Tuesday, April 22, 2008

The market is a discounting mechanism?

I've never really understood this one. I hear the pundits blindly repeating this one all the time. But let's think about it. Did the market discount the end of the recession in 01? Did the market discount this recession? Can someone explain to me how anyone can see into the future and have any idea how this is going to turn out. The fact is that no one knows how it's going to turn out and just because you add up all the investors in the world still in no way suggests that this collective mind can see the future. I'm sorry folks that's just not possible with today's technology.

So why does a bear market normally bottom half way through a recession (not withstanding the fact that the last bear market didn't bottom until a year after the recession ended)? The market doesn't discount anything. What the market does do is respond to liquidity. Obviously as soon as it's apparent that we are in a recession the Fed opens the money spigots. Low and behold the market starts to rally. Everyone immediately points out that the market is now discounting the end of the recession. And in a secular bull market the flood of liquidity does work it's magic and a few months later the economy is back on track.

The problems start to develop when you are no longer in a secular bull market. When stocks are in a secular bear market and commodities, because of supply and demand fundamentals are in a secular bull market the equation changes. Now when the Fed opens the flood gates it doesn't have the same effect. A large percentage of this liquidity flows into the undervalued commodity sector. The end result is an increase in commodity prices above and beyond the supply and demand fundamentals otherwise know as inflation. Rising inflation puts a squeeze on the economy limiting economic expansion thus making the recession worse not better.

Take a look at what has transpired so far. Since the Fed has opened the money spigots wide using every tool at their disposal and a few new ones the market has rallied 9%. Oil on the other hand has rallied 37%. This is of course the one commodity that puts the most pressure on economic expansion. Food is also rising at a similar rate. So the two sources of energy, oil for economic growth and food for human growth are rocketing skyward. Now despite the governments phony core inflation rate I suspect we all must eat and use oil. If these costs are escalating we aren't going to have as much to spend on those core rate computers or core rate rent now are we?

If the consumer is not only getting pushed down by falling real estate values, crushing debt and rising unemployment but now everything he needs to live is spiraling upward it's going to become tougher to frequently the local AAPL store or Cheesecake factory on a regular basis. Since our economy is more than 70% consumer spending it doesn't seem logical to continue to hammer away at that 70% with rising inflation if you want the economy to mend now does it?

I think the economy is going to have trouble pulling out of this recession easily like it did the last time or during the preceding 28 years simply because increasing the money supply is not going to have the same effect it did during the secular bull market. As I've said before the fun part of the monetary expansion is probably over. Now we are going to have to pay the price for continuing to expand the money supply in an environment where it will not cure what ails us. In this environment it is only making matters worse.

So what if the market moves back to new highs if oil goes to $150 and unemployment is moving towards double digits. By the way the job creation numbers were helped along tremendously by the birth death model the last several months. Does anyone really believe the country is creating lots of new businesses as we enter a recession? I suspect the true jobs numbers are in the -150,000 to -200,000 range.

The market is now in a race between massive liquidity injections and soaring energy and food costs. In the end inflation is going to win this battle it's just a matter of how long it takes to bring down the house of cards the Fed is building. The frightening thing is that the higher they build the house the bigger the collapse is going to be. If they don't come to their senses soon they risk the onset of a hyper inflationary depression down the road.