Tuesday, October 02, 2007

Liquidity Driven Stock Rally-Again

Financial journalists don't know what to make of the seemingly puzzling stock market rally yesterday that meant a new all-time high for the index journalists for some reason focus on-the Dow Jones Industrial Average. Here is CNN Money on the issue:

"Stocks have been on a run recently on hopes that the worst of the credit crunch is over and on expectations that the Federal Reserve will keep cutting interest rates."

But if the worst of the credit crunch is over, the Fed isn't likely to cut interest rates. Good thinking, Beavis.....

It was seemingly puzzling because the day featured only bearish news, such as earnings warnings for Citigroup and UBS and a weaker than expected ISM manufacturing index. Yet even though there was only bearish news-the stock market rose more than 1%. What's up with that?

The reason why the stock market rose yesterday is basically the same reason for why it has risen more than 10% since mid-August. It is also the same reason that explains why the dollar has dropped roughly 5% and commodity prices risen more than 10% during the same period. The explanation spells massive monetary expansion.

If you adhere to the narrow money supply definitions of Frank Shostak and his followers, such as Mike Shedlock and Gary North, these movements would indeed seem unexplainable, as M1 actually fell more than 1% between August 6 and September 17. It is also down 0.1% compared to the same period last year.

However, if you look at MZM, it is up 3% in that same period, which is equivalent to an annualized increase of 29.2% and up 11.8% in the latest 52 weeks. Similarly bank lending is up 2.1%, or 19.5% at an annual rate (some "credit crunch"), and up 11.6% in the latest year.

This again illustrate that not only is MZM better than M1 from an essentialist point of view, it is also far, far better in explaining economic trends in general and financial market movements in particular.

Given the extremely loose monetary conditions, it seems possible and even likely for the U.S. stock market to continue to make new highs for a while. However, I don't think the rally will continue for much longer. Because first of all, most stocks are very expensive from a fundamental point of view. Stocks are up more than 16% in the latest year even though earnings are likely to be up only 5-6% (official estimates point to 3%, but as they are always beaten we should add a few percentage points), so they are in fact roughly 10% more expensive. Stocks are arguably more overvalued now than at any time in history except for the late 1920s and late 1990s.

Moreover, contrary to Wall Street expectations the Fed's room to cut interest rates is limited as even official consumer price inflation is likely to rise sharply. They will probably still cut in the next meeting, but after that, the surge in inflation will tie their hands.


Anonymous Anonymous said...

But, relative to the long term bond yield it is undervalued?

And money velocity is slowing, consequently FED can increase money supply without any imediate inflationary pressure.

Consequently the stock market can continue to rise.

6:27 PM  
Blogger stefankarlsson said...

Well, bonds provide lousy returns too, reflecting upon the loose monetary conditions. That is why I certainly don't recommend bonds, particularly in this inflationary environment. But I don't recommend stocks -with a few exceptions as I note below- either.

Instead I am bullish on commodities which I think will continue to rise as central banks attempt to inflate their way out of the problems created by previous inflation.

If you want to invest in stocks, that would be stocks of commodity producers which generally should benefit from rising commodity prices.

Also, there are a lot of stock markets that provide better value than the U.S. stock market -which was what I discussed-. For example stocks on the Swedish stock market are generally much cheaper.

6:56 PM  
Anonymous Anonymous said...

In regards to M1 vs. MZM, to me it appears that consumer price increases have tracked closer to M1 and asset prices have tracked closer to MZM.

This is likely because most people buy stuff with income that grows at a rate roughly comparable to consumer goods prices, while most large assets (houses, business, etc...) are financed on credit.

Thus, both metrics seem valid to me. M1 tracks the real economy. MZM tracks the bubble economy.

7:11 PM  
Anonymous Anonymous said...

Thank you for your comment.

As a matter of fact I do not recomend bonds either.

But I recomend Gold Stocks (NEM in USA) and LEH (Lehmann Brothers) in USA wich is verry good value.

In Sweden it is also bank stocks and SEK as currency of course. Not EUR.

Also Japanese stock index NIKKEI

Oil, commodities are overbought
along with ABB, Nokia, Emerging Markets.

European Blue Ships are all right.


11:30 PM  
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7:00 AM  

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