The Rally that Isn’t

posted at 2:47 pm on October 7, 2009 by CK MacLeod
[ Economics ]    printer-friendly

The other day, we prepared to say good-bye to the Global Warming “hockey stick” and all of the assumptions that accompanied it. Here’s another, maybe even bigger disappearing act.

Aside from “when will it end?” and “is now the right time to get out before everyone else?” – one question a lot of people are asking about this year’s bull move in the stock market (from the bottom called by market analyst extraordinaire Barack Obama) is how stocks can be rallying so powerfully even while the US dollar is sinking to new lows. We’re used to thinking that rising stock prices forecast a strong economy, but also are used to thinking that confidence in the US economy should generally be reflected in confidence in the US dollar as well.

Many traders and economists have concluded that the two phenomena, rather than contradicting each other, are in fact mutually reinforcing and co-dependent; that the massive expansion of the monetary supply and massive intervention in the financial sector itself have fueled this year’s stock market rally, not an improvement in economic fundamentals; and that any sustained rally in the dollar is more likely to accompany a major “correction” in equities, not least because the unwinding of “dollar carry” positions (in which the weakness of the dollar makes it the currency of choice to leverage investments in equities) could be brutal.

In short, according to common sense, the stock market appears un-moored from reality.

One way to square monetary with everyday reality, at least intellectually, is to attach the market indices to something harder than our floating currency. The obvious candidate for “something harder” is, of course, gold. Peter Boockvar, in a post entitled “It Feels Good But…” at The Big Picture Blog performs the calculations:

We can put into perspective the asset inflation we are seeing in many different asset classes that has been achieved in part due to a depreciating US$ by analyzing the returns in the S&P 500 and DJIA for 2009 in terms of gold (real money as opposed to fiat). This highlights again the nominal gains we are seeing in stocks this year as opposed to real gains. In gold terms, the S&P 500 is down .7% in 2009, a far cry from the 16.9% nominal gain, as the S&P 500 buys 1.017 ounces of gold vs 1.024 on Dec 31st 2008. The DJIA in gold terms is lower by 5.7% in 2009 vs the nominal rise of 10.7% as the DJIA buys 9.37 ounces of gold today vs 9.94 on Dec 31st 2008.

David L. Singer extends and broadens this analysis in chart form, while asking a simple question “When did this bear market start?” His answer: “2000.” To help you understand his work, the top chart, or top section of the chart, compares the S&P 500 ($SPX) to gold (actually the “continuous contract” for gold futures). Singer shows that, valued in gold instead of dollars, the broad market top of 2007 wasn’t really a “top” at all, and the 2009 rally has amounted to a relatively minor “snapback” – one that still leaves you around 80% off the major high.

The second chart is a reference, tracking the S&P by itself. The third chart tells a story similar to the first, but in terms of silver prices. The fourth chart looks like a happier tale – until you realize that its S&P vs the Yen (the former weak currency choice for the carry trade). The fifth chart tracks the S&P vs. Australian Dollars (a strong currency), and the bottom chart tracks the S&P vs. the British Pound. If you look closely you’ll see the symptom of the Pound’s own recent “un-mooring” as compared to the Australian Dollar.

If today you liquidated your positions US dollar-denominated stocks or S&P futures, you’re still well off the double highs of 2000 and 2007, but you’re well above the decade’s lows of ’02-’03 and early this year. If you liquidated your position, but had to take your profits in British Pounds, you’d also get a lot more of them than you would have around the beginning of the year or in 2003. If, however, you had to convert your money into Gold, you’d merely be back up to the lip of a trough… dug into the floor of a deep pit. For the Aussies and Silver Bugs, the S&P 500 hasn’t even risen off its absolute panic lows. If you need Aussie Bucks or silver, you’re still in the pit of the pit!

In other words, in our own monetary universe, we seem to be recovering. In the other universe, we’ve gone nowhere.

To return to those other two questions: No one knows how long this divergence – and any doubt about which universe is operating according to known physical laws and which one is the Twilight Zone and subject to collapse back into nullity – can last. I’ve seen some bears capitulating to the rally, which classically signals the approach of a top. As for how and when to get out and where to put your money – all I can say is: not my problem. I got cured of stocks a long time ago. Ask Barack “profits and earnings ratio” Obama.

OK, more serious answer: As noted in an earlier post, economist/bubble expert Andy Xie thinks that rising oil prices (fueled in the US by dollar depreciation even without greatly increasing demand) will eventually put an end to the phony rally, force the Fed to tighten, and initiate a psychologically as well as economically traumatic “double dip” recession. I’m watching oil – and wondering about events in the oil-producing regions. Others will watch gold. Still others are watching for a massive equity- and global-economy-destroying dollar rally (this guy is short gold and almost everything else except the Dollar – though I don’t buy his analysis completely, I do love his graphic).

Others will prefer to look away, and I can’t blame them. For the rest of us, an intimation of the social consequences of such events comes from an ultra-bear blogger (Fund My Mutual Fund: Guest Post: Gregor.us – the Alignment of Asset Reflation and a Collapsed Economy) who recently put things this way:

Our society’s hierarchy rests in part upon the following assumption: that the intellectual capacity of the chairman of the Federal Reserve, with his PhD and his white papers, is superior to that of a mortgage broker from Orange County, California. I think we need an adjustment to this type of assumption. Because the spread I see opening up everywhere in the US economy is what I call the Prestige-Performance gap, whereby the assertions of our elite no longer comport with observable reality…

For those who recognize a rising stock market as evidence of disarray, what we should anticipate now is the recognition phase where the wider public finally comes to understand the nature of our inflationary depression. My marker has been 100 dollar oil and 15% unemployment in California. That should finally get the message across. But other combinations will do: 1300 dollar gold, 1300 on the SPX [the S&P 500], and more problems with Commercial Real Estate will also suffice. Like the prestige-performance gap, the divergence between the economy and asset prices apparently has to become even more grotesque before people will understand.

Whether it’s gold at $1300 and oil re-tracing its Summer ’08 path, or some completely different stew, I don’t think the potential impact of such an awakening on the American psyche can be overestimated. Even before taking into account the global ramifications of such events, the prospect makes me very wary of any assumptions about what will be politically or in any other sense possible in 2010, 2012, and beyond.

Of course, events can break in a lot of different ways, and the American economy has made fools of pessimists for a long time. It could be that the adults are in charge and everything’s just fine – except maybe for Global Warming and health insurance…

cross-posted at Zombie Contentions

Blowback