Dear reader

In Brief:

Government stimulus, also called Quantitative Easing - a process of lowering interest rates, providing credit and buying bonds- was used in 2008 to stop financial Armageddon; now government’s  want to create a boom with more of the same stimulus, but research shows it may lead to a global economic crisis of larger proportions than that of 2008.

Too much chemo will kill the patient! Not wanting to be pessimistic, but the outcome looks potentially ominous as government stimulus appears to have lost its effectiveness to revive economic growth and hold up asset prices.

We have recent history to indicate where the money making opportunities are. Buying stocks in early 2009 after the 2008 collapse offered one of the best short term profit making opportunities in the past 20 years, this will be better.

Cheap dollars are not the answer

In our MMO published two weeks ago -  ‘The Dollars Two Faced Smile’ read it here - we showed how cheap dollars issued by the US FED created the boom from 2003 to 2007/8. It did this by promoting low interest rates and easy access to finance, credit and money. These easy policies weakened the US Dollar. If one looked at asset prices in a mix of gold and other currencies it was clear the US stock market boom was in large due to the weak USD. i.e. USD down and the DOW JONES up.

On September 21st the FED stated they would be accommodating if the economy needed it (QE2) .The dollar fell on the FOMC (federal open market committee) statement and equities, after initially falling for 2 days and then rallying.

When things begin to heat up on the sovereign debt issues of Europe and the US (which is likely to happen soon) history shows one can expect a strong USD and weak equities.

In 2009 vast quantities of cheap dollars printed by the US FED lifted global stock markets. Cash offered very little return with close to zero interest rates forcing risk taking to get a return on money. Previous government stimulus created equity bull markets (post 1987 crash, post 1998 emerging market crisis, post 2000 IT Bubble bust). All these previous bull markets had full participation of the private sector.

The 2009/10 equity rally was thus based on an assumption: that like a relay race, the economic baton was to be passed from government to the private sector. The private sector would start to recover, initially from the help of government stimulus. Then by its own momentum, it would create jobs and growth, no longer needing government help.

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The rally of 2009/10 was absolutely based on the assumption the private sector would take over, but as of September 2010 this hasn’t happened.

The announcement of more stimulus on Sept 21st  implied, in no uncertain terms, that the FED believes the economy still needs help.

Stimulus does not appear to work anymore. The first stimulus, Quantitative Easing 1(QE1), of 2008/9 was unprecedented in size and scope, but has not worked. The US economy is still weak, unofficial unemployment is close to 20%, and consumers have downgraded their shopping habits, with around 40 million Americans on food stamps, and 115 million living below the poverty line. With the political rumblings in Washington the next stimulus or QE2 can only be smaller. Voters are anti-stimulus, and politicians dare not support more. So the market knows now that QE1 did not work and QE2 is unlikely to either. Like I said, administer to much chemo to a patient, and it becomes toxic!

23 Years of More Stimulus with diminishing results.

The DOW JONES graph clearly marks the 3 major stages of government economic stimulus over the past 23 years. It starts with the 1987 crash, marked in Green, the IT bust, marked in Orange, and the current credit crisis, marked in Red.

Each time the market needed more stimulus, it resulted in a smaller rally. (Let’s call these STIM, and STIM 3 is the 2008 to-date event). STIM 1, 1987 resulted in a 576% rally that lasted 4236 days; STIM 2, 2001/3 yielded an 85% rally that lasted 1664 days, and STIM 3, 2008 resulted in a 74% rally that lasted 436 days.

The price action in the graph is like a plane running out of fuel, you have the burst up through the 1990’s, a stall in 2000 to 2003, a final flutter up on the last bit of fuel to 2007 then a very sharp nose dive in 2008, that created enough momentum to get some small lift into 2010, but with no fuel in the tanks, and then? Likely a nose dive to the ground.

The 2009 rally was the fastest and the smallest but with the largest stimulus. Believe me when we say there is nothing left the FED or governments can do and the market is working it out fast. When the tipping point comes the DOW may fall all the way back to where it was in the mid 1980’s.

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What will be the tipping point?

The DOW appears to have overcome current short term resistance and may be headed to test the April highs, but looking out more than 6 months the picture gets cloudier and more risky. Experts are divided between debt deflation and high to hyperinflation. But either way there is a commonality, and that is the economy will suffer.

Each is a form of Depression. Just look at Zimbabwe today, they have had hyperinflation, opposite to the Great Depression of the 1930’s but with the same unemployment and economic misery. (Listen to the link where market veteran Art Cashin notes in his 40 odd year career he has never seen such a divided view between highly inelegant people as to where the economy and markets are headed.)

(In 2008 we saw the USD rally as debtors were forced to pay back Dollar loans and sell assets in the process. So the DOW USD relationship remained inverse, BUT in the opposite direction. The Dollars Two Faced Smile article outlines this clearly.

Below is a graph of the Swiss Franc to the Euro from 2005 to today. The Swiss National Bank (SNB) tried to peg the currency exchange rate at 1.50 during mid to late 2009 to ‘help’ support cheaper Swiss exports into Europe.

The SNB succeeded for a few months, but market forces and real facts on the Euro zones problems pushed the price to 1.40.The fall was large as the market worked out the SNB could no longer afford to intervene, and their policy was doomed, based on flawed logic and economics. None the less the SNB stepped in again to try and stop CHF strength, this time they managed for only a few weeks, but now it’s sitting at 1.32, and the Swiss National Bank has accumulated over CHF10 Billion of trading losses in its failed manipulation.

The markets are bigger than any government or central bank and economic reality will always win in the long run. Capitalism is the global system that has trampled every other political or economic model/ theory/doctrine in history.

The graph makes a point: Government intervention does not work!

To Sum up:

Government intervention in the long run cannot change true market fundamentals .Government response to each crises over the past 2 decades has been the same – STIMULUS. And each time more stimulus was added, it yielded diminishing positive economic results in both time and price. It is clear that stimulus is not working today, and the world may be headed for a global crisis with equities likely to fall a very long way.

As the market wakes up to the fact that the private sector is not coming back soon and the government has wasted trillions of Taxpayer dollars on stimulus policy after stimulus. This realization will be the tipping point and ripple around the globe, affecting all economies and markets.

Traders and investors who are nimble enough and smart enough to be on the right side will profit from short positions, or get the best buying opportunity in a half century post the collapse ,while governments and those who believe the mass media today will suffer. Technicals and fundamental analysis will proved the window for timing to profit from what looks like an unavoidable event, as it did for those few who profited hugely in 2008.

This fall may be the largest in history but the Trillion Dollar question is When?

Good Trading

Kevin Wides
Macro Analyst, Atlas Macro Trading

PS.  Sign up and trial  www.atlasmacrotrading.co.za for free and gain access to research normally only available to fund managers plus enjoy trade tips for free until November 2010.

PPS.  Looking for tips on how to trade single stock futures, cfds or any other form of highly leveraged instrument, then make sure you visit www.tradingtips.co.za

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