Liquidity, The US Dollar And Market Direction

Taking a look at last week’s posts, I was undoubtedly early in my “go short” prognostications. We now have five straight positive days for the S&P 500 (^GSPC) on decreasing volume, with resistance above. Since the rally has been stronger than I expected, I have been looking for reasons to justify further bullishness. In addition to government support for Citibank (C) and consumers this week, we can take a look at actions by the Fed. John Kemp tells us that Quantitative Easing Has Begun:

Quietly, without fanfare, the Federal Reserve has turned on the printing presses. The central bank is flooding the market with enough excess liquidity to refloat the banking system - and hopes to generate an upturn in both economic activity and inflation in the next 12-18 months to prevent the economy falling into a prolonged slump.

…The Fed is now very deliberately supplying more liquidity than the banks need (or are willing to lend on to other banks, corporations or homeowners). By paying a low but positive interest rate on these reserve balances, it can ensure that the federal funds rate remains above zero (currently about 35 basis points) even as it floods the banking system with excess funds.

…Bernanke once threatened to send in the monetary helicopters if that was necessary to avoid deflation and a renewed Great Depression. The massive surge in bank reserves in the past fortnight suggests the helicopters have now been scrambled and the strategy is being put to the test.

As we can see from the charts of the US dollar and gold, there has been a change in the monetary dynamics during the past couple of weeks.

- UUP (UUP): The US dollar ETF formed a double top, and now appears to be trading within a range.

- GLD (GLD) had a strong week. A lot of people I respect are bullish on gold here, including Marc Faber and Rev Shark. I do not have a strong opinion either way, although some mining stocks are looking attractive on the long side.

Jim Rogers is bearish on the dollar, although he says dollar bullishness could last into next year. Rogers says buy commodities and Chinese stocks. Faber, in the video link above, favors gold over industrial commodities, saying demand for the latter will continue to languish.

iShares FTSE/Xinhua China 25 Index ETF (FXI) looks interesting for a potential long side trade if we continue to rally, or see a low volume pullback.

A few more indicators to consider: first, the Baltic Dry Index continues to drop, indicating demand for raw materials is still decreasing.

I recommend this article: Understanding the Baltic Dry Index.

The Baltic Dry Index is also a compelling indicator because it is a simple, real-time indicator that is difficult to manipulate. Some economic indicators-like unemployment rates, inflation indexes and oil prices-can be difficult to interpret because they can be manipulated or influenced by governments, speculators and other key players. The Baltic Dry Index, on the other hand, is difficult to manipulate because it is driven by clear forces of supply and demand.

The supply that affects the Baltic Dry Index is the supply of ships available to move materials around the globe. It is difficult to manipulate or distort this supply because it takes years to build a new ship that could be put into service to increase supply, and it would cost far too much to leave ships empty in an attempt to decrease supply. The demand that affects the Baltic Dry Index is the demand of commodity buyers who need the raw goods for production. It is difficult to manipulate or distort demand because it is calculated solely by those who have placed orders to have raw goods shipped. Nobody is going to pay to book a Capemax cargo ship who isn’t actually going to use it.

Some people seem to be expecting a bottom in oil prices here, but this is still a bearish chart for now.

Commodities in general still have some work to do.

Also, looking at the Bullish Percent Index, investors are getting a bit complacent.

Right now volume is not confirming a particular direction, so it is time to wait and watch. We have a new month, and the market also will be digesting news regarding the weekend’s retail sales. This bear market rally could still have some legs. At the same time, this seems like a risky place to be buying stocks for more than a day trade. There are an abundance of good short setups out there, but we need to see some distribution before taking any aggressive action.

This WSJ article by Christopher Wood is worth reading: The Fed Is Out of Ammunition. Wood points out that the Fed can print money, but it can do little about how businesses and individuals use that money.

…for now, the issuance of nonagency mortgage-backed securities (MBS) in America has plunged by 98% year-on-year to a monthly average of $0.82 billion in the past four months, down from a peak of $136 billion in June 2006. There has been no new issuance in commercial MBS since July. This collapse in securitization is intensely deflationary.

…What happens next? With a fed-funds rate at 0.5% or lower in coming months, it is fast becoming time for investors to read again Mr. Bernanke’s speeches in 2002 and 2003 on the subject of combating falling inflation. In these speeches, the Fed chairman outlined how policy could evolve once short-term interest rates get to near zero. A key focus in such an environment will be to bring down long-term interest rates, which help determine the rates of mortgages and other debt instruments. This would likely involve in practice the Fed buying longer-term Treasury bonds.

It would seem fair to conclude that a Bernanke-led Fed will follow through on such policies in coming months if, as is likely, the U.S. economy continues to suffer and if inflationary pressures continue to collapse. Such actions will not solve the problem but will merely compound it, by adding debt to debt.

Wood mentions that Hank Paulson has been put in an uneviable position with this crisis. At the same time, many knowledgeable commentators, from Mr. Wood to Marc Faber to Jim Rogers, have noted that our problems originated with too much credit, and therefore too much indebtedness. Increasing burdens are being placed on future taxpayers on a daily basis. And the more I hear about specific bailout details, the less I like:

So the preferred shares purchased by Treasury with the TARP money, and other preferred issuances to Buffett for example, rank “senior” to all common equity and anything else equivalent to it in the company’s capital structure.

What does that mean in English? That common shareholders are still in-line to absorb the first losses. If assets fall in value, common equity is the first thing to be marked down. And it will get marked to zero before the preferred starts to lose dollar 1.

That’s why banks stocks kept falling despite the TARP bailout, especially after Paulson said the government wouldn’t be buying troubled assets. When he said that, it became clear common shareholders would be the first to lose.

But not anymore! With the Citigroup bailout today, the government is actually agreeing to absorb hundreds of billions of losses BEFORE common shareholders lose anything. That’s why financial stocks are up huge, because Paulson reversed himself, saying the government WILL absorb losses.

Citigroup’s stock price confirms what the rest of us know to be true: this latest bailout (and all similar ones to follow) is simply a transfer of capital directly from taxpayers to Citigroup shareholders, to the tune of hundreds of billions of dollars.

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