Monday, October 4, 2010


Quantitative Wheezing

It's time to temper Tepper's expectations for a 'heads investors win, tails investors win' scenario.

Ten days ago, Appaloosa's David Tepper made some very optimistic comments about the U.S. stock market and on the domestic economy. In part, based on those remarks, equities embarked on a sharp run up that began that Friday morning and has continued to date.

Sometimes it's just that easy.... What did the Fed just tell me? What did they say? They want economic growth. And they said, We want economic growth, and we don't even care -- not only do we not care if there's inflation but we want a little more inflation. Have they ever said that before?... They want the market up. So, what am I-I'm gonna say, No, Fed, I disagree with you?... Either the economy is going to get better by itself in the next three months. And what assets are gonna do well? You can guess the assets that are gonna do well. Stocks!... Or the economy's not gonna pick up in the next three months, and the Fed is going to come in with QE. And then what's gonna do well? Everything!... Let's see. So what I got-I got two different situations. One, the economy gets better by itself.... The other situation is the Fed comes in with money.... You gotta love a put.... I gotta buy; I can't take the chance of not being a little bit longer now.... That does not mean that I'm going balls to the walls.... That's how easy it is right now.

-- David Tepper, "Squawk Box" comments

Let me begin by make one thing clear: We can admire our icons, but we can question and be in disagreement with them:

* I greatly admire Quentin Tarantino's movie productions. While most of his body of work can be viewed as pure genius, I hated Kill Bill (both volumes).

* I greatly admire Les Claypool's musical prowess, but his views on politics, the economy and global warming really turn me off.

* I greatly admire the work of consumer advocate Ralph Nader, but he never knew when to get off the stage and cost Vice President Al Gore the Presidency (not that I necessarily wanted Gore to win......).

* I greatly admire the work of Warren Buffett, but BRK.A shares were a short in early 2008, based on the belief that his portfolio was too skewed toward financials (an industry that that had lost their "moat" feature), and I disagreed with the timeliness of his derivative short of the S&P 500.

* Similarly, I continue to admire Appaloosa's David Tepper, but I am questioning the conclusion he made during his "Squawk Box" appearance that, if the economy fails to recover up to expectations, the Federal Reserve will embark on a successful QE 2 that will dutifully bring a rally in the U.S. stock market.

Shock and Awe (QE 1) to Shucks and Aw (QE 2)?

* interest rates are already low

* absence of global cooperation in reflating

* weak confidence and uncertainty of policy

* bank loan demand and credit extension weak

* bank reserves are already plentiful

* increased suffering by the savers class

* QE 2 fails to address structural unemployment issue

* long-term costs considerable

Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren't even sure if it has any effect on the economy.... The Bank of Japan tried quantitative easing to revive their economy and avert deflation, but it didn't work....

Bernanke knew back in 1988 that quantitative easing doesn't work [Bernanke and Blinder research]. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.

-- Ed Yardeni

The economic signs continue to point to the need for more quantitative easing. (This view is generally agreed to by bulls and bears alike.)

What is not agreed to is the likely effect of QE 2, especially when compared to the first round of quantitative easing.

Will David Tepper be accurate, or will the "shock and awe" of QE 1 be replaced by "shucks and aw" in QE 2, having very little incremental benefit? (See Ed Yardeni's comments above.)

Last week, Credit Suisse's Andrew Garthwaite captures the consensus that QE 2 will be implemented in November/December and that it will be successful for the following reasons:

* By driving down real bond yields (which helps government funding arithmetic, lowers the savings ratio and pushes up DCF valuations of assets);

* Through the funds flow effect: it gives asset allocators money, which they partly invest in other assets;

* Via the currency: a weaker dollar forces other central banks to adopt QE (Japan, U.K. and maybe eventually after a stronger euro the ECB). This, of course, will eventually lead to a revaluation of emerging-market currencies (which is what most policy makers in the developed worlds desire) as GEM countries have an inflation backdrop that will not permit them to participate in QE. (They either have to accept an asset bubble or currency revaluation, probably a bit of both);

* Through psychology: the lower the bond yields, the more fiscal tightening is postponed (as we have now seen with the likely renewal of the Bush tax cuts).

I previously chimed in that there is little doubt that QE 2 will have some positive influence but questioned the degree of its impact:

* It will pull the U.S. dollar still lower, serving to improve our exports and slow down our imports and resulting in a more balanced trade deficit.

* The yield curve will likely flatten further -- in theory, serving to encourage banks to lend.

* The consumer will continue to benefit by a further drop in mortgage rates as debt service ratios improve. Refinancing activity will also increase; a pickup in consumer spending could follow.

* Even though housing will continue to be haunted by an unsold shadow inventory, lower mortgage rates raise the odds that the residential real estate markets stabilize sooner and, with less pressure on home prices, that consumer confidence might recover quicker.

* Real interest rates will drop further, so risk assets should theoretically gain in price.

The times, they appear to be a-changin', and the effect of QE 2 -- its ability to move the needle -- despite David Tepper's assurances, remains uncertain.

Back then, QE 1 was instituted at a very depressed level of worldwide economic activity, during a period when market participants were fearful of a financial collapse. Balance sheets were unstable, and funding was problematic. There was unanimity of opinion (over here and over there) that our financial institutions needed to be backstopped, and they were by central bankers in a synchronized and coordinated global fashion.

Everyone was "all in."

Today, our financial markets are stabilized, credit and spreads and risk markets are in far better shape, and our stock market is up violently from the March 2009 lows.

We needed (and got) stability two years ago, but today we need growth.

Today we have a broken domestic money multiplier, we suffer from structural unemployment, interest rates are already at zero (and our savers' class continues to suffer from policy), lackluster credit demand is lackluster, our domestic banks hold large excess reserves but are reluctant to extend credit in the face of economic, and regulatory uncertainty and the housing market (price and activity) is losing some of its historical correlation to interest rates (as it is haunted by a large shadow inventory of unsold homes). Also, with the ECB not playing ball with respect to a global coordination reflation program, not everyone is "all in" today for QE 2.

From my perch, it is growing increasingly hard to see QE 2 as a significant needle mover and as a successful/meaningful follow-up to QE 1, but it is easy to see some intermediate-term fallout.

Rather than a consensus-like response that QE 2 will be successful economically and market-wise -- currently the U.S. stock market is having a benign response to a weakening dollar (as it did in 1987) but for how long?) -- I would offer some additional questions investors should be asking:

1. What will the costs of QE 2 be?

2. At some point, shouldn't increased monetary intervention by the Fed (and fiscal intervention by the government) cause market participants to lower the market multiple as opposed to increasing it?

3. Isn't QE 2 simply reducing the quality of earnings and, similar to Cash for Clunkers or the Homebuyer's Tax Credit, borrowing from future growth?

4. How does QE 2 resolve the single-most headwind to growth, structural unemployment?

5. At the very least, at what point have the prospects for QE 2 been priced in?

The above issues and the uncertain impact that QE 2 will have on our currency helps to explain the very public debate going on now among the Fed members that we have witnessed over the last week. And it also helps to explain why some of those members are encouraging an incremental policy, not a "shock-and-awe" QE 2 but a "shucks and aw" QE 2.

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