Equity Bunnies Head for the Tall Grass

by YDLM

First, a splash of Dominic Rossi:

It is clear now that the Fed cannot bail equity markets out any more and any interest rate cuts by the ECB may not have much of an impact on markets. The solution on the fiscal front will be either Greek default or Germany accepting that it has to fund debt restructuring and so reduce the quantity of debt in Greece. This will be a prototype for other European countries.

[…]

Markets will have to consolidate so that oligopolies or duopolies are created and the remaining companies have strong cash flow and don’t have to rely on the debt markets. This is a carbon copy of what happened in emerging markets 15 years ago. Equity will shrink as well-financed companies grow by acquiring others and buy back their own equity. In time, this will stabilise equities.

If you don’t follow financial literature at all, you’ll be excused for not believing it, but there is a school of thought that considers it the Fed’s job to prop up equities–stocks, for instance–FOREVER. A bailout, a stimulus, a bubble (in this case the words are tautologous) that never ends.

Actually, this means a marketplace which bears hardly any relation to reality. Under this version of the Mandate, equity values merely reflect, because they are over-determined by, Policy.

Fed policy.

This works perfectly until it stops working completely. For every “wealth effect” obtained by these debt-inflated equities, the epistemology of the market deteriorates, until finally the nominal value of a given instrument unhinges entirely from its “book”; nobody knows what anything is worth because money’s ability to signal value has been destroyed. Predictably, by the time the Fed has exhausted all its tools to trick people into taking risks, the market has come to resemble a rumor-driven version of roulette, massively unstable and inefficient, highly susceptible to free-fall.

At last, the bubble has to be pumped dry, an excruciating process. The housing bubble is undergoing this and has a  long way to go (Why are there any net homestarts now? Why would there be any for years?) before the inflated value is gone, the glutted inventory of empty homes reduced, and real value can be built again.

The stock market will go through this same deflation, because it has to, once the Fed exhausts its epistemological “toolkit,” its ability to send good vibes to investors via distortions in the price of money.

Look out below.

UPDATE: Atlantic Capital Management concurs

There is something wholly unsettling about this entire affair that goes beyond simple market volatility. How can the entire stock market be reduced to the whims of central bankers and their blatant attempts at controlling expectations?

Investing was never supposed to be about gauging if, when, and how a central planning authority was going to intervene in what were once perceived of as free markets. Markets may have never been fully free, but at least they exhibited a more than passing concern about the fundamental qualities and particulars of economics and finance.

In our current case, despite trillions in monetary and fiscal interventions, the overriding economic reality has not changed since 2009, or even 2001. The recovery, such as it was, was completely dependent on the government picking up the slack in economic flow that was destroyed first by the credit collapse of the housing bubble, and then the weak dollar as it “influenced” large and liquid businesses to invest capital offshore. There has been no private or sustainable effort to close the loop of economic activity through employment.

Largely, the lack of employment reflects the actual economic potential of an economy no longer under the monetary influences of runaway credit. So much activity was built on the housing bubble (like the tech bubble before it) that nothing short of another asset bubble would do – and policymakers have tried hard to accommodate. The Fed disregarded the caution that the 2008 collapse exemplified and tried to rebuild the economy as it was in 2006.

Again, if you’re among the vast majority who doesn’t read the literature, you might be thinking, “Surely, nobody could be pro-bubble. Surely, no human being could be that cynical.”

Your mouth God’s ears….

The basic point is that the recession of 2001 wasn’t a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

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