ב- 2012 החלו להראות סימנים של שיפור בכלכלה העולמית ובחודשים האחרונים חל שיפור של ממש.  הכלכלה האמריקאית האיצה חזק, עם צמיחה חזקה במכירת מכוניות ובתי מגורים (גרף 5) ולאחרונה גם שיפור ניכר בשוק התעסוקה (גרף 6).  ברבעון האחרון  גם הכלכלה הסינית החלה להאיץ ולכן ככלל הכלכלה העולמית מאיצה למרות שאירופה עדיין במיתון קשה.  בישראל הצמיחה המשיכה להאט תוך שעודף הדירות מתחיל להיספג.  (גרפים 3-4).

    לקראת סוף השנה הפעילו בנק ישראל והממשלה אמצעי מדיניות כלכלית.  בנק ישראל הטיל מגבלות חדשות על הלוואות משכנתא אבל גם הוריד את הריבית במידה מזערית.  האוצר העלה את המיסים העקיפים, כולל מע”מ.  חמור מכך, פקידי האוצר מתכננים צעדים חריפים נוספים לשנה הנוכחית, אף כי שר האוצר מתנגד לכך.  בסך הכל, האוצר ובנק ישראל נקטו מדיניות מצמצמת (נטו) פעולה שעלולה להביא את הכלכלה למיתון של ממש.

    המסקנות ברורות:  על האוצר להימנע מצעדים פיסקאליים מצמצמים נוספים עד שהמשק יאיץ שוב את הצמיחה, בהשפעת השיפור בכלכלה העולמית.  ולאחר שעודף הדירות למכירה יקטן. ומה בדבר הגרעון?  האם לא נהיה כמו יוון? להיפך!  אם יש משהו חשוב ללמוד (שוב) מהניסיון של יוון בפרט ואירופה בכלל הרי הוא מה שידענו כבר מאז קיינס:  אסור לנקוט מדיניות פיסקאלית מצמצמת כאשר הכלכלה חלשה.  מדיניות כזו רק מחלישה עוד את הכלכלה ומעלה עוד את הגירעון וחוזר חלילה.  את בעית החוב צריך לפתור כאשר הכלכלה מחוממת כבר.

    בנק ישראל צריך להוסיף להוריד עוד את הריבית גם בגלל ההשפעה הישירה (המועטה) של צעד כזה ובעיקר כדי להחליש את השקל שהמריא מול הדולר.  ואם זה לא יעזור, על  בנק ישראל לשוב ולהתערב בשוק המט”ח.

The European crisis used to be called the European sovereign debt crisis. Later on, it was referred to as the European banking crisis. Finally, it winds up being just the European crisis. Is there a difference? Not really. Experience in Japan, the US, Ireland, Spain and numerous other countries reveals what ought to have been clear: no developed economy can afford to have one of its large banks go under and when the risk is severe,  the local government (including the central bank) is forced to take over the ailing bank and/or back its liabilities. And vice versa, when the government cannot find buyers for its debt, the local banks will buy it, because if the government reneges on its debt, so will the local banks who normally own much of the existing government debt. Of course if the government and the banks go bankrupt, so will the whole economy.
These facts are best demonstrated by the evolving story of Spain. At present, nobody would buy Spanish government debt except for domestic banks or an occasional large speculator who thinks he is buying these bonds cheap and will eventually be able to sell them (directly or indirectly) to the ECB. After all didn’t the president of the ECB, Mario Draghi, say he will do everything necessary to support the EMU? And didn’t the EU summit decide that the ECB will buy any amount of Spanish government debt necessary to support their prices. And wasn’t the only precondition that Spain will ask for aid (and by the way also sign a memorandum transferring the power to run fiscal policy to Germany)?
Meantime, only a slight delay. German finance minister, Schauble, said he does not believe the Bundestag will approve this aid to Spain so soon after € 100 billion was allocated to support the Spanish banks. But there could be another slight problem. If the Germans are worried about a `measly`  € 100 billion, what will they say when they find out that the ECB has to finance all the maturing Spanish and Italian debt plus their budget deficits, over 3 years, a total of € 3 trillion or more? Yes, the IMF, Japan and even China may possibly come to the rescue – provided they miscalculate the amount involved. But they all, including Germany, the Dutch and other smaller economics cannot shoulder this task.
Shortly, when all of this becomes clear, what else will follow? The Spaniards may revolt when they see the punishment the Germans have in store for them, but assume for the moment that they are so demoralized already that they will not go to the streets. And assume also that that applies to the Italians and the Greeks (and the Cypriots) too. To be optimistic, assume also that Catalonia does not secede so fast from Spain. And in the same  optimistic vein, assume that not all holders of Spanish and Italian debt with up to 3 years to maturity will line up to sell it to the ECB. And that Chancellor Merkel survives all of this for a while. So the ECB will only be called upon to buy several hundreds of billions in the next few months, and so it does. The money paid for Italian and Spanish debt will of course flood Europe, including Italian and Spanish banks and French and German banks that own Italian and Spanish debt. And the ECB may be called upon to bail out the latter group of banks too if they own obligations other than short- term soverign debt.

This flood of newly created money will come on top of € 1 trillion in “liquidity” the ECB already injected several months ago and a few hundred billions injected into or now expected by the Spanish banks and in the support programs for Greece, Portugal, Ireland and Cyprus. But given the size of the needed aid for Spain and Italy, it is likely that all of this will not suffice and the Eurozone will eventually have to be taken apart.
Meantime, the Fed has engaged in money (reserve) creation on an enormous scale as well. Its balance sheet has increased 200% in the last 4 years. And since the banks were not able to use all of the reserves they accumulated, their excess reserves grew to $1.5 trillion. China actually increased its money supply much faster.
Eventually Germany will have to  decide that the burden of keeping the euro intact is too heavy whether before or after funneling a few more hundred billions of euros into the weak Eurozone economies .  When it comes, the decision may be made by the Bundestag, by Merkel, by the courts or by the general public. (This decision reportedly has already been made by the Bundesbank). As it stands now, Spain will soon after that default on its obligations, followed in short order by Italy and probably by France. Investors the world over will re-learn that government obligations are not “risk free”, and neither are bank obligations. But there is no reason to believe that this lesson will be confined to Europe. Investors (savers) in Japan may finally conclude that their government obligations are too large to be safe, and investors in US federal debt securities may soon reach the conclusion that these obligations are increasing too fast for comfort. Finally, China which holds all these obligations in huge quantities may be hurt too.
Obviously, there is a big difference between the Eurozone members who can’t each just print more Euros on their own and the US, for example,  that has been doing just that (in US. dollars, of course) big time in recent years. Therefore the process in the US will be different. As people lose confidence in government obligations they will naturally also lose trust in those little government pieces of paper (or plastic, or book entry) called money.  After all they are only different from bonds in that they say “In God We Trust” and other interesting imprints. As investors lose confidence in government paper and rush for real assets such as real estate or gold or even stocks that represent some real income stream, inflation will start rising.
The inflation foreseen here is not the type of “cost push” or “demand pull” that the US experienced in the 1970′s. Rather, it is more akin to the hyperinflation experienced by Germany in the early twenties in that it is caused by loss of confidence in government obligations. It is unlikely to reach anywhere near the levels seen then, but could reach levels not even imagined by most analysts, let alone being reflected in the markets.
In some respects the risk of inflation now is even harder to fight than it was in Germany. First, its nature is global. So much so that it is not even possible to tell where it will develop earlier. Second, some governments and central banks are actually trying to boost inflation intentionally for various reasons. These include Germany, Japan and the US. Finally the speed at which it could develop and ratchet around the globe may make it intractable.
All of this does not have to happen but it will take a lot of ingenuity and flexibility on the part of several major decision makers to avoid it. Some, like Merkel, Draghi, Bernanke and others would have to reverse policies. And the chances of that are slim at best.
The writer is Chief Economist and strategist of 4L Macro Opportunities SP

Those of us who nearly 14 years ago foresaw that the euro would eventually have to be taken apart have had to endure several years of cynical comments. Even now, however, we cannot breathe a sigh of relief, because the economic well-being of the world depends on it being done immediately and in an organized manner. And the chances of that are slim.
The inherent flaw in the construction of the euro is now plainly visible to most observers: it is not possible to construct a uniform monetary policy for all members each with a separate and diverse fiscal policy. A uniform fiscal policy is not only those items Germany was pushing for in the “fiscal compact” but also a re-distribution of wealth from the strong economies of the north (Germany and may be France and Holland) to the periphery states, a measure that of course cannot be agreed politically.  What is surprising is how long it lasted while all the time the relevant data were so blatantly obvious.
The problem is evident even with the simplest and least controversial data. It is enough to take a look at wage increases since Greece joined the euro in 2001. Clearly, Greece and Spain were bound to get into trouble due to loss of competitiveness. Also, while short-term interest rates were uniform across the eurozone, real — inflation adjusted — rates were much lower in Greece, Ireland, Spain and Portugal than in Germany. In fact, for some of these countries, they were probably negative for much of this period, helping create the bubbles in housing in Spain and Ireland, and more generally, “bubble economies” in Europe’s periphery.
The conclusions from Chart 1 are generally valid except for Italy and for the comparison with the U.S.  During the period shown, all countries discussed had an increase in productivity, except for Italy. Therefore the Italian economy could not afford even the relatively slow increase in wages it experienced. In contrast, the U.S. had a strong increase in productivity and therefore remained competitive with most of the eurozone other than Germany.
Chart 1

The data are therefore rather clear: the so-called “sovereign debt crisis” and “banking crisis” only name the symptoms of the structural deficiency in the euro. Of course, the cracks appeared first when and where the structure was most vulnerable. First to fail were those eurozone members that were weakest, most indebted, least competitive and so on. It is conceivable that at the early stages of the crisis it was still possible to delay its progression if the U.S., China, Japan, Germany and the IMF were to have banded together to build a “firewall” massive enough to recapitalize the European banking system, the ECB, the EFSF the ESM and any other institution the Europeans designed to stabilize the “European monetary project” i.e. the euro. Had that been done, there would have been some meaning to the “fiscal union” the Europeans plan to discuss at their June 28 -29 summit meeting. The time gained could also allow the German policy, begun in 2011 and continued in the more recent union agreements of accelerating labor wage increases, to work. This policy makes Germany less competitive and therefore the rest of Europe gets a relative gain. Finally, the “new” idea of the new European leaders (and of the UK) that Europe cannot make do with only austerity and that it needs some growth enhancement, could have been implemented.
But, that was then. Now, time is up. The euro experiment is over. The patient is barely breathing and cannot hold his breath for long. People with money in Europe are not thinking about where to invest for growth but where to shift their deposits. Money is flowing fastest out of Spanish banks into Germany that itself will be insolvent once the euro falls apart. Some funds are also flowing to Swiss banks (will they survive when the eurozone collapses?)  and to the most highly indebted economic power: Japan. Consumers are afraid to spend. As a result, the European economies are shrinking fast, as the latest PMI indices show. And in the age of information, US consumer and investor confidence is shaken too, with China not far behind. Finally, in reaction, the global stock markets are plunging too, guaranteeing that the confidence will ebb some more.

In their enlightening paper, Simon Johnson and Peter Boone describe the mayhem in the European markets and conclude that the euro is doomed and will have to be taken apart in a few months or even years. In his piece, Jim O’Neill at Goldman wrote several weeks ago that since the Europeans cannot agree on fiscal unification that will solve the euro’s problem, or on dismantling the euro, they will just keep kicking the can down the road.
That, however, is not how markets work. To see how they do behave, just look at one relevant example: when the true magnitude of the Greek fiscal problem surfaced, it took four months until the eurozone had to come to help and the amount necessary to temporarily  calm the market was relatively small (30 billion euro loan). Recently, when private investors wrote off more than 100 billion euro of Greek debt and made Greece eligible for additional help of similar magnitude from the eurozone it didn’t take the market more than a few minutes to reprice the new debt to reflect highly likely default levels. In other words, the markets are forgiving at first but their reaction time grows shorter and more violent as the problem persists. The Europeans are now trying to kick the can up the hill.

What would it cost to stabilize the euro? Various commentators calculated that the direct cost could reach between 1 and 3 trillion euros. (See Dumas)  It is highly doubtful that that is even doable and in any case Germany could not pick up the tab. Taking the euro apart would cost much more and calculating the likely direct cost is not a worthwhile exercise That’s because the heaviest cost is not calculable. Investors around the globe have just learned in Greece that government debt is not the safest investment. Indeed, it may turn out to be the riskiest. Government (in the most inclusive use of the term) can always pass a law that says that it only owes 50 cents on the dollar it owed before, or that payment  will be made only in new bonds maturing in the distant future, or any combination of the two, or even that government doesn’t owe anything to anybody. That lesson will be re-learned now in Spain and eventually, at the end of the line, probably in Germany, too. The investors who run for cover in Germany, Switzerland, Japan or the US will re-learn it there as well. Eventually, it’s likely that governments around the world will not be able to roll their debts forward and there is almost no government in the developed world that can repay its debts when they are due.  Taking apart the euro immediately and in an orderly manner is therefore critical despite the heavy cost.
President Obama’s statement that the US taxpayer would not foot any part of the bill is therefore just wishful thinking. The whole world will pay and pay dearly for the euro experiment and since costs are growing daily, the US Administration should give up the hope of postponing the eventual collapse until after the elections.

* * *

A couple of weeks ago the Chancellor of the Exchequer gave a great speech in Parliament (see link: www.hm-treasury.gov.uk/statement_chx_110811.htm). The essence of it was: we cut government spending and the deficit and therefore retained our Triple A credit rating. Left unsaid was the comparison to those that did not cut the deficit and did not retain their Triple A rating.

It took some nerve for the Chancellor to say what he did at a time when there were already riots in the streets of London and other cities, even before the cutbacks became effective. More to the point here, the UK economy is barely growing and tightening fiscal policy can easily tip it into recession (see chart 1).
A recession in the UK is of course of limited significance for the global economy. Unfortunately, however, the UK was only following decisions taken by the EMU for its members. And some governments were forced by the sovereign debt market to take more painful cuts in spending (Italy is the latest, soon to be followed by Spain and France).
As a result of this tightening of fiscal policy, economic growth in the EMU came to a screeching halt (see charts 2-5). Against this background, the leaders of the largest economies in the EMU, Merkel and Sarkozy, had an emergency meeting last week. Their decisions included even more aggressive tightening of fiscal policy in the future and a tax on financial transactions (don’t worry about the latter decision – politicians periodically fall in love with the idea of taxing something they hate because it brings home the bad news. Eventually, they always retreat before causing the damage). What was glaringly absent from their decisions was any measure to boost the economy, even if only by monetary policy means.
This is not the first time Europeans have ignored the need for them to do something when their economy is falling into recession. In 2001, the US economy fell into recession but bounced back after 6 months. The recovery however wasn’t solid enough and Europe remained in a recession so that the Fed had to keep taking Interest Rates lower for the next couple of years. Eventually, rising house prices solidified the recovery in the US and the US in turn through its balance of trade deficit helped Europe out of the recession. This of course was a dangerous gambit in which the housing market in the US had to pull the world economy out of recession. I warned about those risks already in 2003 and the end result is well known. Unfortunately, the world cannot expect the US to pull it out of recession this time. On the contrary, Europe and China with a large and growing trade surplus – which of course means trade deficit for the rest of the world —can easily pull the US down (see charts 6-8). The only hope of avoiding this rests on the dollar continuing to go down sufficiently so the US balance of trade does not worsen significantly. This is also contingent on China continuing to let the yuan appreciate at a faster pace.

Chart 1

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Chart 4

Chart 5

Chart 6

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Chart 8

♦ The main cause of this slowdown in growth is an almost universal tightening of economic policy. In the developing world, interest rates were raised to stop inflation. In the developed world, government spending was cut in order to reduce the debt. Thus, irrespective of its motives, tightening of monetary or fiscal policy has caused a slowdown around the world.

♦ The immense power of a uniform policy (tightening in this case) can be appreciated by the fast exit from the large recession once all governments around the globe eased policy. But despite the already obvious result of the tightening measures, policy makers are still tightening in the developing world (China, India) and the developed world (U.S., Italy). Therefore, steps in this direction could guarantee a doubledip in the near future.

♦ The US: Total government spending – - including the federal government and the much larger sector of state & local governments – - has been declining steadily from the beginning of the year. This tightening of fiscal policy, with the added effects of the tsunami in Japan and the slowdown in the rest of the world, slowed growth to a pace that historically ended in a recession. The reaction of Congress was a decision to cutback federal spending in the next ten years. Even worse, this was done in a way that made it clear to everybody that the president is weak and most members of Congress are willing to cause any damage to the economy for their political gain. Not surprisingly this horror show in Washington caused a collapse in consumer confidence, producer confidence, economic growth and the stock market, despite the sharp rise in corporate profits. The danger of doubledip has thus increased considerably in the past few weeks.

♦ Europe: In the Eurozone the rate of growth of the economy also slowed to zero for similar reasons. When the attack on the peripheral economies got started the Eurozone forced them to cut spending sharply in return for the IMF’s help. At the same opportunity it also demanded a budget cut from all other members of the Eurozone, immediately and in coming years. England too joined this move. Lately the bonds of Spain that is already in a recession and Italy that has one of the highest debts/GDP ratio in the world, came under attack and prices of these bonds fell so that the yield increased to over 6.25%. This means a tightening of monetary policy as well as fiscal policy because cost of interest on the debt increased. The automatic reaction of policy makers was to declare a further cutback of the budget. And now when even the strong economy of Germany is slowing down it is doubtful if Europe can escape a doubledip.

♦ China: In many of the developing economies and especially in China and India interest rates were increased and other monetary measures were implemented in order to cool off the economies that suffered from overheating. In China growth of the industrial sector has already stopped while the services sector is still growing but at a slower pace. It appears that policy makers in China still haven’t grasped the relative size of the Chinese economy and the importance of growth there to the rest of the world and vice versa. Therefore it is reasonable to assume that tightening of monetary policy will finally prove to be overdone, as was the case with the easing policy in the big recession.

♦ Japan: In Japan as in Japan. The economy recovered quickly at, least partially, from the impact of the tsunami, but lately it has stopped growing. The big budgets that were promised for the rehabilitation of the areas impacted by the tsunami haven’t been spent yet, but policy makers are already talking about budget cuts and tax increases in order to reduce the deficit.

♦ The banking system: In the large recession the banking system failed in many parts of the world. In the US government was forced to inject capital to several banks and even now banks are still forced to write off loans that were made before the recession, especially mortgages. Their share prices are still about a third of what they were on average before the recession. In Europe too banks were impacted the same way but losses are now increasing on bonds of their governments and other governments in the Eurozone. In China too the banking system is unstable mainly because of off budget loans, loans to foreign entities and to government owned companies, mainly those owned by regional governments. Although the large banks have allocated meaningful reserves to cover such losses it is doubtful if those will suffice in case of recession.

♦ Money & exchange rates: The dollar fell in recent months to new all times lows. This is a result – - maybe intentional – - of massive printing of dollars by the Fed in QE2 and recently of the “horror show” in Washington. The dollar is recently getting some support mainly due to the fact that there is no alternative. The Euro of course is not more stable than the dollar. Scared investors have been moving their money into non-reserve currencies such as the Japanese Yen or the Swiss Franc, or into gold. But all of these have already made sharp new highs so that the risk is high in case the world economy recovers. The gravest risk to the world economy is therefore loss of confidence in fiat money in general, and in such a case the Swiss franc does not provide any protection.

Conclusions
The US stock market is attempting to go higher, based on actual and expected corporate profits and low interest rates. It can’t do so, however, as long as the foreseen risks keep materializing or just aggravating over time.
The list of major risks has not changed dramatically over the past quarter. Topping it in terms of potential damage is the risk of loss of confidence in all fiat money. This may be triggered by a collapse of the Euro, the Dollar – if Congress fails to raise the debt ceiling, or even from China. Geopolitical risks emanating from Libya, Syria, Pakistan, Afghanistan and elsewhere are also near the top. So also is the risk of concurrent tightening of fiscal and monetary policies worldwide.
The risks are of course heightened by widespread economic weakness in the developed world. They are well reflected in the new highs made by gold prices.

Chart 1

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Chart 5

Channel viewers can already see the first videos uploaded there, taken from an MIT forum that took place in 2008 at Tel-Aviv University. A set of 7 videos all from the same conference divided to main subjects all around the Global Financial Crisis at the time.

See Mike Astrachan up close speaking about the economic collapse bringing his unique interpretation of the past and the future of this event.

You are all welcome to visit, subscribe to the channel and comment on the videos at this link:

http://www.youtube.com/user/USEconomist?ob=5

See first video called: Fannie & Freddie and the economic collapse

Lower Interest rates

Since the S&P 500 peaked in 2000, short term interest rates have declined a net of 5.7% and since the 2007 peak they are down 4.6% (Chart 4). This, of course, means that monetary policy is much more expansive now, which tends to boost economic activity and stock prices. More importantly, with a Federal funds’ target of 0-0.25% the Fed can inject any amount of reserves into the banking system, which it is now doing through the quantitative easing 2. The main cost of this move will become clear only later.
Long term rates – - though up considerably from their recent lows – - are still down 2.8% from their level at the 2000 S&P peak (for 10 yr treasuries) and down 1.3% from the 2007 S&P peak. (Chart 5). Corporate America loaded up on cheap intermediate and long term money and is now ready to invest, frequently in buying other companies in a leverage buyout, or in their own stock in a buyback. And alternatively, they are increasing dividends. Thus corporate financing costs are down, profits increased and the attractiveness of owning stocks is enhanced. Naturally, the rise in bond prices also contributes to some corporations’ profits and even more to the consumers through their pension funds, etc. Finally, for the more economics- inclined reader, the decline in the long term “risk free” rates tends to reduce the discount rate for future cash flows thus raising the P/E ratio – - but see below.

Corporate Profits, Earnings Per Share and the Price Earnings Ratio

Corporate profits have now doubled from their level at the 2000 S&P peak and are slightly higher than they were at the 2007 peak.  (Chart 6). Specifically, earnings per share in the S&P 500s are now 56% above their level in 2000 and 0.2% over their level in 2007.  (All estimated for 2011). (Chart 7). That’s despite the fact that earnings per share of financial companies are down 21.5% from 2000 and -32.7% from 2007. (Chart 8). The latter data are mainly due to the fact that bank profits are now suffering a double whammy. First, interest rates at zero don’t really help the banks because they have to pay depositors something and they have to charge something for the expense of running the bank. Second, banks are still deep in the process of writing down bad loans made before the big recession, particularly on mortgages. As we get further away from the recession, loan write-downs will taper off, as they already have on credit card debt. Thus bank profits will return to “normal” and profits of the financial sector of the S&P 500 will go up.
What factors other than low interest rates enabled earnings of all other sectors to zoom up after the big recession? Strong stimulative fiscal policy at the federal level, including extended unemployment benefits, certainly helped in creating the surge in consumer spending (Charts 9-10). But that was offset by tightening of policy in the much larger state and local government sector, including tax increases, budget cuts and massive layoffs. And things are now getting worse as Congress tries to cut the budget deficit while state and local governments are forced to tighten much further in the coming fiscal year. Fortunately there are other positives, both cyclical and secular now at work.
First and foremost is, of course, the normal force of latent demands.   These include consumer demand such as the purchase of big ticket items that were postponed during the recession. In the present cycle, though, an even stronger and abnormally pronounced upturn has developed in business investment, both because financing has become so cheap and due to the sharp cutback during the big recession.
A second cyclical positive factor is the red – hot state of the developing world economy that now comprises well over half of the world GDP. (Chart 11). This is now helping to pull forward the weaker US economy as well as the rest of the developed world.
The third through fifth “positives” are all results of quantitative easing 2. While this policy did not achieve the simple stated objectives of reducing long term interest rates and increasing effective bank capacity and willingness to lend, it did result in an improvement of the mood in the stock market (an explicitly stated objective of such a policy); an increase in inflation expectations – - O.K., call it reducing the threat of deflation if that helps you think positively about it; and a devaluation of the dollar to an all time low – - a well hidden yet clear for everybody to see objective of this policy.
Finally, we come to what may be the most important but least noted and generally misunderstood positive factor for the US stock market and for the economy in the long run. For the past two decades the US economy has been going through a process of restructuring to increase productivity. This accelerated during the last recession as corporate America and labor were forced to cope. The results have been tremendous. The private sector was able to keep raising nominal wages and salaries at a rate close to normal throughout the recession (for those employees that were not laid off). (See chart 12). Indeed, real wages and salaries are higher now than they were at their bubble prerecession peak. (Charts 13-14). Still, unit labor cost (the cost of labor used to produce one unit of product) is now much lower than it was at its recession peak. (Chart 15).  Hence the sharp bounce in corporate profits and S&P 500 earnings per share.

Conclusion

The stock market can keep rising fast well beyond current expectations. Even a gain of over 50% in the next couple of years can’t be precluded. But the risks (detailed in part 1) are correspondingly high. The market will reach its potential only if none of these horror stories (e.g. oil at $150 per barrel, a financial contagion in Europe, radioactivity reaches Tokyo, the budget deficit is cut severely and prematurely etc.) plays out in full. And for the sophisticated investor, this means investing in call options or option spreads rather than in stocks. And for institutional investors it means holding maximum investment in stocks, while buying protection such as out of the money puts on stocks or on the market.

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Chart 13:

Note: the sharp rise in real earnings in 2008 is due to a decline in the CPI resulting from a drop in oil prices.

Chart 14:

Note: the sharp rise in real earnings in 2008 is due to a decline in the CPI resulting from a drop in oil prices.

Chart 15:

Yet the market does want to go up, and, if none of the possible horror scenarios now materializes, it will. How do I know that? Well, on any day that the news is not awful but just bad – - a day when oil prices go up only $1 or the minuscule housing starts just fall another twenty odd percent – - the market does go up.

The Wall of Worries

Just in case you are in a good mood, which means you have not heard or read any news for quite a while, let me list for you some of these walls:

1. The US economy is doing reasonably well with a very strong push from fiscal and monetary policies but they have to come to an end soon. The Fed will probably end quantitative easing 2 in June and Congress will try to cut the budget deficit this week while state and local governments are cutting budgets and raising taxes.
2. The housing market is dead: average house prices are still falling, foreclosures are expected to reach one million this year and deflation is still a risk.
3. Congress may not be able to pass a budget and government may have to shut down.
4. Food and oil prices are high and still rising world-wide (except in China where food prices turned down).
5. The Islamic world is in upheaval and that may raise oil prices sky high. (think of what will happen if the Iranians shoot one missile at a tanker carrying Saudi oil in the gulf. It is probably not in their best interest until they have The Bomb but how can Ahmadinejad resist when the Shi’ites in Bahrain are oppressed and asking for his help).
6. The West is involved in another war, in Libya, in addition to Afghanistan.
7. Al-Qaeda is still out there and may get control of a state (Yemen).
8. Poor and starving people in Pakistan may get into the Islamic trend, topple the government and give The Bomb to Al-Qaeda.
9. The Assad regime may fall and Syria has chemical and biological weapons.
10. A meltdown in Japan is still an uncomfortably high probability scenario.
11. Shortage of various high tech parts from Japan may stop production of various products world-wide.
12. The US is up to its neck in the war in Afghanistan and seems to be losing it. It is also still in Iraq that seems to be destined to be taken over by Iran.
13. The US is too scared to face up to the Chinese who seem to be breaking every rule of free trade they can break (e.g. stealing IP, manipulating their currency, dumping products in the US and Europe, etc.).
14. The US $ (real, trade weighted) fell to a new all time low due to (intentional?) debasement of the currency by the Fed’s quantitative easing 2. (Chart 1)
15. Several European states and banks are on a verge of bankruptcy and are (temporarily?)  being floated by the EMU, the ECB, the IMF and others. The latest summit was supposed to come up with a permanent solution but although they made significant progress didn’t even come close. They postponed dealing with some aspects of this matter to June but the Euro financial system may not hold together that long.

16. Interest rates are being raised almost world-wide, from the BRICs countries and other developing economies, to,apparently soon, the Euro Zone .

17. … At this stage I just got too tired and depressed to keep this list going. The reader can do it for himself.

Why the Market Should Go Up

So, why is the market trying to go up and isn’t it too high as it is? After all, it got to the present levels only twice before when two bubbles were fully inflated and about to burst. The first time was in 1999 when the high tech bubble was about to burst the next year. The second time was in 2006 when the housing bubble was getting to the same stage. (Chart 2)
The answer is negative. The market is not too high because interest rates (short term and long term) are lower and unlikely to rise much near term, the world and US economies have grown since then, and corporate profits have increased (+70% from 1999 for the S&P 500). Data and discussion on these in my next post soon.

Chart 1

Chart 2

Chart 1: Quantitative Easing 2

Chart 2: Quantitative Easing 2

2.    One unstated objective of Quantitative Easing 2 was achieved in February. The real trade weighted value of the $US declined to a new low (chart 3). No surprise there either. There were strenuous objections to this operation from around the globe and particularly from countries exporting to the US and those holding large amounts of dollars as foreign reserves. China in particular apparently stopped accumulating dollars some time ago. There may be harsh implications for this debasement of the dollar – - including loss of confidence in it as a reserve currency – - but for now, it helps in improving the US balance of trade and reducing the real value of US debt.

Chart 3: Quantitative Easing 2

3.    Recently the Fed announced a policy target of raising core inflation from about 1% closer to its presumed target of 2%. I proposed a similar policy a couple of years ago in order to ease the down pressure in the housing market. Now, however, maybe a bad time for such a policy. With headline inflation already running high and assuming that by time this policy starts showing results China will be accelerating again – - it has already started easing monetary policy – - and Japan will be pouring money for reconstruction, there is a substantial risk of a further sharp rise in inflation expectations.
In testimony in Congress, Bernanke said he is 100% confident that he could stop the rise of inflation when this is deemed desirable. This would be a reasonable assessment under normal circumstances. All that would be needed is to raise short-term rates high enough. That would be accomplished by the Fed absorbing enough reserves – - via the sale of treasury securities – - to set the market price of reserves (the Federal Funds rate) at the desired level.
In the present situation, however, this would be impossible. The Fed would probably have to sell over a trillion dollars worth of intermediate and long-term treasuries (or MBSs it bought in the Quantitative Easing 1) to mop up excess reserves, before the federal funds rate started to move up. Doing so at a time when the treasury is selling large quantities of securities to finance the budget deficit would crack the bond market. Alternatively, the Fed could raise reserve requirements but here too size would be a problem. Finally the Fed may pay interest on reserves held at the Fed at the rate it wants to set as a floor to the Federal funds rate. This, of course, would be a cost to the taxpayer. Also, it would not reduce the amount of excess reserves and would not set an effective limit on the growth of bank loans and of the money supply. Thus, the effectiveness of such a rate increase in curbing inflation is doubtful.
All in all, there is no easy exit strategy from quantitative easing and the problem is still growing.