When the Fed Expands the Balance Sheet, the Market Rises and Vice Versa
Golden Anniversaries and Dead Trading Gurus
Let me start by confessing that I am in one of my moods. So you are forewarned. I could not help it, as today is the 50th anniversary of President Nixon taking the United States off the gold standard. I thought it was worth mentioning since the 50th is a “golden” anniversary, pun intended. The U.S. debt of nearly $30 trillion and growing would not be possible without that monumental step taken on a warm Sunday afternoon in August 1971.
And then there are those pesky “unfunded” liabilities. Would they still be possible?
Unbacked, fiat (paper) currencies have been the undoing of every global reserve currency (and world power) in history. As we see today, the people demand more, the politicians deliver, and the central planners kick the can down the road until they can’t. At least gold forced a modicum of discipline. That is why it had to go. It was the cost of the Vietnam War then.
Coincidentally, there are vestiges of the 1970s all around us now. Gas lines, inflation, riots, protests, Marxists – I have seen this movie before. Now Afghanistan is the new Saigon.
The most any reserve currency has lasted in history is about 100 years. Whether you trace the roots back to the Romans, Dutch, British, etc., it all ends the same, and it doesn’t end well.
Try as they might, central banks cannot cancel the economic cycle. By deferring the pain of the Financial Crisis, and now the China Virus, the ultimate price we pay is certain to be much greater. We could face the worst bear market of our lifetime. A depression of the 1930s variety is unimaginable to the modern world, and that is why we are vulnerable to repeating it right on time for the longer-term cycle trough.
The only thing that backs the U.S. Dollar now is confidence – plain and simple. What do we know about confidence? It takes a long time to build but can be eroded overnight. And there is no lack of enemies willing to help us fall. China, Russia, Iran, and even our European competitors, are waiting in the wings to pick up the pieces.
Perhaps the only thing we have going for us is that none of those countries are any more responsible than we are for fiscal reality. It will be a “global” solution with a new, “global” currency to replace the U.S. Dollar when it all comes tumbling down. No doubt we will all be paying a world income tax, too, as our sovereignty gives way to the New World Order. Brace yourselves.
I hope I don’t live to see this, but it is as inevitable as the sun coming up in the morning. Let me ask you, how is your confidence in the U.S. Government these days? How will the world look at Afghanistan’s overnight collapse and surrender to terrorists? What about our government’s fiscal responsibility? Another $6.5 trillion in spending goodies on the table, really? What about the national debt. What about inflation?
Today’s anniversary also got me thinking again about the Fourth Turning. We are in the midst of the Fourth Turning, which is why there is so much consternation and turmoil. It is part of the generational cycle.
To simplify it, we are four generations (roughly 20 to 25 years each) removed from the Great Depression and World War II. In other words, most of us are the spoiled grandchildren of our grandparents and great-grandparents. So we tend to ignore or minimize the risks and realities of life – like avoiding debt, hard work, individual responsibility, frugality, a responsible government, ethics, and the like. I always like to call it “unearned wealth in undisciplined hands.” And so, history repeats as memories fade.
The Fourth Turning that preceded the Depression and World War II encompassed the Civil War. Before that, the turning encompassed the Revolutionary War. This turning likely won’t end until 2030. The precedent is both sobering and grim, and we are barely at the midpoint of the cycle. If you wonder why everything seems so unhinged, the Fourth Turning is your explanation.
The generational cycle also got me thinking about a fairly well-known and deceased market guru named W.D. Gann. As with most dead gurus, he tends to be more celebrated now than when he was alive. Rumors abound that he died with a several hundred million dollar fortune. His son, once interviewed, stated otherwise. His son indicated that Mr. Gann sold trading programs from the trunk of his car.
Nevertheless, Gann’s math and predictions were contemporaneously tested by a reporter for a prominent financial publication in the early 1900s. To the reporter’s astonishment, Mr. Gann’s predictions came true day after day during this “test.” So there was (is) something to the Gann number calculations and predictions. In 1912 or so, he predicted a stock market crash in 2020. That is certainly an attention-getter.
Important for our discussion, Mr. Gann was keen on a 90-year stock market cycle, which I believe is somewhat related to the Fourth Turning. The last 90-year cycle trough was the 1929-32 stock market crash and bear market. The cycle provides a window between 2019 and 2022 for its next trough or bottom. Maybe the March 2020 China Virus crash was it. But what if we were to revisit the March 2020 lows sometime in the next year?
That would be a shocker. Is it probable? Likely not. But when I look around, I cannot exclude the possibility. There is no lack of catalysts.
Taking the micro view, the vaccines don’t work. The government was slow to reveal this, but the evidence mounts daily. The Delta Variant is highly contagious, as are government bureaucrats who enjoy their newfound authoritarian rule. More lockdowns? Maybe. Socialism and Marxism seem to be taking root in our government and previously trusted institutions. The printing presses are out of control, and interest rates seem to be going up right now – which could burst the financial asset bubble.
Taking the macro view, corporate and sovereign debt is beyond historical comprehension. Interest rates are artificially low. How do I know that? Who in their right mind would accept a yield of 3% on “Junk” Bonds? That is what you pay for your secured first mortgage. Who buys this junk? I want to hire the Junk Bond industry’s marketing person. By the way, junk bond prices are not confirming the new highs in the S&P 500 index. That is a bad omen.
With the supply of debt at historic levels, who will buy all of it? What will they be willing to pay? The less buyers are willing to pay; the higher interest rates will climb. The fundamentals of supply and demand tell us that rates will go higher. I cannot tell you if it is now, next week or next year. All I can say for sure is that the fundamentals support higher rates, and they won’t stay low much longer.
For all of this historical debt to work and not crush all of us, the Fed has to stay in control of interest rates. It is the key to avoiding national collapse and bankruptcy, not to mention financial ruin for the rest of us. But there have been times in history where the Fed loses control, and the market takes the helm. That could be underway even at this writing.
It is scary to contemplate that the cheapest asset class on the planet is commodities, even after the recent rally. Likely, the rise in commodity prices is just getting started. What if all the money chasing stocks suddenly shifted to commodities? What would that do to the price of wheat, corn, cotton, and the like? Inflation anyone? Likely so. What will we do if the commodities indices were to go vertical as the NASDAQ 100 has?
Is the stock market rally real anyway? In the chart at the beginning of this discussion, the Fed’s balance sheet is green, and the broad Wilshire 5000 Index is blue. The green line rises when the Fed expands its balance sheet (going into debt). Notice how the stock market then correlates and zooms.
Yet, when the Fed stops growing the balance sheet, and the green line flattens, the market stalls and corrections are deep. When the Fed reverses and starts shrinking their balance sheet, the market starts throwing what is now called a “taper tantrum.’ Do you recall the 20% decline in the latter part of 2018 into Christmas Eve? How about the expanding triangle from 2017 until 2020? It was not fun.
My goal in sharing these thoughts is not to terrify you. First and foremost, be aware. Don’t be a sheep, be a sheepherder. Stay tuned to these pages. My goal is to help you avoid the coming pain. Then I want you to take advantage of the situation, just like our esteemed elite will do. So don’t fret, prepare.