Details On The Fed’s New Trading System

Details On The Fed’s New
Trading System

November 1, 2010
By John M. McClure 
www.profitscore.com

A Brief Performance Update
Is the Fed Helping Fund the Treasury's Pawn Shop?
Did the Germans Just Invade Poland?
Why Should You Care?
Quantitative Easing 2 - Will It Save Stocks?
Is Gold Too Expensive?
Dollar Demoralization
Real versus Nominal Returns - Vive le Différence
‘Foreclosure - Gate' - Implications for Housing and the Economy
Chasing Chuckars with My Buddy Jack

On March 18, 2009 the Federal Reserve announced that they were going to purchase 300 billion dollars in treasuries in the Fed's Permanent Open Market Operations (POMO).  The days which the Fed does these purchases are now famously known as POMO days.  Over that time, the Fed purchased an average of 50 billion dollars in treasuries per month over six months.  All POMO months in 2009 were positive for U.S. equity markets.  As a matter of fact, U.S. equity markets climbed faster and higher during the treasury's buying binge than any other time since the 1930's.

Fast forward to present.  In the month of September 2010, the Fed started up POMO operations again in earnest with 10 POMO days and even more purchases planned for October and the first part of November.  Should you care that the Fed is manipulating the markets and causing risk assets to rocket higher?  The price of gold is sure saying you should care.   

In this ProfitScore IQ, we dig into the details behind POMO days, and their intended and unintended consequences.  The next round of Fed intervention is being called QE 2.0 and it is expected that the Fed will announce in November that they will be purchasing an additional 500 billion dollars in treasuries over the next several months.  I have read reports where the market has already priced in one trillion in purchases, so Mr. Market is expecting a really big boost from the Fed.  If the Fed surprises to the low side of this expectation, there could be painful consequences. 

Before we get started, I wanted to mention that I will be speaking in New York at the Global Equities Trading Summit on the topic of Risk Management Strategies through the Lens of Technology Solutions during October 25th and 26th.  If you are interested in attending or you would like to meet, please send me an email.
    

Something You Should Read
I have been a big fan of John Mauldin's for many years.  His most recent report exposing the true foreclosure mess is a must read.  What John discusses in this report will make 2008 look like a walk in the park.  Do yourself a favor and give his report a careful read.  Here is the link to a PDF of John's latest letter:

http://www.frontlinethoughts.com/pdf/mwo101510.pdf

Please be advised to remove sharp objects from your vicinity before reading this letter.


A Brief Performance Update

Below are some quick performance stats.  For more detailed performance analysis, click on the blue highlighted portfolio names listed in the table below.


Jan 08 to

YTD

Sept

Sharpe

Name

Present

2010

2010

Ratio

Income Builder  (IB)

13.96%

5.35%

0.02%

1.33

The Guardian  (GRD)

4.56%

0.25%

-1.09%

1.51

Harmony Plus  (HMY)

3.28%

-3.52%

-1.75%

1.29

The Expedition  (EXP)

0.87%

-7.00%

-2.23%

1.03

S&P 500  (SP500)

-22.28%

2.34%

8.76%

0.54

Important Performance Disclosure





Is the Fed Helping Fund the Treasury's Pawn Shop?

Around the middle of September, I was driving in my truck and listening to the ever entertaining Kai Ryssdal on NPR's Marketplace show focused on the day's stock market action.  Kai had a guest on the show that was somehow tied to the Obama administration, but I can't remember her name.  This guest was answering questions about the Treasury's plan to sell the stock it owns in AIG in order to speed up the repayment process of the 86 billion dollars AIG owes the American tax payer. 

The treasury currently owns 80% of AIG's stock.  The normal loan repayment plan was going to take many years and the Obama administration wanted to be repaid sooner.  Having AIG owe the treasury 86 billion dollars will not be considered a positive campaign influence in the upcoming presidential election campaign.

In the interview, the guest was asked what would cause this plan not to work.  She mentioned three challenges to this plan but all were tied back to the economy and a falling stock market.  Basically, if the market goes through another bear market, then shares of AIG could not be sold by the treasury.  I thought to myself at the time of the interview, what a huge conflict of interest.    


Did the Germans Just Invade Poland?

September of 2010 was the largest September in the U.S. stock market since the Germans invaded Poland in 1939.  How could that be?

Over the U.S. equity market's history, September has been the worst month to be invested in stocks.  The average annual return of September is actually negative over the markets entire history with some of the worst disasters being recorded in this difficult month.  When August is down, the chances of having a nasty September actually increases.  Since August was down over 5%, and 19 out of 20 government economic reports were negative in September, wouldn't you expect September to have another historical bad month?  How could the exact opposite happen?  If you said Fed POMO days, you were 84% correct. 

The problem with government manipulation for a quantitative manager like ProfitScore is that there is no way to model the data.  How could you possibly model the Sunday night chats in 2008 where President Bush, Paulson, and Bernanke would announce the baling out of Bear Stearns, Fannie Mae, Freddie Mac, Money Market Funds, Long-term Interest rates, etc?  These events are random events that are impossible to predict. 

Fed POMO days are different because the Fed openly announces them on their web site before they happen.  Here is a link announcing the next round of purchases http://www.newyorkfed.org/markets/tot_operation_schedule.html.  POMO days are also unique in that there is now enough of them to begin to model their effect on U.S. and world markets.

The market has closed higher on the last 14 POMO days.  Actually, the 12th day closed down 5 basis points but for the sake of keeping this example easy to understand, I am going to call it an up day.  Since every day has a 50/50 chance of being up or down the chances of having 14 up days tied to POMO days is 1 in 1,400. 

I summed up the monthly performance of the S&P 500 from March 2009 to September 2010 and the number comes to a non compounded gain of 46.96%.  I then summed only those months where the Fed had 5 or more POMO days in the same month (March, April, May, June, July, August, September 2009 and September 2010) and the non compounded gain was 46.36%.  Let me be more clear -  98.72% of all market gains since the bear market rally began in March of 2009 can be attributed to Fed intervention.   

The current month of October will be another POMO month and it is already up over 3%! 

I could mention that this next round of POMO days is two weeks away from mid-term elections and that there is a POMO day the day before the election, but I will refrain myself from bringing politics into this maddening discussion.    

For those of you who would like to jump into the numbers, here is an excellent blog post from Trading The Odds discussing the statistical probability of the market closing higher in and around POMO days. http://www.tradingtheodds.com/2010/09/permanent-open-market-operations-pomo/   


Why Should You Care?

Some of you reading this are probably saying - why should I care if the Fed used manipulation to make equity markets go higher in price?  Heck my 401k is now worth more than it was in March of 2009.  That is a fair point so let me ask you a few questions.

  1. Are you better off today than before the crash?
  2. Is your real estate holdings worth more or less than they were 5 years ago?
  3. How much interest are you earning on your savings and fixed income investments?
  4. What are your job prospects?
  5. Is it harder to get a loan today than it was 10 years ago?
  6. Can your dollar buy more today than it did 10 years ago?
  7. Why is our budget deficit projected to run over a trillion dollars a year for the next several years?
  8. Does mortgaging your children's future make you feel good or bad?

The Fed and the U.S. government are conducting damage control, and they are the ones that caused much of this damage in the first place.  Yes, they have made the stock market go artificially higher but they also helped get us into this stinking mess.  Dropping interest rates in 2002 to historically low levels and keeping them artificially low is one of the main drivers for catapulting real estate prices into the stratosphere until they finally collapse.  In economics, there is always a cause and effect. 

Ultimately low interest rates, ridiculous amounts of stimulus spending, and trillion dollar budget deficits will lead to the incestuous printing of money and spiraling inflation.  I am not sure if it will be this decade or next, but a loaf of bread will cost many times more than it does today. 

The Feds manipulation of the market has negatively affected me and my clients short-term, but traditional investors will pay the price long-term because risk assets are priced to perfection and the next bump in the road is going to once again rip the guts out of the average investor.  Investment roller coaster rides are no fun for any type of investor. 

If you have been a reader of this letter, you could sense my frustration over the last 16 or so months.  I knew something was wrong with the natural flow of the markets, but I couldn't prove what it was.  I called it the invisible hand.  Markets were not functioning in a normal way, but I didn't know why.  I felt that government intervention was probably the culprit, but I didn't have the data to back up my claims.

I'm relieved to finally know what influence caused the greatest bear market rally since the 1930's, because I thought it would be 30 years or more before the real reason was finally disclosed.  It is a sad day a sad day indeed when you have to factor Fed intervention into your investment models. 

The United States considers itself a free capitalist society but our actions in difficult times don't reflect this belief.  Straddling the socialist fence is political in nature and there is going to be hell to pay for our politically motivated bad decisions.  Quantitative easing is about to be kicked into hyper gear with QE 2.0, so we haven't seen anything yet.  In about 50 years, it will be hard for our grandchildren to believe that a loaf of bread only cost $2.27 in 2010.  As my good friend Tim Burke recently wrote, the dollar is going to a sad place. 

Let's see what others are saying about QE 2.0?


Quantitative Easing 2 - Will It Save Stocks?

A very interesting paper was published in early October by Erico Matias Tavares, he asked the all-important question in the title: Will Quantitative Easing Save the Equity Markets? No doubt most traders and investors are asking themselves the same question.

Tavares wasted no time getting down to brass tax.

"Notwithstanding  persistent  headwinds  in  the  global economy,  ranging  from  sovereign  debt fears  in Europe to double dip risks in the US, equity markets had their best September in over seventy years. This may be largely attributed to the expectation that in order to prop up a flagging recovery the US Federal  Reserve  will  soon  embark  upon  a  second  quantitative  easing  (QE)  program,  as  further evidenced by recent US dollar weakness and gold reaching historical highs (in nominal terms)."

"This expectation seems to be getting traction.  According to a leading financial blog (Zerohedge.com), Goldman Sachs recently sent a note to its clients stating that the Fed will announce $500 billion in asset purchases at the November 2-3 meeting.  Even prominent hedge fund managers are publicly proclaiming that QE is a sure thing, and that this will put a floor under equity prices."

"But will the Fed implement a sizeable QE program over the near-term?  And how much is actually needed to keep equity markets humming along?" 

To answer this question, Tavares examined liquidity growth and the performance of the S&P500 Index from 1998 to present in a period that covered two bear markets, the tail-end of the Internet bubble as well as the birth and death of the housing bubble.

What he found was very interesting indeed.

"Liquidity growth typically slows considerably as the S&P 500 goes into a bear phase, and surges just before its end - primarily due to the Fed's intervention. Coincidentally (or not), the current gold bull run started around the first time the Fed embarked upon this process in the early 2000s."  This relationship re-asserted itself again eight years later but in reverse.

"Liquidity growth started declining precipitously after March 2008, reaching negative values around November. This was the only time negative growth was recorded in our series, which goes back to the early 1990's.  To put this in perspective, in mathematical terms the index needs to grow at least by the "average" interest rate of the economy, otherwise an increasing number of borrowers will start defaulting on their interest payments (let alone amortize their loans). A negative print is thus a severe event, leading to a downright contraction in the economy."

Not long afterwards (final quarter of 2008), the Fed took "unprecedented monetary policy actions".

Note the response of the S&P500 Index (blue line) to changes in liquidity (green). There is an approximate lag of six months between liquidity changes and the response from stocks.


Chart 1 - Graph showing the relationship between percentage liquidity growth (right-hand-side in green) and the S&P500 Index (blue).  Source - Will Quantitative Easing Save the Equity Markets.

Roughly six months after liquidity started to drop (April 2007), stocks began a massive correction in early November.

Traditionally, the two major liquidity providers have been banks and the Federal Reserve as we see in the next chart.  Until around October 2008, bank liquidity rose.  

Since the fall of 2008, bank liquidity has been a less dominant factor in stock price appreciation with the Fed's accounting for the lion's share of market liquidity. It shows the impact of government and Federal Reserve stimulus programs such as TARP - a reality clearly not lost on politicians and bureaucrats!


Chart 2 - Bank and Federal Reserve liquidity together with the S&P500 Index. Source - Will Quantitative Easing Save the Equity Markets

A closer look at chart 2 reveals that in 2007, the Fed began to cut back in a trend that continued through mid-November 2008.

"Soon after the S&P 500 peaked in October 2007, the Fed started reducing its holdings of US bonds, from $780 billion all the way down to $475 billion by March 2009," according to Tavares.

Then the Fed began to turn on the stimulus as we see by the blue histogram on the chart, even as banks continued to pull liquidity out of the system. The net result was the beginning of the powerful bull market in stocks in March 2009.

"The Fed thus effectively replaced the banks in the process of keeping liquidity growing throughout the economy, as the private credit mechanism was severely impaired (and still is, with declines not seen since the Great Depression).  Otherwise banks would just keep on padding their reserves with more QE.  Because the Fed does not directly lend to individuals and non-financial institutions, this could only be achieved through expanded budget  deficits.  Accordingly, the US government substantially stepped up its efforts to stimulate the economy."

But the lift didn't last long and barely two years later politicians are "once again contemplating doing another round of QE."

How much will be needed?  According to Tavares, there is no easy answer.

"For instance, a $2 trillion liquidity injection will very likely have a different effect depending on whether equity markets are worth $8 trillion or $13 trillion, all else being equal... With this in mind, the liquidity index we used previously can provide a sense of the amount of QE required to at least sustain the status quo... The historical year-on-year growth has averaged about 8% since the late 1990's. Assuming flat bank liquidity creation, this would mean that the effect of the envisaged $500 billion QE reportedly being contemplated by the Fed would last until March 2011.  Another $500 billion would be required to sustain that growth through to the end of the year."

So how much stimulus does Tavares think would be needed to do keep equity markets going?

"All in all, a QE program of at least $1 trillion may be required throughout 2011 just to sustain the status quo.  Boosting the liquidity growth rate into the double digits - consistent with substantial share price gains thereafter - would require that amount to be injected under a much more compressed time frame, likely [less than] six months."

Here is the biggest risk according to Tavares in simple mathematical terms.

"More QE = more misallocation of resources = more needed for QE in the future."

Unfortunately, the biggest casualty will be the US dollar, but more on that later.

Now let's take a look at how the various types of money supply have changed in the last three years.  In the next chart we see a comparison of M1, M2 and M3. Do they account for the liquidity that has driven stocks?

M3, the broadest money supply measure was discontinued by the Federal Reserve in March 2006.  Thanks to John Williams of http://shadowstats.com/, we have a reasonable facsimile which he calls the M3 SGS.

As we see from the next chart, all three have fallen in the last few months with M3 suffering the biggest drop since around April 2008.  Not surprisingly, given that we are now entering the pre-election year, all three are on the rise again.


Chart 3 - Charts comparing the three types of money supply since 2006. Source -  http://www.shadowstats.com/alternate_data/money-supply-charts

M1-3 does not really account for the liquidity provided in charts 1 and 2. A metric called the Adjusted Monetary Base (AMB) provides a clue. Basically, the AMB is the amount of money in circulation with the lion's share of that being injected into our economy beginning in August 2008 and which had exploded 250% by April 2010. For a more detailed background discussion of the Adjusted Monetary Base complete with charts, please see our April newsletter at http://www.profitscore.com/display.aspx?articleid=OaI8Ma8jZOM=

Here is the updated chart from the St. Louis Federal Reserve showing the latest AMB.  It has fallen marginally from its peak of $2.141 trillion in February to $1.981 trillion in September, but the amount of money being pushed through our economy is still 237% of what it was in August 2008.

The takeaway is that thanks in large part to stimulus and bailouts, the 2010 deficit is projected to hit $1.3 trillion, just $125 billion less than the shortfall in 2009!  Any further programs that would make up QE2.0 would only add to an already crushing fiscal burden.

Perhaps the real question should be, do politicians really care about the long-term health of our economy or is the upcoming election all they really care about?  A growing number of Americans are concluding that long-term economic health has become a low political priority, the victim of electoral pragmatism.


Chart 4 - Monthly Adjusted Monetary Base data charted by the Federal Reserve showing the recent explosion in the amount of money in circulation.  Source - St Louis Federal Reserve.

One only has to look at the price of commodities, especially gold, to see how poorly the politicians have served their electorate.


Is Gold Too Expensive?

With gold on a tear and news stories of just how expensive it is everywhere, we decided it was time again to examine the age-old question.  At its recent record high of just over $1,345 per ounce, is gold getting too expensive?  In terms of the US dollar, it seems to be getting very pricey.  So, is gold the problem or is it the USD?

We know from past newsletters that stocks have been hammered relative to gold over the last decade having dropped more than 80%.  But just how expensive is the price of gold when compared to the most important commercial and economic commodity - oil - over the last quarter century?

As of the October 8 weekly close, crude oil (NYMEX crude oil futures) was trading at $82.66/bbl.  The next chart answers the question. At a ratio of 16.28, gold is not much above the long-term average gold-to-oil ratio of 15.83.

We decided to look at a couple of other precious metals which we consider good storehouses of value - silver and platinum relative to oil. Silver was a tad more expensive than gold with a ratio of 27.95 compared to the long-term average of 23.55.

"Doctor" Copper, used by many traders to measure economic strength was also very close to its long-term average oil-priced ratio of 4.44 with an October 8 ratio of 4.57, so could not be considered overpriced. 


Chart 5 - Weekly chart showing the historic ratio of the price of gold to crude oil since 1986. The long-term average ratio is 16.28. As of October 8, the ratio was close to the average at 16.28.  Chart courtesy of GenesisFT.com

Of all the precious metals we examined, palladium was the most expensive with an October 8 palladium-to-oil ratio of 7.10 versus a long-term ratio of 4.72, and platinum was the least expensive with an October 8 closing platinum-to-oil ratio of 20.67 versus a long-term average ratio of 21.24.


Dollar Demoralization

As we can clearly see by examining precious metals in crude oil terms, they aren't on a tear. The problem is the dollar - politically expedient policies designed to "help" the economy have exerted an expensive "inflation" tax which has made gold and many other commodities "expensive" in dollar terms. As a result, the dollar is now worth about 16% of what it was worth a little more than nine years ago! Is it any wonder that more and more Americans are becoming dismayed with current monetary and fiscal policies?

As we see from chart 6, the greenback basically held its own from 1986 and 2001 relative to gold.  As it hit its 1980's low in August 2005, it started to drop again and just kept going. Since then it has dropped an incredible 74%! No wonder we are all feeling poorer!


Chart 6 - Weekly chart showing the ratio of the US Dollar Index (DX) to gold. It clearly shows the impact of quantitative easing, and other government and Federal Reserve stimulus programs on the greenback which is down more than 84% since March 2001.  Chart courtesy of GenesisFT.com


Real versus Nominal Returns - Vive le Différence!

It is easy to get lulled into a false sense of security by nominal returns.  Since 2000 the Dow is up slightly.  However, in real, gold-denominated terms, the index is down more than 80%. Most would agree that something had to be done to prevent further problems when Bear Stearns and Lehman Brothers collapsed. Certainly our Keynesians on Capitol Hill did!  The result is that in real terms, our portfolios (and incomes) have taken a hit.

As we face another round of stimulus programs which will see the dollar further devalued, it is increasingly important to focus on the real as opposed to the nominal. 


‘Foreclosure-Gate' - Implications for Housing and the Economy

We are currently tracking the unraveling foreclosure situation with some of the big banks that have powerful implications for the housing recovery. In a nutshell, there are growing concerns given the number of bundled mortgage derivative products that were developed as the housing market was taking off. Many of the mortgages may be missing crucial legal components, which has brought into question their enforceability. It is also causing buyers of foreclosed homes more than a little anxiety.  We have included a number of links in Interesting Reading (below).

The part about our future that scares the heck out of me is the quality of leaders we have that are making decisions to get us out of this mess.  Just because you are an elected official doesn't mean you have an above average IQ, or that you are good at anything else other than politics.  Below is link to a CNBC interview with Representative Maxine Waters. 

http://www.youtube.com/watch?v=a_mi1tH2opA

If you listen closely, you can actually hear someone laughing in the background.


Interesting Reading (and Viewing)...

Will Quantitative Easing [2] Save the Equity Markets?
http://www.scribd.com/doc/38803628/Will-Quantitative-Easing-Save-the-Equity-Markets-Oct10

Government Deficit for 2010 Estimated At $1.3 Trillion
http://cboblog.cbo.gov/?p=1457

Why Washington Can't Afford a Weak Dollar Policy
http://snuffysmithsblog.blogspot.com/2010/10/us-will-lose-china-trade-war-washington.html

Largest U.S. Bank Halts Foreclosures in All States
http://www.nytimes.com/2010/10/09/business/09mortgage.html?_r=2

Class Action Lawsuit Against Countrywide
http://market-ticker.org/post=168698

The Coming Middle Class Anarchy
http://www.zerohedge.com/article/guest-post-coming-middle-class-anarchy

"Foreclosure-Gate" Who Will and Who Should Pay
http://www.calculatedriskblog.com/2010/10/lawler-foreclosure-gate-who-will-and.html

"Foreclosure-Gate" - Jon Stewart's Take on the Daily Show (Video)
http://www.calculatedriskblog.com/2010/10/daily-show-on-foreclosure-gate.html

Mortgage Bankers Association - Strategic Default Isn't Funny...Or Is It? (Video)
http://www.thedailyshow.com/watch/thu-october-7-2010/mortgage-bankers-association-strategic-default


Chasing Chuckars with My Buddy Jack

As I have mentioned many times in this letter, fall is my favorite time of the year in Idaho.  Days are cool and crystal clear, nights are filled with stars and it is the time of the year where I seem to spend a lot of my time exploring Idaho's back country. 

Due to a torn labrum in my right shoulder, I missed my traditional 10 day September archery hunt for elk, but my bum shoulder won't slow me down from chasing Chuckars with my good buddy Jack.  Chuckars are considered the mountain goats of upland game birds.  They live in Idaho's steepest and rockiest slopes, mostly along the Snake River Canyon

Most of the people I know who hunt Chuckars are a little crazy because of the difficult terrain they have to endure.  Almost all serious Chuckar hunters train for the season like an athlete trains to complete.  When it comes to hunting Chuckars, I know my days are numbered.  I hope God will give me good knees to climb these mountains until I am at least 65.

Jack is my new dog that I have had trained into a well oiled machine over the last couple of years.  This will be Jack's second season and he is already hunting like a five year old dog.  Jack placed first in recent field trials and he will probably be the best bird dog I will ever own.  Jack and I have been conditioning together this off season and our first day in the field will be this weekend.  Jack was so excited this morning, it was like he somehow understood what I was saying and knows we are about to go chase birds. 

Recent reports from good friends of mine are that this is the best population of birds we have had in years.  Jack and I are hoping the reports are at least half true. 


Working to grow your wealth,


John M. McClure
President & CEO
ProfitScore Capital Management, Inc.


P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors.  If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

  • Complete our Private Client Group request form by clicking here: http://profitscore.com/clientgroup.aspx and submitting your contact information. (This is the most preferred method.)
  • Call us directly at (800) 731-5690.
  • Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.





Posted 10-21-2010 3:38 PM by John M. McClure

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