For Friday July 12, 2013, We Recommend Against Investing

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Investment Recommendations:

Ignore our automated market forecast and avoid US stock markets right now.  Continue to avoid all bond investments. Price inflation hedges remain good long-term investments, but only invest in price inflation hedges amounts that you can leave invested for a very long time.

 Technical Comments:

The S&P 500 advanced 1.36% on Thursday with volume above Wednesday but below the 30 day moving average.  Our software classified Thursday as a strong-volume up-day even though volume was below average.  This was the second strong-volume up-day this week and the 3rd such day in the past 5 trading sessions.  Each of these strong-volume up-days was on below average volume.  If strong-volume up-days continue to accumulate quickly our software might detect a pattern that predicts further market growth, but that has not yet occurred.  If the S&P 500 were to decline about 44 points on Friday (-2.7%) our automated market forecast could change to an uncertain trend.

Subjective Comments:

Long Post Today.

The S&P 500 set another record high on Thursday and has surged 7.5% over the last 12 days.  This is in response to Wednesday’s comments by Federal Reserve Chairman Bernanke.  We think it is significant that his comments caused a large increase in the market index but on volume below average.  The new record high could convince some people to invest.  Up and down motion in US markets is very likely, but we still hold the firm conviction that US markets are going to crash in the near future.  Our opinion is based on the growth rate changes of the US M2 (not seasonally adjusted) money supply as interpreted by Austrian Business Cycle Theory (ABCT).  We’ll elaborate in the following paragraphs.

The Federal Reserve published the weekly US M2 money supply data and the biweekly US banking reserve data on Thursday.  US M2 (not seasonally adjusted) continues its zigzag pattern that started at the beginning of the year.  The overall growth rate of M2 since the start of 2013 has been 1.2% per annum.  This is much below the 9.2% M2 growth that occurred in 2012.  ABCT explains that a bubble boom in the economy and stock market begins and continues when the money supply growth rate accelerates.  When the growth rate stops accelerating a crash will occur.  If the growth rate slows or becomes negative, the crash will happen sooner.  The current 1.2% growth rate is an absolute collapse compared to the 9.2% last year.  This has setup the conditions that ABCT explains will and must lead to a crash.  This is the most direct evidence of a pending crash in US markets.

Additional data is consistent with the slow growth in the US M2 money supply.  US banking reserves are updated every other Thursday, including this Thursday.  Two weeks ago banking excess reserves dipped from $1.96 Trillion to $1.92 Trillion, a drop of $40 Billion Dollars.  This might have been evidence US banks were accelerating lending, but it now appears this drop was statistical noise in the data set.  With the most recent data published (H.3 Weekly) excess reserves are up to $1.98 Trillion Dollars, an increase of $520 Billion since the start of the year.  Excess reserves are the dollars in excess of what is required by Fed regulations.  Required reserves are the minimum required based on outstanding loans, and required reserves have not been changing.  Required reserves are a very noisy data set, so it takes a while to notice any change in trend.  Excess reserves are virtually unchanged at $118 Billion now versus $114 Billion from January 2nd.  Since the Fed has been printing $85 Billion a month and required reserves are unchanged, all the printed money is accumulating as excess reserves.  The $520 Billion increase in excess reserves is nearly an exact match for 6 months of printing (6 x $85B = $510B).  All of this data means US banks have not been lending.  In fact it means bank loans have been maturing at nearly the same rate as the Fed has been printing.  This is how US M2 has remained virtually unchanged despite the printing of over a half trillion dollars.  The chart below shows M2 over the past several years and the 2013 zigzag pattern is obvious at the far right.

US-M2-NSA-Growth-11JUL2013

This is the key point: The Fed’s money printing is not growing the M2 money supply.  It doesn’t matter that Chairman Bernanke promised to keep printing.  The printing for the past 6 months has not grown US M2 at all.  With the overall money supply not growing after 9% growth last year, the economic laws described by ABCT explain that a crash must occur if money supply growth remains where it is.  In fact, US M2 growth would have to accelerate at a very rapid rate to keep the bubble boom going.  We think this is very unlikely to happen.  The market’s reaction to the Chairman’s comments shows most market participants do not understand ABCT and the increasingly likelihood of a crash in the near future.

In fractional reserve banking, lending causes the money supply to grow via the money multiplier effect.  The lack of bank lending is why the US M2 money supply is not growing.  When interest rates were at historic lows there was lending as many homeowners refinanced, but refinancing is not net new lending.  With interest rates currently climbing US banks will likely be more interested in lending, if they can find borrowers.  All other things being equal, the law of supply and demand says there will be fewer borrowers when the price of borrowing goes up.  If something else changes, then lending might accelerate.  Banks will certainly be motivated to accelerate lending as loan rates go up, but will they?

We think the Federal Reserve is worried US banks might start lending their excess reserves very rapidly.  With $1.98 Trillion of excess reserves, US banks have sufficient funds to more than double the money supply by rapid lending.  This would lead to massive price inflation, and this has the Fed very, very nervous.  US banks earn 0.25% interest on excess reserves, but they did not earn interest on excess reserves (IOER) prior to October 2008.  With no interest on excess reserves US banks historically have lent out all their excess reserves, but this changed in late 2008 when the Fed began its massive money printing called Quantitative Easing.  According to Wikipedia, “On October 3, 2008, Section 128 of the Emergency Economic Stabilization Act of 2008 allowed the Fed to begin paying interest on excess reserve balances (“IOER”) as well as required reserves. They began doing so three days later. Banks had already begun increasing the amount of their money on deposit with the Fed at the beginning of September, up from about $10 billion total at the end of August, 2008…”  Since IOER became legal with this law, IOER has been 0.25%.

We have been tracking and reporting on US banking reserves for a very long time.  Our data source has been the Federal Reserve’s H.3 Statistical Release, Table 4.  This data table has been discontinued and a new format with new data has replaced Table 4.  Fortunately the new table still has the data we have been using, but what is very interesting is the new data.  According to the Fed’s announcement of this change on July 11, 2013:

The Board’s H.3 statistical release, “Aggregate Reserves of Depository Institutions and the Monetary Base,” includes data for the first time depicting… interest rates paid on balances maintained to satisfy reserve balance requirements and balances maintained that exceed the top of the penalty-free band…

In other words the Fed has just started publishing biweekly updates of IOER.  IOER has been 0.25% since October 2008, almost 4 years, and now the Fed will be publishing IOER changes every other Thursday.  This data set is available here.  We’re guessing the reason for publishing IOER going forward is because the Fed intends to change it from time to time.  After 4 years of 0.25%, it appears the Fed feels it necessary to publish changes, and if this means the Fed intends to change IOER, it will be very interesting to see which direction that change might be.  If the Fed lowers IOER, we expect banks will accelerate lending.  If the Fed increases IOER, banks will happily leave excess reserves deposited at the Fed and bank lending will remain depressed.  This is a BIG DEAL!  We’re guessing the Fed is afraid of rapid price inflation if banks accelerate lending.  If we’re right about this, and if weekly data on IOER means the Fed intends to begin monkeying around with IOER, then the Fed will likely raise IOER if banks start lending.  This will keep overall US M2 growth depressed.  We think this means there is no reason to expect US M2 growth to accelerate, and this means the near future market crash we’ve been predicting is that much more certain.  IOER’s biweekly updates give us another data source to watch for an indication of what US M2 growth rates will be in the future.

What this comes down to is a guess what a handful of flakey Fed Governors will do.  It is not a guess to predict US markets will crash soon given the M2 growth rate trends and the economic laws of ABCT.  It is a guess when we say it’s unlikely the Fed will allow M2 to grow fast enough to prevent the crash.  It is also a guess when we predict US markets will crash sometime between now and the end of October, but this guess is at least based on historically similar conditions from the money supply growth leading up to historic US market crash in October of 1929.  There is usually a trigger that initiates a market crash, and the debt crisis in the Eurozone could cause problems.  Things in Greece are exceptionally bad.

Avoid US markets for all the reasons we’ve just discussed.  Hold and accumulate cash for an opportunity to short US markets in the near future.  We also suggest putting part of your portfolio into price inflation hedges, but be sure to hold price inflation hedges for a very long time.