Why Inflation Could Signal The Inflection Point For Stocks

As stock prices continue to ascend with very little interruption, the investing public, experiencing the first winds of inflationary pressures, has begun to question the market’s staying power. 

Since this run began with Bernanke’s Jackson Hole speech, it has only seen two minor reversals (if they could be called that). 

Total exchange volume has been reduced dramatically as the only active participants left are momentum players and high frequency traders’ (HFT) computer algorithms buoyed by the Fed’s continuous permanent open market operations (POMO). 

With both traditional buyers and sellers on the sidelines, what could possibly turn this market around?

The obvious answer is inflation.  Since most of the increasing commodity costs have yet to be passed on to end users, the pain is being concentrated within corporate profit margins.  We have just begun to see major companies disappoint in their earnings reports – notably Ford, Cisco and FedEx.  Each of these businesses saw their stock hammered in price after their respective announcements, but those declines had little immediate impact on the markets and have had no lasting impact.

Part of the reason for this loss of leadership among these “bellwethers” is the current structure of the stock market itself.  This current market is not what it was even a few years ago.

Much of the change has to do with two fundamental shifts:  the explosion in the number and use of exchange traded funds (ETF), and HFT.  Together these changes have led to rising correlations among all stocks, creating the conditions for low volatility that disfavor institutional investors, especially alpha-seeking hedge funds.  Volatility has shifted out of stocks and into currency trading, commodities, and even credit, leaving a hole in stock trading volumes.

As HFT’s have progressed into major market players, disjointed stock movements have become more commonplace.  The May 2010 “flash crash” was the biggest example, but there have been dozens of mysterious stock movements in individual names since then.  These movements were the primary reason for retail investors shifting out of stock mutual funds and into bond funds – fear of another flash crash.

So if the lack of alpha opportunities and HFT-induced flash stock movements has kept small and large investors alike on the sidelines, what would induce them to begin selling en masse?

Last May fear over Greece forced banks to begin liquidations that spread quickly to the US, and forced the ECB into its first massive bailout.  Since then, Ireland has imploded (after we were told repeatedly it would never need intervention), Portuguese and Greek bond spreads are now higher than they were last May, and bondholder haircuts are now a real possibility.  Yet stocks in developed countries continue to move higher.

The common theme through all of this is liquidity.  Central banks have done very well ensuring that markets remain liquid enough to forestall any type of fear-driven sell off.  They have done such a good job that these new crises barely budge markets, where a year ago they almost led to outright panic.

It seems like a good thing to keep markets from melting down, and to keep them operating orderly.  But this misses a critical point of systems in a critical state.  If the stock market in particular, and the financial system in general, is a complex system, as surely it is, then each panic avoided does that system more harm than good.  Instead of removing fear, each intervention moves the system closer to criticality.  Like a rubber band being stretched, every bailout and liquidity intervention puts more pressure on the markets.

In its June 1938 annual statement the Bank for International Settlements looked back on the debacle of 1936-37 (the depression within the Great Depression) to figure out exactly what had happened.  They saw then that:

“And if fear of deflation be identified with a fear for international monetary stability, this may so hinder economic recovery as to force deflation on a world gorged with gold.”

In other words liquidity was not enough to prevent another calamity.  Simply creating money alleviates some symptoms but never really addresses the imbalances that are responsible for the crisis in the first place.  As such, fear is never far from the equation.

In 1936 the Federal Reserve raised the level of required reserves for the banking system because it began to worry about the potential inflationary pressures that the accumulation of money and liquidity within the banking system represented.  In doing so it triggered a massive drain in available liquidity as banks scrambled to restore their excess reserve levels (liquid cash above required reserves).  Deflation resumed and the economy collapsed again.  Despite all the intervention of the period the economy was still in a critical state, ready to snap from any change in conditions.

This episode showed that liquidity interventions by policymakers are something like a doctor giving a patient morphine.  It takes away the immediate pain but leaves the disease untreated.  However, once the body, or financial system, gets used to a certain level of the drug it needs ever increasing doses to maintain some semblance of functioning.  In 1936 and 1937, the removal of liquidity led to collapse because the economy that had grown from the depths of the Great Depression was entirely dependent on money-driven inflation – it was artificial.  Gold flows returned to the US after the dollar devaluation in 1933 but that had only solved immediate liquidity problems.  The imbalance of too much debt and production capacity remained in place through the whole of the decade.

For today’s markets, drowning in excess liquidity and interventions, a reversal is possible through the same withdrawal process.  We saw this already in 2010 – the market swoon from late-April through August came after the Fed had stopped printing money on March 31, 2010.  Addicted to the easy credit, the markets and the economy began to reverse.

For 2011, the Fed’s current monetary stimulation is slated to end on June 30.  If inflationary pressures combine with enough political pressure then quantitative easing may not be renewed.  At that point (long before that actual deadline) the bellwether companies will certainly begin to influence stock sellers – generating volatility that just might entice the institutional investors into shorting stocks again.  Once marginal liquidity production falls off, like taking the addicted patient off pain medication, the pain of the uncured disease becomes very real again.

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