Correction on the Horizon

The author of the article believes that we are rapidly approaching the point of stagflation, caused by the Fed's efforts to resolve the economic problems. He believes that another round of quantitative easing will be the final nail in he coffin.

Joe Calhoun
On August 26th, 2012
Alhambra Investment Partners

I’m traveling today (and a little under the weather to boot) so this will be a fairly short update. I’ve spent the last week visiting clients and potential clients in Augusta, GA and Asheville, NC and before I get started, I’d just like to thank our representatives Larry Hogue and Bob Williams in Augusta and Asheville respectively for their true southern hospitality during my visit. I grew up in Aiken, SC just across the river from Augusta and it is always nice to return to the South – although it is a bit ironic that I have to travel north from Miami to do so. We had a good week of meetings and Alhambra is well represented in both localities. If you live in either area and want to learn more about Alhambra’s offering, please contact Larry or Bob directly. You can find their contact information on our website.

I have been fairly upbeat about the markets over the summer despite the ongoing, albeit mild to date, deterioration in the economic data. My positive outlook was based primarily on my readings of the sentiment tea leaves and it has proved rewarding so far with the market near its highs. Unfortunately, the bearish mood has taken a turn for the worse for those of us who call ourselves contrarians. The sentiment polls, whether of advisers or individuals, have turned up a growing number of bulls lately and that has me thinking more and more about the risks to the downside. Much of that bullish enthusiasm seems to be rooted in rising expectations of action by the Fed at the September meeting or before. Evidence of those expectations were on display just last week when less dovish comments by Fed Governor Bullard pushed the market lower on Thursday and more dovish comments by Bernanke fueled a recovery Friday.

Also in that vein are comments I’ve seen recently intimating that Bernanke is likely to take action because he is concerned about being replaced in a potential Romney administration. That line of thought packs a lot of assumptions that I find hard to swallow. First, and most obvious, is that it assumes the effectiveness of another round of QE, something that is hard to justify based on the track record. Second, it presumes that Bernanke is more concerned about preserving his job than doing it correctly and ethically. I have many problems with how Mr. Bernanke has performed as Chairman of the Fed but I have no doubt that he believes the actions he has taken were the correct ones based on economic theory. Finally, it also assumes that President Obama would re-appoint Bernanke if re-elected. Considering the hostility to Bernanke in Congress that is far from assured.

Other sentiment readings are also pointing to a renewed bullishness. The volatility index is scraping near its lows, indicating a potentially dangerous level of complacency. Put/Call ratios have also recently shown an enthusiasm for calls over puts.

The economic data continues its mixed ways with manufacturing and consumption data showing signs of weakness while housing data continues to indicate an emerging if not exactly exuberant recovery. The Chicago Fed National Activity index last week improved somewhat but still shows growth below the long term trend. Durable goods orders rose smartly, but that was primarily a function of transportation orders. Ex-transportation, the gauge was slightly negative. A lot of the spike in transportation orders was due to another strong month for aircraft orders and was quickly dismissed by many observers but I would point out that within the transportation sector, auto orders also showed a solid gain, up nearly 13%. Auto industry activity has a much greater impact on the economy than aircraft orders. The report also contained a negative reading on non-defense capital goods orders ex-aircraft, an indication of capital spending, and that can’t be so easily dismissed. Housing continued to show some strength with existing and new home sales both surprising on the upside.

Another source of my bullishness has been my belief that Europe would be able to fend off Armageddon for a while longer and that has also proven correct. Mario Draghi’s comments that he and the ECB would do whatever is necessary to preserve the Euro confirms my belief that the common currency and the European Union are political constructs in which the politicians have invested heavily. They are unlikely to allow its dissolution without a determined effort to preserve their generational efforts at forming a more perfect – or imperfect as the case may be – union. I suspect those efforts will, in the end, involve much more intervention in sovereign bond markets by the ECB than has been seen to date. We’ll find out more when the German courts rule in September on the legality of the various funding mechanisms being considered for purchasing Spanish and Italian debt. In other words, expect some angst out of Europe in the coming weeks.

There are a number of potential disappointments on the horizon and with sentiment now firmly in the bull camp I would not be surprised at all to see one or more of them realized. Ben Bernanke will speak at Jackson Hole this week in a widely anticipated speech on the economy. It was at the same annual confab in 2010 that Bernanke essentially announced QE 2 so the speech will be carefully parsed for hints of the third version. After that we’ll get a raft of economic data including the monthly read on the jobs market. Finally we’ll get the September meeting of the FOMC and the aforementioned German court ruling. All of these events have the potential to upset the bullish mood and investors would be wise, I think, to prepare themselves for some form of correction in the coming weeks. At Alhambra we’ve added a long position in the volatility index and are watching our positions carefully.

One last quick observation. I have been warning since the crisis that the Fed’s efforts to resolve our economic problems would eventually lead to stagflation. I think we are rapidly approaching that point and another round of QE might be the final nail in the coffin. The fact is that our problems are structural and require changes in fiscal and regulatory policy. They cannot be solved by monetary policy alone. We are about to repeat the mistakes of the 70s with similar consequences. Adjust your portfolio accordingly.

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