For Friday, September 14, 2012, We Recommend Against Investing

Market conditions are changing.  Please read our entire post to fully understand our current recommendation and the potential for changes in the near future.

Technical Comment:

The S&P 500 advanced 1.6% on Thursday with volume above Wednesday and greater than the 30 day moving average volume. The strong advance in the index puts the S&P 500 about 47 points above our stop-loss trigger. The market would have to decline about 3.2% on Friday to change our forecast to an uncertain trend.

Subjective Comment:

The very strong advance in the US markets on Thursday occurred with the highest volume seen in the past three months. This marked the third consecutive day for the S&P 500 to experience a strong-volume up-day. This marks the beginning of a pattern that could predict continued growth for the market; however the pattern is not yet fully formed.

The Thursday announcement from the Federal Reserve regarding the beginning of a new quantitative easing program is why US stock markets advanced so strongly. The very simple assumption by market participants is that QE3 will provide a sustained boost for US stocks and possibly the economy as well. This is a very likely possibility and one we recommend you prepare for. Another possibility is that US banks will accumulate this additional money without accelerating their lending rates, resulting in an increase of excess reserves in the US banking system. What will ultimately drive a resumption of a bubble boom in US stocks is the growth rate of the M2 money supply. The weekly update of the money supply from the Fed published on Thursday shows M2 growing at 7% (annualized) through September 3. It will be 2 to 3 weeks before this new action of the Fed starts to show up in the M2 money supply data.

QE1 began in November 2008 and resulted in $600 billion of purchases of mortgage-backed securities (MBS).  QE2 was launched in November 2010 to purchase $600 billion of US treasuries at a rate of $75 billion per month.  As announced, QE3 will purchase mortgage-backed securities (MBS) by an additional $40 billion per month.  QE3 is different from the first two because no end date has been announced. This is the most important aspect to understand about QE3.  QE1 and QE2 were both announced as $600 billion programs.  QE3 has no limit. The history of QE2 is very important for context.  As the Fed printed new money US banks accumulated excess reserves. When QE2 ended US banks accelerated the pace of originating new loans. It was only this accelerated rate of lending money that actually caused the US money supply to grow at 25% (annualized) from late June to early August 2011. The key point is that bank lending accelerated only after QE2 ended. With no end and no limit announced for QE three the key question becomes, will US banks begin accelerated lending immediately or will they first accumulate excess reserves? The Federal Reserve refers to this as the “transmission mechanism”. (It is also called the money multiplier.)

The other interesting piece of the announcement from the Fed was the target of the federal funds rate. The statement indicated the Fed will maintain this rate as they have been between 0% and 0.25%. The Fed funds rate is currently at 0.15%. From January through the end of April earlier this year the Fed allowed the Fed funds rate to gradually increase from 0.08% to 0.16%, 0.08% increase over four months. This gradual increase allowed the Fed to effectively sterilize their other monetary operations for short period, contributing to the collapse of the US M2 growth rate to 0%. If the Fed truly desires QE3 to have an immediate stimulative effect it must allow the Fed funds rate to fall. If the New York Fed’s open market operation desk takes action to maintain the current Fed funds rate at 0.15% or even tries to increase the Fed funds rate closer to 0.2% or 0.25%, this would counteract and delay QE3’s impact. It is also entirely possible that the Fed funds rate was allowed to increase from 0.08% to 0.16% earlier this year so it could fall once QE3 commenced. This would certainly explain why the 7% US M2 growth rate briefly collapsed to 0% before resuming its 7% growth.

It is very likely for the next several days US markets will continue to advance. Price inflation hedges will also advance on the expectation of a debased dollar. For US markets to continue a bubble boom from here, QE3 must happen with a falling Fed funds rate. US banks may also decide to accelerate originating new loans given that QE3 has no end date. Aggressive investors should begin positioning part of their portfolio in US equities with the use of leverage indexed funds. If you’re going to be aggressive do so immediately to take advantage of the short-term lift following the QE3 announcement. More cautious investors could wait a few weeks to see what happens to the Fed funds rate and the US M2 money supply growth rate. Investing in price inflation hedges is also a good strategy for the long term because QE3 will certainly cause more price inflation in the future. Continue to avoid all bonds. We are quite serious on this point. As price inflation gets worse bond prices will eventually fall. We will carefully watch the Fed funds rate and the US M2 money supply for clues what will happen to the money supply growth rate. Should it become obvious that the money supply growth rate has accelerated in response to QE3, our subjective recommendation will change from “Hold Cash” to “Invest for Growth”. We recommend preparing your investment portfolio to move from cash into leveraged index funds in the near future.

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