The definition of insanity

Stocks rose 74 Dow points yesterday. Gold dropped $3.

Then again, what do you expect? Yesterday was April Fools’ Day.

This should be a good quarter for stocks, according to macro-economist Richard Duncan. He believes that it is ‘excess liquidity’ that drives markets – that is, cash and credit in excess of what borrowers and spenders actually need.

We haven’t been able to connect every tarsal, hallux and tibia of Mr Duncan’s theory, but the skeleton, as he presents it, is serviceable. Even attractive. The more ‘excess liquidity’, the more people use it to bid up asset prices. As excess liquidity goes down, on the other hand, so do asset prices – particularly stocks.

This quarter is expected to produce a record of excess liquidity. On the one hand, the Fed is still pumping liquidity into the market at the rate of $65bn every month.

Meanwhile, it is tax time, so the government’s needs for borrowing this liquidity will be relatively low. The difference between the available liquidity and the need for it in the regular economy has to go somewhere.

In the past it has gone into stocks and real estate. After this quarter, however, the outlook changes. The Fed is scheduled to reduce its quantitative easing (QE) down to zero by the end of the year. And the federal government’s rosy budget scenario will begin to fade.

The third quarter is expected to produce only a slightly positive excess. And in the final quarter, the ‘excess’ turns into a shortage.

If the Fed persists in its plans to curtail QE, says Duncan, the third quarter will probably see a sell-off in the stock market. This, he believes, as we do, will give the Fed’s forward guidance a kick in the rearward quarters. Under pressure, instead of tapering off, the Fed will panic. Its entire theory of life, its philosophy, its sacred religion will be challenged. In its view, credit, prices, and GDP must always go up.

There was a time, of course, when the Fed was merely charged with making sure the nation’s money was secure. It failed miserably. So it was rewarded with more responsibility. Its mission creeped toward making sure the nation had full employment. At that, too, it fails regularly.

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So, now it has taken upon itself – Congress never authorised it – to hold interest rates down and prices up. Consumers prefer lower consumer prices, not higher ones, but such is the confidence of the central bankers that they are willing to contradict 100 million households. They insist that the dollar lose about 2% per year of purchasing power.

As we have been saying, it is an odd recovery that leaves people with less income than they had before it began. But it is an odd recovery that we have. Stock prices – not to mention prices for antique guitars – have soared. Incomes have limped downward. This leaves the typical household feeling richer, but having less money.

Total US household wealth has never been higher – at $81trn. But it is supported by precious little household income. Mr Duncan tells us that the ratio of household disposable income to household wealth is an important one. At the end of the day, he tells us, wealth must be supported by income, or it disappears.

This is exactly what happened twice in the last 15 years. From 1952 until the 1990s, the ratio of household wealth to disposable income was fairly stable – at about 525%. Then, it rose above 600% twice. At the end of the ‘90s, before the dotcom crash, and in 2006-2007, before the property/finance crash.

Once again, the ratio is above 600%, only the third time in history. And once again we should be prepared for a crash, or at least a substantial bear market, in stock prices.
That will probably happen in the third or fourth quarter of this year. And it will probably be followed by an announcement by the Fed that instead of taking QE off the table, it will continue the programme.

Instead of allowing the Fed funds rate to rise, six months after the QE programme ends, as Ms Yellen recently suggested, the rate will stay at zero for this year and all of 2015 too.

Mr Duncan believes this ‘QE IV’ will produce the same results as QEs I, II and III. That is, it will send stocks flying again. If so, we could be looking at another big run-up in the stock market, after, of course, a substantial decline.

Our advice: get out of the US stock market now. This market is manipulated, over-priced, and dangerous.

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