Economy doing too well. Stocks slump.

On Monday night while everyone was peacefully sleeping (possibly on a mattress stuffed with money because they don’t trust the Bernanke fuelled financial system) the US markets did a peculiar thing. Good (or should I say improving) economic data from the United States has started to trickle out over the last eight months in the form of a slightly lower unemployment rate. The market marched steadily higher but then hit a roadblock. Then, on said Monday night, the inflation fairy Ben Bernanke commented on the frailty of this recovery in jobs, and the unchanged weak outlook for the US economy. Markets rallied. This is a prime example of the short term mindset of Wall Street traders driving prices.

The obvious question is why should stocks rally when the economic outlook is dire? The obvious answer is that there is no good, long term sustainable reason. However there is a short term, get rich quick, Ponzi scheme reason. And here it is. In The Wonderful Central Bank of Oz I outlined how Central banks like the RBA and the Federal Reserve manipulate interest rates by buying and selling bonds. In practise central banks only deal in government bonds when manipulating interest rates. However as interest rates on these bonds fall, holders find themselves less willing to hold them. They sell their government bonds and use the money to buy slightly riskier bonds. This higher demand for riskier bonds increases their price and lowers their interest rate. The price changes tend to ripple through all assets, until money flows into stocks, pushing up their price.

In theory this is how monetary policy spreads through the economy and affects interest rates, including the implied rate of return on stocks. As Ben Graham originally highlighted, this return is inversely related to price like all assets, but I digress. Traders and fund managers know this so as soon as they get a wiff of words like Quantitative easing they dive into the share market. A more realistic description of the same (monetary policy) process is that with interest rates at rock bottom levels traders can borrow money cheap and plow it into the stock market. Ben Bernanke wants this because it makes everyone feel richer. People who feel richer spend more, which will supposably kick start the economy. Ben Bernanke has promised the continuation of this cheap money until 2014. But what traders have been worried about up until Monday night is that if the economy improved too much, the proverbial punchbowl would be removed in the form of higher interest rates and less cheap money being printed. Traders are aware that without these low interest rates the market will fall and the economy wont be able to stand on its own two feet. However they will buy as long as the “hot” money is coming thick and fast and cheap from the "fed". They all think they’re smart enough to jump out before the drop. They can’t all be right. Bernanke’s less than stellar report on the economy has allayed their fears of stimulus withdrawal, and the market surges. Anyone who can’t get to sleep tonight click here for the same old scripted political drawl. This is classic short termism at its greediest, and the first sign of the “mal-investment” that begins every boom cycle. In the next article we’ll talk more about this term and see how we’re already stoking the next asset bubble before we’re even finished popping the last one.