Only inflation can pop the bubble and only war can inflate again

What will inflate US equites after the next inevitable crash? I would argue the only thing left in the quiver of the global elite is war. And it lurks on the global chessboard in Syria.

There is no question when looking at this chart that the current bubble in US equities is brought to you by the Federal Reserve by way of Bernanke and his accommodating buddies at the FOMC. The three run ups in the S&P 500 that have taken place since the mid 90's have represented bubbles driven by innovation, disproportional euphoria brought on by the innovation, the stimulating effect of war inspired deficit spending, government stimulation of the housing market, and a bond and equity asset bubble caused by excess liquidity.

This chart alone allows a few assumptions about the Fed's actions in the next few months and years. The Fed move that serves as the basis for these assumptions is the emergency 75 basis point cut of the Fed Fund rate that took place on January 22 2008. I wrote about it at the time here. At the time I knew it didn't feel right that the Fed would step in on a holiday weekend in reaction to a plunge in foreign markets on seemingly no news. It showed sheer panic on the part of the Fed. Hedge fund manager David Einhorn when being interviewed on Charlie Rose said that emergency rate cut "signaled to (him) that the Fed was more concerned about the direction of the next 50 points in the S&P than the average hedge fund manager." The S&P was also approaching the 38.2% fib retracement from the July highs. Shortly after breaking through that support level it entered a free fall and retraced all the way back through the 2003 lows.

This recent history tells me that the recent talk of tapering is nothing but jawboning by the Fed to float a trail balloon of tapering over the market. And in typical new normal fashion the market overreacted. Inflation is likely the most important indicator going forward because it is not improving employment or growth numbers that will get the Fed to back off but only when inflation overshoots their current target of 2%. And even then the Fed may take there chances with inflation. The Fed is getting away with their policies because of global deflationary pressures coming from the Eurozone, Japan and now to some extent China.

Recently the Fed's St. Louis chairman Bullard stated that he will be more comfortable with tapering once CPI has reached a target rate of 2-2.5%. This indicates that the FOMC has no intention of tapering anytime soon. Using the last 20 years as a lesson the only way that the market will be able to sustain numbers relatively close to current levels without the help of the FOMC's asset purchase program is drastic disruptive innovation on par with the spread of the internet or large scale war.

There is no shortage of innovation in the US from shale oil and gas exploration to 3D printing to self driving cars. While these innovations are exciting they do not equal the arrival of the internet in the 90's. War however is definitely on the table in the Middle East with Syria/Iran. North Korea is always an option and of course China and Russia loom large on the world stage.

So in the coming months it will be interesting to watch just how aggressively stocks continue to advance. But more importantly what type of panic button is pressed once they breach a 23.6% pull back from the eventual highs.

When looking at the chart below it is hard to believe that deflation is a real concern but with CPI under 2% it shows a few things. First the dollar's strength as a reserve currency. The world's top economies are engaged in a race to the bottom when it comes to the value of their currencies. In this environment the dollar is the de facto winner because the world needs it to purchase oil and it is also backed up by the strength of the US military.

Filed Under: Economics

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  1. Major says:

    Unfortunately, Bernanke has things seriously backwards.

    He stubborly fail to understand that it’s a growing and increasingly prosperous middle class that makes for prosperous bankers and speculators — as he continues to insist that it’s increasingly prosperous bankers, still massively subsidized through with ZIRP, tax and regulatory “indulgences,” that make for growing and increasingly prosperous middle class.

    Our real economy, national productivity (and standard of living) will also continue its eight year run backwards until this basic reality is understood, acknowledged and acted upon.

    Perhaps it’s time to outsource banking?

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