? Well, you’re looking at it. In what has to be one of the most embarrassing economic circumstances in modern times we find the world’s wealthiest and most prosperous nation with 9% unemployment in the midst of a “recovery” that feels like anything but. And when your leaders don’t even understand the system in which we reside, how could we have possibly expected anything else?

I’m sorry reader Bill, but our problem is not the Federal debt, your Medicare checks, or the deficit. It is the simple fact that the people running this country (and the majority of its citizenry) have no idea how our monetary system actually functions yet they continually use fear tactics to scare the rest of us into believing that what’s good for them is good for the rest of us….

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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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