Quantitative Queasing

So we have been having Quantitative Easing already, and Baruch doesn’t  like it.  The stockmarket is up (or was), the data seems to be improving; QE has done its work and for all we know it will continue. But there is a special unhealthy quality to it all. It feels like a “wrong” rally, like the cat from Pet Sematary was clearly a wrong kind of cat.

The problem as I see it is this: QE lowers overall interest rates and makes all the stocks go up when they wouldn’t have normally. It raises their valuations, which you can also express by saying it makes for higher PEs. This makes people feel richer. They will go and buy more stuff like LCD TVs, making the companies who make the stuff they buy richer too. They will invest more, and buy more stuff from companies who make stuff not for people, but for other companies. Eventually all the companies grow into their higher stock valuations, and we are all fine.

The key word here however, is “eventually”. What happens in the bit between the 2 points:  after all the stocks have gone up, and before the fundamentals improve to justify their new valuations? Because I think that’s where we are if stocks have stopped going up, or where we will soon be.

Now, my tech stocks aren’t exactly expensive. Lots of them are to be had for PE multiples in the low teens, which really isn’t bad. But there has been no fundamental improvement in their businesses since the summer, as far as Baruch can tell, and yet their stocks have absolutely zoomed to levels I frankly have difficulties buying them at, at least on the charts. Baruch was astonished last week to see that the NASDAQ 100 was basically back to its pre-crisis high!! You get that? That index is telling you that things are as good as they were before the Great Unwind.

I can’t short them either, at least not on past form. That’s been a mug’s game; the subtext of QE is “kill all the shorts” — another way of making sure stocks go up. Returns on short books have been pretty brutal, and most long short guys in the past couple of months have learned to be mostly long, or if they have to stay balanced, then long stocks, short indices.

So, now what? If stocks are now disassociated from their fundamental realities, however short a time that disassociation is supposed to last, non-fundamental realities are going to rule, and I have no idea what that means. Will we get stasis, a crunch in volatility and volumes? Will we have vast nauseating unexplainable swings in stocks, huge moves in the VIX? Will we crash? Will we carry on straight up? Will we pause and rally? Who can say? We’re in a period where anything is possible, as I’ve said before, a world of unintended consequences coming down the pipe. Some may be good, and some may be bad.

This is why in his darker moments that Baruch thinks a very good analogy for where we are right now is Pet Sematary. The people who buried their cat (and later their son) in the Indian burial ground to bring it back to life got something which looked ostensibly like a cat, but was so only on the outside. On the inside their little puddy tat  was really an undead homicidal zombie cat, as became clear through its increasingly odd behaviour. Unintended consequences followed (mayhem, murder, horror, the Wendigo — all that Stephen King stuff).

The Bernank is like the guy who buried his cat, but in this case instead of a resuscitated cat he wanted his rally back, a healthy stock market and the wealth effect that would bring. I worry we have got something else.

I’m not saying we’re in an undead homicidal zombie market, though we may be. But here’s an example of what the Pet Sematary market is capable of in terms of unintended consequences: QE inflates all asset prices, including commodities. This pressures the Chinese consumer, who we are relying on to pull us all out of this mess, who can suddenly not afford his new LCD TV because his Moo Shu pork is costing 20% more than it used to. Changes in commodity prices have a much greater impact on his consumption than Joe Schmoe in Idaho, with his low cost high fructose corn syrup and processed trans fat diet. The BoC has to raise rates to offset the inflation this is causing, hurting Chinese growth even more, and global GDP growth drops 50bp. Bravo the Bernank. With your Quantitative Easing you just killed off the only good thing in this market which was working naturally without outside interference.

OK, Baruch may be exaggerating, but a big part of today’s selloff is driven by fears of commodity prices in China and a collapsing Shanghai stockmarket. It’ll probably turn out to be nothing, a damp squib. But if it doesn’t, you heard it here first. I feel sure there is a wider point here to make about the bad things that happen when you mess with the signalling mechanism of the stockmarket. After all, the stockmarket does not exist solely to make us richer, does it? But that’s probably for another post.

13 responses to “Quantitative Queasing

  1. They want to make inflation no matter how and where. If it is China that’s the best – hopefully they will want to export that like everything else.

  2. Nice analysis as always, but the Moo Shu Pork chatter is probably unnecessary.

    • I added some unnecessary comments about American food to make it more even-handed. Let me know if you are still offended.

  3. Baruch:

    Why do you think QE2 is inflationary ?

    It is nothing but swapping 3-5 year maturity paper for zero maturity paper. So, if someone wanted to consume, this someone could have easily swapped his T-notes for some FRNs, before the Bernank came to help.

  4. Random Grad Student

    “The key word here however, is “eventually”. What happens in the bit between the 2 points: after all the stocks have gone up, and before the fundamentals improve to justify their new valuations? ”

    I don’t follow. You pointed out that lower interest rates cause stocks to go up. Absolutely! Equity prices are simply a reflection of discounted future dividends. If real interest rates decrease, future dividends are worth more today, and hence stock prices increase.

    Then you imply that the “fundamentals” aren’t justifying these new valuations. That’s irrelevant. The future stream of dividends doesn’t *need* to improve for higher equity prices to be justified — all it takes is a decrease in real interest rates. This is Asset Pricing 101.

    The real questions, then, become:

    1. Do you have any reason to think that, relative to the real interest rate, equity valuations are too high? (The problem with PE ratios, btw, is that they don’t incorporate the real interest rate — which is why they’re an extraordinarily crude measure in the first place.)

    2. Do you think that the Fed is causing the real interest rate to be lower than it should be?

    I don’t think there is any good evidence for (1). (2) is possible, but it conflicts with everything we’re seeing in the markets; if the Fed was really pushing the real interest rate substantially below its proper value, there would be massive inflationary pressures bubbling to the surface. In a more coherent view of the economic slump, the inability of the real interest rate to adjust to its equilibrium value once nominal interest rates have hit zero is absolutely central.

    • Dear Random, 1. no I don’t, as I said, they are still in the median zone, quite acceptable overall and 2. I have no idea what the real interest rate should be.

      You are right, I guess I could explain away higher stock prices simply by lowering the risk free rate in my DCFs. There are only 2 problems with this:

      1. I don’t think interest rates or bond yields are actually falling, and in the past 2 days at least have been rising — so we have to posit higher inflation to get the real rates lower, which is a bit of a stretch at this point, but possible (Bankster, that might be why QE is considered inflationary)
      2. None of what you write helps me with the real problem at hand, ie what am I to do RIGHT NOW with my portfolio, when all the stocks price in their current and near-term fundys and more and it’s no good shorting anything? Yes, nothing, is the right answer probably.

      I am not saying the current, higher, stock valuations are wrong. Just that the range of unintended consequences of the valuation raising methodology (QE) is very big, and these unintended consequences may prove to be more important when it comes to real world outcomes than the impact of the attempt to raise valuations. In other words it could have an effect on the earnings.

  5. QE2 is a kind of power game between Fed and China. Fed needs lower real interest rates but because the funds rate is already zero they need to increase inflation (to reach the same effect). However that’s the tricky point because China fixed it its currency to USD with almost endless supply potential.
    So the Fed now tries to corner China on the US bond market and increases the future cost of stable yuan-USD exchange rate. Eventually China needs to appreciate yuan. The sooner they do it the less they will lose on their USD investments.
    As soon as this happens the price of debt will decrease and the global (and US) inflation rate will increase. This will both solve the generic real-interest rate problem and also the debt problem for US government and consumers.
    The question is of course how drastic/chaotic the debt/USD repricing will be.
    The repricing moment can be frightening and might not do good for the stocks as well.

  6. This kind of sensitive dependence on microdynamics is not unexpected in a system with weak couplings between agents, even in crude models:

    Zero interest rate: (H=0) The average amount of consumption and savings is perfectly balanced, even with an infinite money supply. In other words, when the system is flooded with money and interest rates are held at zero, exactly half of the population consumes and exactly half of the population saves. When interest rates are zero and money is plentiful, individuals basically act as if independent of their nearest neighbors. But note well what happens when interest rates are zero and the amount of cash in the system is withdrawn. At a critical threshold (Tc in the diagram), individuals spontaneously start to align with their nearest neighbors by either saving or consuming — either is possible — even when interest rates are zero. This is a textbook example of spontaneous symmetry breaking, which is the phenomenon from which this blog takes its name. The broken symmetry is a consequence of the coupling among nearest neighbors — i.e., “animal spirits.”

    http://brokensymmetry.typepad.com/broken_symmetry/2009/08/a-systems-theory-of-animal-spirits-an-application-of-the-1d-ising-model.html

  7. Richard Tull

    Wait, the stock market does not exist solely to make us richer? Then why do we spend so much time obsessing over it? And is Pet Sematary your best example of unintended consequences? What about the Knicks’ hiring of Mike D’ Antoni?

    I’m also confused by this market. Thanks for the post.

  8. The Fed is saying that they (1) want to increase inflation to create a “wealth effect” (though this is unsupported by any real evidence or precedent) and (2) that other parts of the government are not doing enough to support employment and that this “wealth effect” will help….

    The bottom line is that if the Fed does succeed in increasing inflation (although you would have to ask what inflation), then equity values overall should DECREASE and you will have PE multiple compression as you had in the 1970s.
    Of course monetary assets directly linked to resources / commodities which increase in real value, assuming that extraction costs increase at a lower rate than inflation.

    Some on the Fed are also saying that they do not believe the dollar should weaken (although the dollar is an area covered by the Treasury)….however, you cannot have both artificially lower interest rates AND a stable dollar, indeed the dollar should weaken which will further raise inflation rates…

    This policy is a disaster. Like him or not, Taleb appears dismayed by this as are many others, interesting video below…

    http://alaricinvestments.blogspot.com/2010/11/nothing-is-as-permanent-as-things.html

  9. I love it when you go Macro.

    It appears you have given us the ‘undead cat bounce’!

    There must be a really horrible fi-ku about this slouching towards being written by some undead trader.

    • ha ha, yes, the undead cat bounce!

      Actually since writing that I feel much better. I am enjoying the bounce, ready for more. After all, in the film it took some time for the cat to show us what a nasty moggy he really was. And zombies don’t necessarily have to be bad. Have you seen the last scene of Shaun of the Dead?

      I don’t know fi-ku. Is that like feng shui for the undead?

  10. The appearance of faiku, also known as fiku, fi-ku, or “Oh God please no more I’ll talk just make it stop” (the latter generally used when I try my hand at it), is the penultimate Sign of the Financial End Times (the coming of the Undead Cat being the 12th stroke of the Doomsday Clock, Seventh Seal etcetc). The Undead Cat is seen as the mascot for what the three so-called Great Religions view as the Apocalypse, Armageddon, End of the World and so forth.

    As usual, the Three Great Religions get it partially or completely wrong (e.g. their genius for genocidal land-grabs in the name of an allegedly loving and merciful god). What the Undead Cat heralds is the End of the Credit Supercycle, during which the world money supply shrinks to the actual book value of the planet (including extraterrestrial possessions, currently limited to the ISS and a few clever gadgets on Mars), with no allowances for goodwil or forward-looking anything (clashes with the whole “end” theme). To the Masters of the Universe, this is actually somewhat worse than the heat-death thereof and ensuing Big Crunch, and they would rather just skip to that part and get right to nothingness… (so they may be in actuality crypo-Buddhists).

    So for example the whole question of the “Rapture” is just a mistranscription of “Rupture”, which is what happens to the vast majority of the fundamentalists when they discover that they can no longer receive a continuous monetary blessing by refinancing their homes. They leave their bodies behind instead of taking them along to wherever they go, but for those of us damned to the unspeakable torture of living within our means, the result is the same: lots of available houses and cars.

    I’m afraid I have not seen “Shaun of the Dead”, but I must examine it for further secret signs. Should at least beat the heck out of sheep entrials in helping to figure out if Euro-Communism will come back into fashion.