How the Fed creates bulls and bears

If you grasp this you will be light years ahead of most economists. Bull and bear markets can't exist without the Fed manipulating the money supply. Here's why.

Assume the stock of money is fixed. For example, say there exists only $1 trillion in gold and banks have lent out nine times that amount so that the total money supply of gold plus credit equals $10 trillion because the required bank reserves are 10%. Also assume the population remains constant. If nothing changed, prices would remain the same and the economy would be in a state that economists call equilibrium. Profits would equal the cost of credit, say 5%.

Now we have to look at how many times the $10 trillion is turned over, or changes hands, in order to figure out the total sales for the year. We’ll assume that the turnover, or velocity, of money is five. Then total sales for the year would come to $50 trillion. A profit of 5% would mean $2.5 trillion. Now let’s assume the PE ratio, the measure of risk tolerance, is 15. The market cap would be $37.5 trillion.

With a fixed stock of money, productivity increases at zero and the population remaining constant, the stock market would show the same values every day. Planned investment equals real savings.

Poking the bear - what happens next to the market?

The S&P is down about 9% for the year and 10% from the highs last year as of this writing. By the time you read this, the index may be even lower. The bear has been hibernating for seven years and may be waking up. If so, he’ll be hungry for your nest egg. 

Technicians will be looking for the lows of last year for support as if nothing has changed. But a lot has changed. Profits for the fourth quarter of last year are expected to fall over 5%, according to data provider FactSet. And even if you leave out the disastrous energy sector, profits are expected to be flat.

China, Brazil, Europe, Japan are in worse shape. US manufacturing has been in a recession for months. Oil, gas and mining are in recessions. We are beginning to see the effects in the consumer sector as retail sales from the Christmas season sunk below those of last year.

This is a good time to look at where we are in the business cycle using insights from pages 105-107 in my book Financial Bull Riding:

Big Short – good movie, bad economics

The outlaw couple Bonnie and Clyde was not only famous for their bank robberies in the 1930s, they were popular. They lost some of their appeal when they began murdering policemen, but people loved the fact that they robbed banks because the people hated banks. They had watched banks foreclose on farm families during the Dust Bowl and depression. Committing the economic sin of fixating on the seen while ignoring the unseen, an error first identified by the great French economist Frederick Bastiat, they blamed the bankers for the farming disasters.

People have loved to hate bankers for centuries, often for good reason. Until the creation of the FDIC, depositors occasionally lost their life savings to bank failures. Now they don’t, but the people see banks constantly bailed out by governments when they make bad decisions and then foreclosing on borrowers who have made decisions that were no worse.

So it was no surprise that the movie The Big Short blamed greedy bankers for the recent Great Recession. I reviewed the book on which the movie was based, Michael Lewis’ The Big Short: Inside the Doomsday Machine, here. As I noted then, Lewis’ economics is terrible, but the book is a great read because at its heart it glorifies the difficulties, hard work and genius of entrepreneurs and the heroes of the film are entrepreneurs.

Market crash overdue says Spitznagel

According to the legendary hedge fund manager and author of The Dao of Capital: Austrian Investing in a Distorted World, Mark Spitznagel, the stock market should follow Canadian geese and head south any day now. I reviewed his book here because he uses the Austrian business-cycle theory (ABCT) to guide his investment decisions. It has proven the most popular post I have written.

Spitznagel created his own index for tracking the market cycle he calls the Equity Q Ratio. Calculating the ratio starts with the relationship of the cost of titles to capital (stock prices) to the cost of the capital the title represents. That part is roughly comparable to a price-to-book value. Then Spitznagel compares the actual ratio to the historical average. The deviation from the historical average is the Q Ratio. The stock market in October was 71% above the long term average. It was higher only just before the dot.com crash of 2000.

How Christmas ended starvation and enriched the West

The world was flat until 1600. Not the shape of the planet. According to the best economic history, standards of living even in 1800 AD hardly differed from those of 5000 BC. TV shows dealing with the ancient past assume a gradual slope of progress so they portray Egyptians or Abraham and Sarah in the Bible as if they were primitive South American tribes still stuck in hunting and gathering mode for food. But if economic historians are correct, Egyptians in 3000 BC lived as well as the eighteenth century French.

Famine and mass starvation were common. Nobel-Prize winner Robert Fogel wrote that in eighteenth century France 20% of the people could get only enough calories each day to fuel a short walk to the spot where they begged.

Of course, some ancient capitals did better than others by looting conquered nations but per capita wealth never increased; it just sloshed from one conqueror to another. Rome enjoyed wealth and splendor because it had stolen stuff from defeated nations for the most part.

The real economy will end the expansion, not the Fed

The Fed has done an excellent job of preparing the world for this rate hike so it was already built into market prices. Don’t expect much to happen.

Some economists expect rising interest rates to kill the “recovery” and plunge the US economy into a recession. And of course the standard Austrian business-cycle theory teaches that rises rates will cut short an expansion. But as I have written before, recessions can happen without rising rates because of the Ricardo Effect.

But the idea that tight money is the only cause of recessions, as monetarists claim, is an example of the post hoc fallacy: because recessions happen after several rate increases by central banks, people think the event that happened first caused the one that happened later. It’s similar to attributing the rising of the sun every morning to roosters crowing.

US in rut like old German socialism

Mainstream economists and the Federal Reserve are trapped in a rut, condemned to repeating the mantra that monetary policy can save us even though it hasn’t for seven years. Germany after World War I faced a similar situation and the US should heed the lessons.

Socialist ideas swept through Germany like the swine flu in the last half of the 19th century. Otto von Bismarck, the Kaiser’s prime minister, devoted his career to fighting socialists while preserving the monarch by co-opting socialist policies. He promoted unions, nationalized railroads, mines and other large industries. State regulation of industry exploded. He provided social security, healthcare and unemployment benefits. By WWI socialists could not point to a single policy of theirs that Bismarck had not already deployed. Socialists dominated parliament but they weren’t happy because the Kaiser ruled and they didn't.

That changed with the revolution after WWI that gave the German socialist parliament control of the nation. Socialists were jubilant. Now they could demonstrate to the world the superior nature of true socialism. The only problem was that Bismarck had already implemented all of their ideas. They had nothing new to offer. Ludwig Mises described their quandary in his book Omnipotent Government: