For Monday May 20, 2013, We Recommend Against Investing

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Investment Recommendations:

Avoid US stock markets right now.  Price inflation hedges remain good long-term investments.  Continue to avoid all bond investments.

 Technical Comments:

Friday the S&P 500 advanced 1% on volume below Thursday and lighter than the 30 day moving average.  The S&P 500 finished the week with another record high, but it was a light-volume up-day.  Overall the daily market patterns remain favorable for continued market growth because up-days have been on strong and weak volume, but all down-days have been on weak volume for 4 weeks.  The market has broken out on the up-side and technically appears headed for more growth.  If the S&P 500 were to decline about 63 points on Monday (-3.8%) our automated forecast could change to an uncertain trend.

Subjective Comments:

US M2 money supply growth has become highly erratic.  The monthly money printing by the Federal Reserve ($85 Billion/Month) is accumulating in Excess Reserves where US banks are earning 0.25% interest from the Fed.  Excess Reserves are now at $1.82 Trillion Dollars.  Existing loans appear to be maturing either faster or at the same rate new loans are being originated.  Recent speeches by Fed officials have hinted that the rate of money printing might start to slow.  After reading several blogs and opinion pieces, we’ll offer our own speculation on what is happening and what might happen in the following paragraphs.  Regardless of any speculative opinions, the important thing is to track the daily market data and the US money supply.  This will continue to form the basis of our investment recommendations.  Now for our speculation…

When prices decline the law of supply and demand predicts that more purchases will be made by buyers, but it also says that fewer producers will want to sell.  Sellers want to sell at high prices.  As supply decreases the prices will eventually be bid back up.  Right now the Fed is printing $85 Billion per month and buying home mortgages (via Mortgage Backed Securities) and US Treasury Bonds.  The Fed, with its legal monopoly of printing money, is not a normal actor in the law of supply and demand.  When a normal economic actor runs out of money, that actor stops buying.  The Fed is not constrained since they literally have an endless supply of US Dollars.  When they keep buying these securities in huge amounts, the sellers can sell at higher prices and the Fed still buys.  By driving the price of these securities up, the interest (or yield) the return as investments are driven down.  This is the intended result of the Fed’s money printing policy, to drive interest rates down.

The interest rate of a loan is the “price” of money.  When interest rates (prices) go down, demand goes up and more people want to borrow money.  However, fewer lenders want to lend at low rates (low prices).  If the Fed were not printing $85 Billion a month and driving rates down, then the law of supply and demand would drive interest rates up.  Consider the incentives this creates for US banks.  Interest rates (prices) for loans are at historic lows, so banks don’t want to lend.  Lots of people want to borrow at these low rates, but the only “lending” going on is the flow of funds from the Fed’s money printing.  The only borrowers getting loans are Mortgages and US Treasuries.  Banks have $1.8 Trillion Dollars to lend, so they have to decide where to lend the money.  Here are the lending options available to the Banks:

  1. Buy Treasury Bonds – This locks in historic low interest rates for 10 to 30 years.
  2. Buy Mortgage Backed Securities or Make Home Loans – This locks in historic low rates for 15 to 30 years.
  3. Buy Treasury Bonds or Make Home Loans and then sell them to the Federal Reserve at a small profit – This is happening, but at the predictable rate of $85 Billion per month and based on the available data, no more than $85 Billion per month.  Remember, Banks have $1.8 Trillion, so $85 Billion is not much compared to available funds.
  4. Deposit the $1.8 Trillion of Excess Reserves at the Fed and earn 0.25% interest with the ability to withdraw the money anytime they wish.  This earns an annual profit of just over $450 Billion and does not lock up the funds from other uses.

Options 1 and 2 are what the Fed is doing.  Options 3 and 4 are what the Banks are doing.  We think banks are acting based on the law of supply and demand.  As sellers of loans, at the low prices (interest rates) banks are choosing option 4 and earning Billions of dollars without locking up their funds.  This allows them to wait for the option to lend in the future at higher prices (higher interest rates).

The trade-off decision facing banks is to earn slightly higher rates (option 1 or 2) compared to option 4, but the opportunity cost is having funds tied up for 10 to 30 years.  Or, banks can earn a smaller rate that still nets $450 Billion per year and have funds available to earn even more when interest rates go back up.  With the Federal Reserve officials hinting they might start slowing the rate of money printing, Banks know interest rates will go up when that happens.  This is all the more reason to continue to wait for interest rates to go up before moving Excess Reserves out of option 4 and start lending to earn more.

Let’s assume our speculation is correct.  As long as the Fed continues to print $85 Billion per month, US banks will continue to accumulate Excess Reserves and not lend.  US M2 growth will remain erratic.  We noted back in January a few weeks where US M2 dropped dramatically.  In the final 2 weeks of April US M2 dropped dramatically again.  The timing of these two drops is three months apart, and they occurred a few weeks following the end of a calendar quarter.  Banks are businesses, and most businesses have similar selling patterns where quarterly numbers are very important.  Sales tend to increase right at the end of every quarter.  Historically, lending is no different.  Car loans are typically 5 years long, and home loans are typically 15 to 30 years long.  When those existing loans were originated years ago, the pattern of sales spiking at the end of a quarter occurred.  Bank loans do not require the first payment until a month after origination, so with loan originations spiking at the end of calendar quarters, loan maturations spike in the month following the calendar quarter.  This means larger numbers of loans mature in January, April, July and October.  If new loans are effectively not being originated as Banks wait for rates to go back up, then there are no new loans to offset maturing loans, and the maturation spikes will cause the money supply to drop for a few weeks following calendar quarter points.

The speculation we have outlined above is a hypothesis that fits recent observations and data.  It does not mean our speculation is correct, and it most certainly does not mean Bankers will continue the patterns that have been in place these past months and years.  Still, as long as circumstances remain unchanged, and with the Fed officials hinting that rates could go up in the future, we think Banks will continue to hold and accumulate excess reserves until interest rates climb.  We’re guessing this hypothesis is correct.

Eventually interest rates are going to go up.  Price inflation will eventually occur from all the money printing that has happened and continues to occur.  That could be the trigger to drive up interest rates.  The Federal Reserve could slow or stop money printing.  They are saying they might.  This would drive up interest rates for the reasons we just discussed.  When interest rates go up, Banks will have to decide if they want to keep their Excess Reserves earning 0.25% at the Fed or to make loans at higher rates.  If Banks start lending the money supply could easily accelerate into much higher growth rates, and that would ignite a serious bubble-boom in the economy and stock market, along with a collapse in bond prices and accelerating price inflation.  If interest rates remain low then Banks are likely to keep delaying lending.  This will keep US money supply growth erratic and too slow to sustain the current bubble-boom.  A crash could happen before interest rates go up.  The hypothesis outlined here is why we are recommending holding your cash outside of the stock market, and why you should absolutely avoid all bonds for the indefinite future.  Watch the money supply and the daily market data for changes.  We’re either going to have a crash if interest rates remain this low for much longer, or we’re going to have a high price-inflation bubble-boom when interest rates go up.  We think investing now is a guessing game.  We’re not sure which scenario is going to play out.  Whichever way things go, there will be time to take advantage and profit if you continue to watch the key indicators of money supply and the daily market patterns.  We hope you’ll keep following our blog to track these data and encourage others to join our community.  If not, please keep track of these things on your own and prepare accordingly.

One Response to For Monday May 20, 2013, We Recommend Against Investing

  1. John says:

    An indicator which was not mentioned was farm land bubble and the art work bubble. These two assets have increased in some areas 25-30 percent over a one year period. Do not invest in farm land to current values, the ROI is not where it should be on the amount of Capitol needed. Current prices are inflationary due to cheap money.