That Was The Weak That Worked: Part I

By Grant Williams

December 30, 2013

Those aboard the ship were deprived of a chance to hear the words of a journalist and broadcaster without peer in the modern world, whilst the rest of us woke to find ourselves being reminded of the high points of his remarkable life, particularly his famous interviews with Richard Nixon, which were immortalized a few short years ago in the stage play and subsequent movie Frost/Nixon.

But Frost's star was set on its upward trajectory via a completely different type of vehicle when, after graduating from Cambridge University in 1962, he was selected to present a new weekly satirical review devised, produced, and directed by Ned Sherrin and entitled That Was The Week That Was or, as it became colloquially known, TW3.

The writing staff of TW3 was a who's who of British comedy (John Cleese, Peter Cook, Eric Sykes, and Ronnie Barker were all amongst the contributors) but also included literary greats such as Dennis Potter, Roald Dahl, and Sir John Betjemin; and some of its sketches became the stuff of British comedy folklore.
Wikipedia describes TW3 thus:

(Wikipedia): The programme is considered a significant element of the satire boom in the United Kingdom in the early 1960s. It broke ground in comedy through lampooning the establishment and political figures.

You can probably figure out why I'm a fan. TW3 liked to point out the absurdities of the political system and take pot-shots at political figures. If only they'd had some kind of financial crisis in the 1960s, the symmetry would have been perfect ... but no

Instead, after a tumultuous four years between 1957 and 1961, the US, though saddled with high unemployment and huge excess capacity, embarked upon a mid-decade boom, whichhard though it is to believe — was actually helped by constructive government policy in the form of the Kennedy-Johnson tax cuts.

Of course, there was the little matter of a war police action in Vietnam which led to a sudden 3.5% surge in the PPI in 1965, but let's not let anybody get any ideas as to how combat might be used to create a little desired (but controllable) inflation, shall we?

Let's change the subject.


The end of the year is inevitably a time when even the most hard-bitten amongst us wax nostalgic and reflective, looking back on the previous 12 months as though the arbitrary break in the calendar should have some meaningful effect on fortune or fate. Of course, it doesn't, except for the fact that enough people tend to subscribe to that line of reasoning that it feels as though it actually matters.

Human beings change their behaviour around the end of one year and the beginning of the next because over time they've been conditioned to believe that changes are justified. The appropriation of that mindset by various groups over the course of the past twelve months has been, for me, perhaps the most noticeable evolution in 2013.

The title of this week's Things That Make You Go Hmmm... says it all:

"That Was The Weak That Worked"

Throughout 2013, the distortions created by intervention in once-free markets have left many (myself included) scratching their heads. The interventions have worked almost faultlessly — but for them to do so has required the suspension of one belief system (economic reality) and the adoption of anothernamely, that everything will be OK because ... well, just because.

Can the fantasy persist into 2014? Yes. It most certainly can.

Will it continue into 2014? Most likely.

Will this new belief system become the new economic reality? Not a chance.

So we're going to end 2013 by taking a three-part look at "The Weak That Worked" to try to get a sense of what could take place in 2014 if it happens to be the year that economic reality finally reasserts itself.

This week in Part I, I will focus largely on equities, and next week we'll take a look at the bond and housing markets before heading to Europe and beyond.

So let's get cracking, shall we?

2013 was another year brought to you by the letters Q and E.


Quantitative easing spanned the entirety of 2013 and, as was no doubt intended, the market, the public at large, and most certainly just about every single inhabitant of Capitol Hill became so inured to the creation of $85 billion each and every month that the enormity of that policy dissolved from the collective consciousness like early morning mist.

But amidst all the commentary and the debate surrounding QE, most people lost sight of what it actually iseven when we received the much-anticipated news in December that there would, in fact, be a Taper after all.

Before we get to the Taper that happened, though, it's important to revisit the one that didn't.

On May 22nd, 2013, Ben Bernanke, in a question and answer session, said the following:

We're trying to make an assessment of whether or not we have seen real and sustainable progress in the labor market outlook. If we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.


The consequences of that statement — and in particular, the last 20 wordsreverberated around the financial world and wrought havoc in all sorts of weird and wonderful places.

(In a presentation entitled "A Confederacy of Dunces" that I gave to a small group in Spain in late June, after Bernanke's comments, I pointed out the effects of the Taper threat and pinpointed some of those weird and wonderful places.)

The effect Ben's pronouncement on both the S&P 500 and the US 10-year yield were immediately obvious:

Source: Bloomberg

The S&P dropped a quick 6%, and 10-year rates (seen inverted in the chart above) spiked from below 2% to 2.6% — a big move.

But some of the other instruments affected by Bernanke's carefully floated idea weren't quite so readily apparent. Nonetheless, they demonstrated just how pernicious and far-reaching the tendrils of QE had grown.

Like all the way to Indonesian bond yields, for example:

Source: Bloomberg / Grant Williams, "A Confederacy of Dunces"

Or those here in Singapore:

Source: Bloomberg / Grant Williams, "A Confederacy of Dunces"

And even those who held Brazilian bonds saw something meaningful shaved off:

Source: Bloomberg / Grant Williams "A Confederacy of Dunces"

Bernanke also committed the cardinal error of announcing that QE would END once unemployment fell to 7% — a statement he had to back away from, rather embarrassingly, as the slump in the participation rate brought 7% unemployment closer, rather faster than expected:

(WSJ, Dec 6, 2013 ): Back in June, when Fed Chairman Ben Bernanke laid out a tentative timeline for winding down the bond-buying program, he said 7% is where the Fed expected the unemployment rate to be when it ended the purchases. He said central bank officials expected that to occur around mid-2014

Friday's jobs report showed the jobless rate hit that level in November, and the Fed hasn't even started scaling back the program.

The jobless rate for May, the latest data Mr. Bernanke had when he laid out that guidepost, stood at 7.6%. Then it fell much more quickly than Fed officials expected, dropping to 7.4% in July and 7.3% in August.

In September, the Fed surprised many market participants and held the quantitative-easing program steady. At his press conference after that meeting, Mr. Bernanke made no mention of the 7% guidepost he'd set out a mere three months earlier. When asked about it, he downplayed the importance.

"There is not any magic number that we are shooting for," he said. "We're looking for overall improvement in the labor market."

In short, the trial balloon floated to gauge potential reaction to a $20 bn per month Taper was a disaster, and that meant that when the September FOMC meeting came around, the governors in the voting seats just couldn't bring themselves to pull the trigger.


When the minutes of the October meeting were released in November, it became clear that the FOMC, lessons duly learned, were going to try out the Taper again — perhaps in December:

(Fox Business): Federal Reserve policy makers are still struggling to find the right message for conveying to investors their plans for scaling back their easy-money policies, notes from the Fed's October meeting reveal.

The minutes, released Wednesday, also said members of the policy-setting Federal Open Markets Committee could see the central bank trimming its $85-billion-a-month bond-buying program at "one of its next few meetings."

If at first you don't succeed...

But they had clearly realized that even a $20 bn Taper was going to be taken poorly by the markets, and so the FOMC (and in particular its soon-to-be-retired chairman) needed to pull off a delicate balancing act.

On the one hand, Bernanke would want to leave the Fed with the wind-down of his expansionist policy underway so that he would have the kind of plausible deniability that history has gradually been stripping away from Alan Greenspan. ("Hey, don't blame ME. We were exiting QE when I left office!") On the other hand, though, he wouldn't want to hand Janet Yellen an impossible situation.

The solution?


Taper Lite!

"All the goodness of the Taper with no bitter aftertaste!"

... and the markets, after the scares in May and June, LOVED it!!

(CNBC): U.S. stocks surged on Wednesday, with the S&P 500 and Dow industrials closing at records, after the Federal Reserve moved to cut stimulus, saying it expects the labor market will continue to improve and vowing to keep interest rates low.

"Investors are looking past the taper and looking at the strength of the economy that is perceived with this news," said Chris Gaffney, senior market strategist at EverBank.

"The Fed did a great job telegraphing it to the markets, as stocks are moving in the opposite direction than you'd think," he added of equities rallying on the news.

Errrr ... sorry to spoil the party, but a couple of things here:

Firstly, the reason the market spiked is that the Fed's Taper turned out to be a paltry $10 bn a month and not the "whopping" $20 bn a month that had been floated by various Fed mouthpieces back in May cough-cough-cough-hilsenrath-cough.

Secondly, the Fed were at great pains to promise low rates for much, much longer — so the free-money party can continue.

(WSJ): The Fed went to great lengths to send the message that interest rates are staying low even longer than the Fed indicated earlier. It said today that it will keep interest rates low "well past" the time when the unemployment rate reaches 6.5%.

"The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."

Got that folks? Repeat after Ben:


"Tapering isn't tightening."

Thirdly, they managed to communicate that this policy will be reversible at the drop of a hat should things start to look as though the vaunted "recovery" is nothing more than a mirage conjured by their actions.

The danger in that reversibility is one for discussion another day. For now, the markets reacted just as you would expect, once they realized that they had faced down the Fed in the summer and forced them into a taper that is essentially a non-event.

"Only" $75 bn a month from now on? Of course the market went up after the announcement!

Source: WSJ

But amazingly, the mere fact that the Fed had committed to a tiny reduction in their rabid spending led to all sorts of people heralding the greatest monetary victory of the modern age.

Ambrose Evans-Pritchard, for whom I have a great deal of respect despite his somewhat Keynesian leanings, wrote a piece almost inconceivably entitled (and this deserves a line all of its own):
"Farewell QE, You Have Been a Magnificent Success"

Wait ... WHAT?


Now, I've seen a few medals handed out halfway through races in my time ... but THIS???
Ambrose, puh-leeze.

(Ambrose Evans-Pritchard): As the US Federal Reserve starts to drain dollar liquidity from the global system at long last, let us celebrate success. Quantitative easing has worked marvellously well. Monetary policy has been vindicated.

That's just for starters. Once he hits his stride, Ambrose looks like a thoroughbred racehorse. QE Biscuit, if you will:

(Ambrose Evans-Pritchard): The US, UK and Japan are all recovering, moving closer to "escape velocity". The Swiss National Bank — that bastion of orthodoxy — has kept its economy on an even keel by quietly amassing a bond portfolio equal to 85pc of GDP.

Call me old-fashioned, but "amassing a bond portfolio equal to 85pc of GDP" simply to keep your economy on an "even keel" doesn't sound like success to me.

Before he's done, Ambrose takes time out to laud Abenomics; and buried within the story of the stunning success of Abe's policy, there lies, as the Bard would say, the rub:

(Ambrose Evans-Pritchard): Japan, too, has grasped the nettle, breaking free of its deflation trap with the most radical policy experiment of modern era, a repeat of Takahashi Korekiyo's brilliant policies from 1931 until his assassination by military officers in 1936.

After two decades of monetary tinkering the Bank of Japan is mopping up 7.5 trillion yen worth of bonds each month, almost as much as the Fed in an economy barely more than a third the size. It is buying long-term debt for the first time. This ignites the broad M3 supply, now humming at a 3.4pc growth rate, the highest this century.

Japan was the fastest growing economy in the OECD bloc in the first half of this year. There was a hiccup in the third quarter, causing the faint-of-heart to write off Abenomics.

Yet Nomura's Shuichi Obata says the December Tankan survey of business shows that confidence is at last spreading from big companies to small firms, with the services index rising above zero for the first time since 1991.

Much can still go wrong. Next year's rise in consumption tax from 5pc to 8pc could abort recovery. The "Third Arrow" of Thatcherite reform planned by premier Shinzo Abe has yet to fly with much force. The Japanese bond market may take fright once inflation nears the 2pc target. Yet the Bank of Japan's belated panache under Haruhiko Kuroda at least gives Japan a chance of averting slow collapse.

Yes, Japan has a chance of averting a slow collapse ... and it may now be able to avoid that fate — in favour of a swift one.

Back in the 1930s, the rub came when Takahashi's policies needed to be reversed once Japan, too, was on a somewhat "even keel."

Whilst "Takahashinomics" (as the policies would no doubt have been dubbed had the Japanese press of the 1930s possessed any panache) did engineer a remarkable turnaround in Japan's fortunes, it featured military spending that increased as a percentage of the total budget every year, from 31% in 1931, at the beginning of his tenure, to 47% in 1936.

When Takahashi set about unwinding his mammoth stimulus in 1936, however, things got a bit ... sticky, as Myung Soo Cha notes in a paper entitled "Did Takahashi Korekiyo Rescue Japan from the Great Depression?":

... when the worst seemed over, Takahashi began to be concerned about inflation and tried to revert to stabilization. Reducing expenditures, he attempted to put an end to debt financing, while at the same time urging the Bank of Japan to absorb money it had supplied in the course of debt monetization.

Ahhhh ... the first Taper.

"What happened next?" I hear you ask. Well, I'll tell you:

(Wikipedia): Despite considerable success, his fiscal policies involving reduction of military expenditures created many enemies within the military, and he was among those assassinated by rebelling military officers in the February 26 Incident of 1936.

The original Taper Tantrum, whilst extreme, demonstrates the problems that may be associated with taking away stimulus.

That is, the people who have benefitted from it may not like it.

They didn't in 1936, and they won't in 2014.

Before we move on, let's see what Ambrose's "Farewell To QE" looks like in graphical form.

This is a chart I've used many times, but the good folks at ZeroHedge have kindly updated it for me to reflect the reality of Taper Lite:

Source: Zerohedge

Farewell QE, indeed!

But, although 2013 was most definitely the year of QE, there were other interesting facets of "The Weak That Worked" that also bear scrutiny.

Take the strength in the US stock market, for example.

The S&P 500 made a seemingly relentless series of new highs as it powered through 2013. With a couple of light sessions still remaining, the total number of new highs for the year is an astonishing 44.

To put that into perspective, it means a new high was made by the S&P 500 Indexarguably the most important equity benchmark in the worldevery 5.68 trading sessions during 2013.

On average that's nearly a new all-time high once a week throughout the entire year!

Of course, that's not how these things work, but the point is valid. The winning strategy for this year was to buy equities.

Not companies.


Let me explain what I mean.

Source: Bloomberg

Behold the mighty S&P 500 Index as it makes its way from bottom left to top right with nothing but a few short-lived corrections impeding its stately progress.

Now behold the flows out of mutual funds and into ETFs:

Source: Gerard Minack (via Dave Collum)

At the risk of harping on, this is a phenomenon I've also spoken about before: the dumbing-down of investing.

In today's markets, which function at the whim of the Federal Reserve as opposed to market forces, the art of researching companies, analyzing their balance sheets and the strengths and weaknesses of their business, and then trying to sort the wheat from the chaff has been lost.

Only a tiny minority buys companies anymore everybody else just buys markets.

And it's hard to blame them.

A look at the correlation of the S&P 500 to the Fed's balance sheet tells you just about all you need to know. Since 2009, the correlation has been an astonishing 89.7%. Why would anybody not just buy markets, given that they are going to go up based purely on the Fed's aggressive stimulus?

Sure, you could make more money by buying all the shares that might go up because they were good, well-managed companies with good businesses, and by shorting those that were going to go down because they weren't, but contained within THAT strategy (which used to be called "investing") is the risk that you could be (GASP!) wrongso why bother?

Bizarrely, by creating an environment that forces those with capital to seek out additional risk due to the paltry returns afforded by zero percent rates, the Federal Reserve has steered investors to seek out the least-risky place to invest their money, and that has been equities.

Source: Greg Weldon

And 2013 saw the Fed take a BIG step up after what, in hindsight, was a rather anemic 2012 campaign.
Below is the percentage change in the Fed's balance sheet during the calendar year 2012. The chart also shows the date QE4 was announced in December:

Source: Bloomberg

And THIS is the same chart for 2013:

Source: Bloomberg

See how this works now?

Nice and reliable. Consistent amounts of "liquidity" are pumped into the system every month, and things gently float ever higher. The only real hiccup for equities in all of 2013 was, in fact, the Taper Tantrum in May, when this stability was briefly threatened.

Doesn't bode well, I'm afraid.

The chart below, deflating the S&P 500 by the ongoing QE experiment, which I included a few weeks ago courtesy of Raoul Pal & Remi Tetot of Global Macro Investor, strips away the effect of the Fed's pumping and lays bare the market's real performance. It's one of the best charts I've seen this year, and it speaks volumes.

Source: Raoul Pal & Remi Tetot, GMI

Equity prices used to be a reflection of the strength of the underlying economyafter all, the component pieces of benchmark indices were functioning companies that existed in the real world where they need to manufacture something and sell it to a buyer in order to stay in business and make a profit.

So how have companies and the economy they constituted done in 2013? Well, the companies themselves have done incredibly well at tightening their own belts and squeezing every last drop of juice out of the lemons they've been handed. In fact, corporate profits have never been higher; and as a percentage of GDP they have scaled new and almost unimaginable heights, as the chart below demonstrates:

Source: St. Louis Fed

But under the surface and in the wider economy, the story is very different, indeed, as the mountain of cash on corporate balance sheets has led to an avalanche of buybacks, which has in turn boosted earnings and given the impression that things are roaring, when in fact the true story is a familiar one of an increase in debt. And it's one that we saw not so very long ago:

(Karl Denninger): The second important thing to understand is that the other claim — "record corporate cash" — is true but intentionally misleading. What's also at records is corporate debt, and what you must look at is not tangible assets (which includes cash, of course) but rather such assets less obligations, that is, debt. And when you do and compare against equity prices what do you see?

Let's put not-so-fine a point on itleverage, as expressed in the form of stock price to assets less liabilities, is at an all-time post-war high.

Yes, worse than 2000 and worse than 2007.

Assets less liabilities for corporations economy-wide are approximately where they were in the last quarter of 2004 or the first quarter of 2005. But stock prices are much higher in aggregate. That's the correct measurement of operating leverage relative to the marketnot how much cash they have or how many dollars of earnings they return today. It's what the "corpus", that is, what your ownership interest as a stockholder (that's what you are when you buy stock) is that underlies your investment and thus how much you're paying for a given unit of tangible assets less liabilities.

Source: The Market Ticker

This chart was bad at the end of 2012 — in bubble territory, for sure — which was a big part of why I didn't think we'd get through 2013. Well, we did — and now it's worse, because this is only updated through the end of September and of course the market has gone screaming higher in the last three months.

With that said, that which cannot go on forever won't, and this clearly can't — and thus won't. The only question is exactly when, and what, triggers the corrective move back down.

US Q3 GDP was revised up to an eye-watering 4.1% annualized rate, and that headline was received as confirmation that the Fed's policies are working; but a rudimentary dig beneath the surface reveals that a significant contributor to the strong performance was our old friend consumer spending:

(USA Today): Boosting optimism for the new year ahead, the government announced Friday that the economy in the third quarter grew at its fastest rate in nearly two years and much better than previously estimated.

Higher consumer spending was largely responsible for the economy's annual growth rate of 4.1% from July through September, the Commerce Department said. Last month, it estimated a 3.6% rate. In the second quarter the economy grew at a 2.5% annual pace.

Last quarter's better-than-expected performance was spurred by consumers spending more over the summer on health care, recreation and other services.

The government says consumer spending grew at an annual rate of 2.0%, up from 1.6% in its previous estimate last month.

"The consumer is back in the game," exulted Chris Rupkey, chief financial economist of Bank of Tokyo-Mitsubishi UFJ, in a client note Friday. "Is this economic growth fast enough to put America back to work?

The answer is, yes. The wheels of the economy are turning fast enough to bring down the unemployment rate further."

Folks, take it from me, any time you see the words "chief financial economist" and "exulted" in the same sentence, be afraid.

Be very afraid.

Meanwhile, over a third of the strength in the economy was down to private inventory buildup — the biggest such buildup since records began almost 70 years ago:

Source: St. Louis Fed

And the farm component of that particular datapoint provides an even more staggering anomaly:

Source: St. Louis Fed

So, despite equity markets making all-time highs in 2013 more often than Miley Cyrus gave offence, beneath the surface, the economy — which equities are supposed to reflectdidn't perform as well as the headlines would have you believe; and by far the biggest driving force behind the strength of the equity market was free money courtesy of QE.

Though QE has morphed into the means to create trickle-down wealth through higher equity markets, quantitative easing was, of course, a program originally designed to save stabilize bond markets; but there's only so much you can do once bond prices reach the levels they did this past year. And so next week, in Part II of "The Weak That Worked," we'll take a look at ground zero for the Fed's intervention and a few related issues that unwittingly saw themselves dragged into the ring.

As we take a look at the bond and housing markets, we'll see a bunch more headlines that don't quite tally with what's going on under the hood and that show that the "recovery" is really not all that it's cracked up to be.

Until next time...