For Thursday November 14, 2013, We Recommend Against Investing


Investment Recommendations:

Avoid US markets and watch closely to see what trend develops.  Cash positions (including currency) and price inflation hedges are still recommended.  There is too much uncertainty in US markets right now to make an investment recommendation, but things are turning bearish again after having been bullish for most of October.

Technical Comments:

The S&P 500 advanced 0.81% on Wednesday with volume slightly above Tuesday and still below the 30 day moving average, making Wednesday a strong-volume up-day.  A strong-volume up-day by itself is bullish, but this makes just one such day during the past two weeks where there have been five strong-volume down-days.  It will take more strong-volume up-days to form a bullish market pattern, and bearish market patterns are still highly likely to form given recent history.  If the S&P 500 were to decline about 53 points on Thursday (-3.0%) our stop loss algorithm would likely change our market forecast to an uncertain trend.

Subjective Comments:

We received great questions and debate from an interested reader, so we decided to share them and our answers as today’s post.

Why do you insist that M1 and M2 money supply have a bearing on stocks?

We look at M2 (not seasonally adjusted) as a measure of the money supply, not M1, not M0, and certainly not seasonally adjusted numbers.  Probably the purest measure of the money supply is “True Money Supply”.  There is plenty of debate by Monetarists and Austrian Economists about the best way to measure the money supply.  We choose M2 (nsa) because it is the broadest measure available weekly.  If anyone knows where better measures are available at least weekly, please let us know.

Per Austrian Business Cycle Theory (ABCT), we insist the money supply growth rate has a major influence on the stock market as well as all asset prices and the economy as a whole.  If you follow our posts you notice we always talk about the growth rate of the money supply.  The growth rate is the rate of change, which is the first derivative of the money supply itself.  We are not claiming there is a correlation between the money supply and the stock market.  We are claiming, based on ABCT, that there is a cause and effect where the growth rate is the cause and market prices are the effect.  Additionally, there is a time lag between changes in the growth rate of the money supply and market prices, and this lag is not constant but changes all the time.

Clearly, the fed is pumping money printing presses at a velocity never seen before in human history.  Just because they print it doesn’t mean that the people use it or the banks lend it, right?

Absolutely!  We completely agree.  When the Fed prints money the M0 money supply grows.  (M0 is also called the Fed’s balance sheet.)  M2 is influenced by M0 and lending by the fractional-reserve banking system.  Fractional reserve lending results in the money multiplier, and well understood mathematical result of the required reserve ratio.  However, the money multiplier is not always constant but in fact changes if and when commercial banks choose to lend, or not lend.  Commercial banks have been lending, but only at the same rate their existing loans are maturing.  This is obvious by the unchanged level of required reserves over the past 10 months.  Instead excess reserves have been growing as the Fed has been printing.  All the $85 Billion of monthly printing is going into excess reserves.  Banks now have over $2.3 Trillion Dollars of excess reserves.  Prior to the 2008 market crash banks used to have virtually no excess reserves.

This is why we track the M2 money supply.  If we only tracked Fed money printing, we would be tracking M0, but that is too narrow a definition of the money supply.  M2 goes up and down as the Fed prints and as banks lend.

Earnings growth and deceleration in that earnings growth drive stock prices higher and lower.  Fund flows into mutual funds and into stocks have a bearing on market direction.  Overall massive insider selling in stocks has a bearing on direction.  Big surprises on bond buying programs and fed fund rate can have a bearing on stock price direction.  A change in president or a geo-political even can have a short term effect on market direction.  But placing [the money supply] at the top of a long list of things that move markets is a stretch.

Allow us to respectfully respond to these comments and explain why placing the money supply growth rate at the top of the list is not a stretch.

“Earnings growth and deceleration in that earnings growth drive stock prices higher and lower.”

We agree.  When the growth rate of the money supply accelerates or decelerates, that results in accelerated and decelerated Earnings.  Part of ABCT is Austrian capital theory, and it explains how accelerated money supply growth drives down interest rates, which in turn encourages malinvestments in the capital goods sectors of the economy.  It is well known that capital goods industries boom first and crash first, and this is because they are more sensitive to changes in interest rates.  Examples include construction, construction equipment, manufacturing machines and items used by businesses.  An example today is Cisco.  Cisco is in the capital goods sector as their technology equipment is primarily purchased by other businesses.  Cisco announced today they expect their revenues to drop up to 10%.  The near zero percent growth in the money supply is causing capital goods companies to see their revenues decline.  See Caterpillar for another example of this.

“Fund flows into mutual funds and into stocks have a bearing on market direction.”

Again, we agree, and we are of the position that accelerated growth in the money supply causes more funds to flow into mutual funds and into stocks, causing prices to be bid up.  When the money supply growth slows there is less money to keep bidding up prices.  Hence our contention the growth rate of the money supply affects all asset prices.

“Big surprises on bond buying programs and fed fund rate can have a bearing on stock price direction.”

We agree with this statement as well.  Surprises on bond buying and the Fed Funds rate are impacted by changes in the money supply.  Half of the monthly money printing by the Fed is being used to buy bonds, causing bond prices to remain high thanks to the demand from the Fed’s buying.  With all of the crazy Quantitative Easing since 2008 “the Fed is now responsible for monetizing a record 70% of all net supply [of bonds].”  Additionally, the Fed Funds rate is manipulated by the Federal Reserve’s bond trading desk in New York when the Fed buys or sells bonds to maintain the target Fed Funds rate.  To drive the rate down, they have to buy bonds.  The Fed Funds rate has been driven to and kept near zero percent for years.  To do this, the Fed has had to buy bonds again and again.  Where does the Fed get the money to buy all these bonds?  Simple, the Fed prints it into creation, thus increasing the money supply.

Here is the logic of our argument: Bond buying, fund flows into funds and stocks, and earnings growth all affect stock prices.  Money supply growth rates affect all of these things.  Hence, the money supply growth rate affects stock prices.

The history of M1 and M2 when overlapped with the major indices shows that you often have market move up with slower money supply growth.  Why do you insist this is the case when history says just the opposite?

Attempting to correlate M2 to the stock market is not what we do, but this question does note our emphasis on money supply growth.  It is true if money supply growth rates are overlapped with the major market indices there are indeed times when the market has gone up when the money supply growth has slowed.  A simple overlap confirms this, but we did say there is a time lag between changes in the money supply growth rate and when the market follows.  A straight overlap fails to account for the time lag.  Austrian Business Cycle Theory has been developed deductively, not empirically.  By the same deductive reasoning that created ABCT, human action is highly variable and people do not always react the same way.  Human choices cause variability in the time lag between money supply growth rates and when the market reacts.

On May 18, 1970, Friedrich A. Hayek presented this essay before the Foundation for Economic Education at Tarrytown, New York.  In this essay Hayek provides explanations why money supply growth (what he calls inflation) must continue to surprise (accelerate) in order to keep a boom going.  The essay takes around 20 to 30 minutes to read.

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