Summer of ‘29? The “Vomit Comet” Economy

Elaine thinks I was being lazy this weekend,  Lounging in my overstuffed leather recliner, staring at the big screen computer display once in a while, I can see where that might be the impression.

But the reality is I’ve been doing a lot of deep-thinking on the application of neural networks to markets.  Multilayered feed-forwards, and other such tools, as gaming the market takes a lot of time.

Today, the Dow figures to tack on 50-points in the early going today  – ostensibly for any number of “headline reasons” including:

Election in Ukraine is behind us.  Still, this could blow up again this week as dozens of pro-Russian fighters died in Donetsk.

The right (small /EU/ groups made gains in European Union voting, but it could have been worse.  Global world government lite seems to be the fallback chatter.

And oh, another mass/outrage killing will spur more gun control discussion.

Fine, on the surface.  But there’s something much more serious going on.

Math.

There’s a dirt simple equation for rising markets and it works out thisaway:

Say you have one share of a stock and it is earning $1.

If the prevailing investment environment is giving people returns of 10%, then you would own $10-dollar stock.  The markets are competitive like this.

But, suppose that you still have $1 worth of earnings and the prevailing yield of competing investment choices drops to 5%.  What happens to the stock price?  It  tends to rise to $20.  (Ceteris paribus, all other things being equal.)

Now suppose that the same $1 worth of earnings exists and the prevailing interest rate drops to just 2%.  What is the stock price likely to be (again, cet.par.)?  $50!!!

So the Big Story that no one is explaining worth a crap behind the headlines is that the reason stocks could hit new highs is that rates are heading toward deeper, lower, lows!

If this was only a US phenomena, it wouldn’t spell global economic disaster down the road (when rates rise).,  But look out!  When rates do begin to rise, then things will turn exactly the other direction and what has been the “virtuous cycle” will turn into a vicious cycle.

And that gets us to the most important financial lynchpin story of the morning:  “Europe’s deflation threat may be growing” says the Boston Globe.

Provided companies can hang on to at least some earnings, record Dow highs are just ahead, as are highs in the S&P.  The NASDAQ has some catch up to do, but we could be in one of those “Summer of ‘29” events shortly.

I don’t say this lightly.  The greatest challenge the Federal Reserve will have to face over the next three years will be how to manage the eventual “turn” in rates.  Put simply, rates will have to reverse as some point, or the world collapses in a heap.

But if they get it even slightly wrong, as happened when rates were being raised in 1929, things can collapse – globally. 

Here’s a snip from a San Francisco Federal Reserve Bank Economic Letter “Monetary Policy and the Great Crash of 1929: A Bursting Bubble or Collapsing Fundamentals?”  (From 1999):

“Price-dividend ratios continued to fall until July 1929, but then prices began to take off. In August, the Fed raised the discount rate by another percentage point to 6%. The stock market peaked in the first week of September. It is worth noting that at its peak the price-dividend ratio was 32.8, which is well below values reached in the 1960s or 1990s. Share prices declined in a more or less orderly fashion until the end of October, but then the market crashed. From its peak, the price-dividend ratio fell roughly 30%, to a level roughly similar to that prevailing at the beginning of 1928, when the Fed began to tighten.

In the immediate aftermath of the crash, the New York Fed took prompt and decisive action to ease credit conditions. When investors attempted to liquidate their equity holdings, many lenders also called their loans to securities brokers. With the encouragement of officials at the New York Fed, many of these brokers’ loans were taken over by New York banks, who were allowed to borrow freely at the discount window for this purpose. The New York Fed also bought government securities on its own account in order to inject reserves into the banking system. In this way, they were able to contain an incipient liquidity crisis and prevent the crash from spreading to money markets.

But this respite from tight money proved to be temporary. After the liquidity crisis had been contained, monetary policy once again resumed a contractionary stance. Throughout 1930, officials at the New York Fed repeatedly proposed that the System buy government securities on the open market, but they were systematically rebuffed. The reasons other members of the Federal Reserve gave for opposing monetary expansion are instructive. Several felt that much of the investment undertaken in the previous expansion was fundamentally unsound and that the economy could not recover until it was scrapped. Others felt that a monetary expansion would only ignite another round of speculative activity, perhaps even in the stock market. In any event, monetary policy remained contractionary; the monetary aggregates fell by 2% to 4%, and long- term real interest rates increased.

By maintaining a contractionary stance throughout 1930, after a recession had already begun, the Fed contributed to a further decline in economic activity and share prices. By the end of the year, the price-dividend ratio had fallen to 16.6, or roughly 34% below the long-run average. By then, there was a consensus that speculative activity had been eliminated!

The Fed no doubt has computer modeling staff working holidays to figure out the problems ahead of time.  Some Fed sources are saying that a rise in interest rates could come in the second half of next year.  Or, says another, late Q1 2015.

An Economic “Vomit Comet”

The analogy would be made to the famous “Vomit Comet” airplane rides.  As an airplane goes “over the top” in a weightless arc upward and into descent, things get weightless for a while.  That’s where the stock market is right now.

However, at some point the pilot has to pull out (or go crashing to earth at terminal velocity, pick one).  And as backpressure is applied to the controls, tremendous stresses build up.  Suddenly, what has been weightless before gets heavy – in fact, in a 5-G pullout, Ures truly weighs something north of 1,000 pounds.

That’s when things can break.  In airplanes and economics.

The problem the Fed faces is really two-fold:  First:  They can’t be sure exactly how the flows of funds will work when then start to pull out of the present “Zero Gravity Economy.”

Secondly: When they do pull back on the controls (raising rates) will things have gotten so “heavy” (in pullout from the dive) that the airplane of State will simply suffer structural failure?

That’s what we have to look forward to in 2015-2016.

And if interest rates rise from 2.5% to even a modest 5% in the period (which is closer to historical norms) that implies a Dow at around 8,300.  All other things being yada, yada.

Not that it will be easy timing in and out of the decline.

The problem today is that the world is comprised of a deeply interlocked financial system comprised of disparate interests, each seeking maximum personal advantage.  And that’s where I expect the economic airplane’s  “control problems” to come from.

In a sense, globalism has let an unruly gang of children enter the cockpit of the economic airplane and right now (in public) they are fighting over the controls.  The US Fedspeakers are hinting at rates doing up as soon as late this year.  They can read airspeed and know how much money is sloshing about in the banks.

But notice over in Europe, Mario Draghi of the European Central Bankers is about to push the globalista “airplane” into an even steeper dive, trying to get up some additional speed before trying to pull out.  Yesterday’s European elections is being heard as the Euro class passengers on the plane demanding more airspeed.  Not smart, but it’s the Euro-class, what can I say?

Which means, at some point, the US Fed essentially loses control of the  global airplane and the Vomit Comet financial airplane breaks up from being over-stressed in flight.

The comments just crossing this morning from Chris Legarde (and other similar pap about inequality and whatever else as sideshows and distractions) is merely diversion from the real problem.  It’s symptomatic of fighting over the controls as the airspeed is still climbing. 

Gimme MY candy bar or were going to 900 knots in this dive!” is what I hear LeGarde saying, as each of the cockpit gang jostle about  trying to avoid blame for what’s sure to come.  A few passengers, ignorant of airspeed and gravity, will cheer damn near anything or anyone. Saying banking reform has not made enough progress is akin to “We don’t have ALL the controls yet.”

Having short positions at the ready, and buying gold (dollar cost averaging on the way in) are not unreasonable responses, since just before “economic impact” from the flight control brawl, all kinds of “solutions” will come up, including direct confiscation of wealth from traditional economic safe houses. “Bail-ins!  That’s what we need now!” will come the words from the cockpit after impact.

A rational society would ban the practices that led to the crash, but we don’t score too highly on the Developed Civilizations Index.  Like technologies, civilizations have life cycles, too.  So do economies.

Paid up land with a well and five years of taxes may sound like a fool’s position, but if you are paying attention, the commotion up in the cockpit is getting louder and the ground looks to be getting closer every day.

Durables, Housing to Come

What Monday on Tuesday is complete without an offishul (sic) press release on durable goods orders?

New Orders
New orders for manufactured durable goods in April
increased $1.9 billion or 0.8 percent to $239.9 billion,
the U.S. Census Bureau announced today. This increase,
up three consecutive months, followed a 3.6 percent
March increase. Excluding transportation, new orders
increased 0.1 percent. Excluding defense, new orders
decreased 0.8 percent.

Transportation equipment, also up three consecutive
months, led the increase, $1.7 billion or 2.3 percent to
$76.9 billion.

Shipments
Shipments of manufactured durable goods in April,
down following two consecutive monthly increases,
decreased $0.6 billion or 0.2 percent to $237.2 billion.
This followed a 1.3 percent March increase.
Transportation equipment, down following three
consecutive monthly increases, drove the decrease, $0.7
billion or 1.0 percent to $69.5 billion.

Unfilled Orders
Unfilled orders for manufactured durable goods in
April, up twelve of the last thirteen months, increased
$10.4 billion or 1.0 percent to $1,081.0 billion. This was
at the highest level since the series was first published on
a NAICS basis in 1992, and followed a 0.8 percent
March increase.

We’ll discuss the implication of the Housing data in Peoplenomics tomorrow.

Vietnam War, II

China sank a Vietnamese fishing boat this weekend as tensions continue to rise between the countries.

For those who don’t remember (or, might now have been born yet, come to think of it) the northern part of Vietnam has a decent-sized Chinese population and they tend to be the owners and merchants.  Fallout from centuries of domination, as it makes things tense between them, especially when it’s a small country next door to one with “dynasties” embedded in their thinking.

Speaking of Chinese history, do you realize that if Tibet were a free country (as opposed to an autonomous region) it would be the size of Colombia?

White House Ooops

Outing a CIA agent.  Now trying to unlay that egg.

Dying to Visit Switzerland?

Elderly who are NOT terminally ill are to be giving assisted dying they want it.

I wonder how they’d handle a “No, I’ve changed my mind…” case?

Plane Speaking

Let me see, the MH-370 flight went missing around March 8, so it has only 2 1/2 months to release satellite data.

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