The Yo-Yo Market and You

by Andy Kessler Friday, July 16, 2010

The stock market will suffer dizzy spells until the fog of monetary policy uncertainty is lifted.

Bull markets, it is said, climb a wall of worry. Smart investors buy in early when worries about profits or inflation or wars scare away the faint of heart. Latecomers then bid up stocks as each worry becomes unfounded, until there is nothing left to worry about. Once there is only good news, the market peaks as there is no one left to buy.Call it the yo-yo market—from the top of the wall to the bottom of the pit and back—and you better get used to it. It's hard to tell which market moves are real and based on prospects for better profits, as opposed to moves that are driven by all the extraordinary government measures to prop up the world economy. Until a few things are resolved, you'd better learn the yo-yo sleeper trick—that is, keep spinning at the bottom without going up.

Bear markets, on the other hand, fall into what I like to call the pit of doom. Forget about worries—actual bad stuff happens, until nothing bad is left to happen and the market bottoms as there is no one left to sell.

From early May through last week, the market dropped 1500 points into the pit, on the backs of gushing BP oil, riots in Europe, a 30% drop in pending home sales and the news that maybe your next door neighbor is a Russian spy. But now we've seen 680 Dow points added over seven straight up days before a sharp end-of-week decline. What the heck is going on?

ZIRP: We live in abnormal times. The Fed is running what is essentially a zero interest rate policy, aka ZIRP. The stock market lacks a compass, a true north, to find its way.

Good news, like the private sector adding 80,000 workers in May, or container shipping up 12% over last year, is truly good news. Bad news, like Portugal's debt downgrade or a 10.8% drop in auto sales in June, suggests the economy is slowing. No wonder the market can't figure out which is the dominant trend. And so it goes up and down, up and down.

To make things worse, the Fed's zero policy is wreaking havoc in the real world, not just on Wall Street. In most companies, projects are funded when expected returns are higher than the risk-free rate of return, i.e., investing in T-bills.

But the risk-free rate today is a big fat zero! Every project makes sense, which can't possibly be right, so corporate planners sit on their hands and companies just sit on their piles of cash. The sooner we zip the ZIRP, the sooner we return to some sort of normal.

Crutches: We all know that the economy is being held up on crutches—the biggest being the Fed printing dollars, a quantitative easing that saw the monetary base jump to $2 trillion today from $800 billion in September 2008. That program stopped March 31 and at some point has to reverse. May's 33% drop in home sales, despite record low mortgage rates, happened because an $8,000 tax credit expired at the end of April. Auto sales are down as "Cash for Clunkers" expired eight months ago.

But we still have the crutch of the remaining funds (about half) from the 2009 stimulus bill. And now the Europeans are threatening a new round of euro printing. The stock market won't believe that growth and profits are real until it sees the economy without these crutches. Until then, the yo-yo.

Taxes/Seizures: January 2011 will most likely see the expiration of the Bush tax cuts. ObamaCare means higher levies on most Americans. There is talk of a value-added tax and a lame duck Congress porkfest.

What is even more troubling is the prospect of government seizures built into the Dodd-Frank financial bill. This is much like the seizure of property from auto industry bond holders (denounced as speculators) in the bankruptcy of GM and Chrysler.

Dodd-Frank also provides government leeway to seize firms it considers a systemic risk, without really defining what that systemic risk is. Why anyone would provide debt to large financial institutions (or auto makers) is beyond me, certainly not without demanding a huge premium for the seizure risk. The cost of capital for the U.S. economy is sure to rise, slowing growth.

Until public policy returns to some semblance of stability, or at least more certainty, get used to 1000 point swings. Get used to the fans of gold and canned goods leading us to the pit of doom one week and bullish optimists up the wall of worry the next. For me, I like to get my bad news over with.

I'm waiting for Spain to melt down the World Cup to pay off its debts, or more seriously, real defaults from Spain, Greece and maybe California and New York. Let's get on with it and put the structural reforms behind us. That would be a true buy signal.

Mr. Kessler, a former hedge fund manager, is the author most recently of "Grumby" (Vigilante, 2010).