I've Got a Funny Feeling About the Stock Market

The dollar has reached a point of double-bind for the Fed: push it down further or allow it to rise, it won't matter: either way, stocks will fall off a cliff.

I've got a funny feeling that all the ramp-and-camp, extend-and-pretend POMO games propping up stocks are about to stop working. That would of course trigger a long, deep slide in equities, because as we all know, it's the Federal Reserve's games which have goosed the market to its current lofty heights. The market's confidence in the Bernanke Put--that is, the belief that the Fed will never let stocks decline-- remains supremely undimmed.

A lot of very good technical analysts see sentiment reaching lows which usually mark market bottoms. I am not so sure about this interpretation, for the investors intelligence readings are still complacently bullish.

Other very good technical analysts haven't yet seen a break in the long-term uptrend, so they too have reservations about any real decline.

Various Wall Street analysts are predicting a "mild correction" of 7% to 10%, after which it's off to the races once again--a pause that refreshes the permanent Bull.

I've got a funny feeling that it's lose-lose time for the Fed's games. here's the basic game plan: inject tens of billions of free money into the "risk trade," i.e. equities and commodities, ramp the futures markets when volume and liquidity are low, and crush the U.S. dollar.

It's practically a perfect inverse correlation: when the dollar tanks, stocks move higher, and when stocks hit bottom then the dollar peaks. Think see-saw: when one tops out, the other hits bottom, and vice versa.

Interestingly, there is a rough correlation with the 40-week (9 month) cycle that many chartists watch. If that holds in the chart of the dollar, then the dollar should rise to a near-term peak in about 8 to 12 weeks. That further suggests stocks will crater.

Notice that the dollar has been driven down to an important inflection point. If the Fed forces it below the 75 level, then that opens the way to 72 and a careening collapse below the line-in-the-sand at 71.

There's an inherent limit to the "drive the dollar down to boost equities" game: inflation, which is already on track to hit 8.3% in 2011 (via Zero hedge).

For there's another see-saw dynamic: the lower you push the dollar, the more all the imports the U.S. depends on cost, generating a loss of purchasing power that is often called inflation.

Here is a simple real-world definition: you pay more for the same (or smaller) goods and (degrading) services than you did in the recent past, though your wages have been stagnant for decades.

Though the Ministry of Propaganda is running full-tilt pumping out statistics that "prove" inflation is near-zero, the recent "you can't eat iPads" heckling of a Fed official reflect the growing disbelief in these official pronouncements.

So here's the lose-lose double-bind: if the Fed continues destroying the dollar, then they will feed the rising-input-costs monster which devours corporate profits like a 10-year old devours Oreos. In a climate where consumers' incomes haven't risen for decades in real terms, passing on higher prices is a non-starter.

So profits will take a hit, and since the market has priced in ever-higher profits, the market will plummet when profits "unexpectedly" decline.

But if the Fed insists on pushing the dollar below 75 in the hopes of pumping up equities, they risk triggering a meltdown of the dollar globally and forcefeeding the rising-input-costs monster until a positive feedback loop kicks in and inflation sinks its teeth into the economy. As noted above, that will destroy corporate profits and thus the stock market's lofty valuations.

I also have a funny feeling about this chart. The NASDAQ, heavily dependent on a few superstars like AAPL and riddled with gaps all the way up from its lows in August, could be topping out not for a few weeks but for years.

The always excellent and provocative Imperial Economics blog of B.C. has published some eye-opening charts which overlay the current bullish utopia with those from previous eras. The sobering conclusion is that if history echoes, then the market is about to roll over in a massive decline that will last a year or two.

As I noted in Sorry, Fed and People's Bank of China: You Can't Have It Both Ways (March 15, 2011), you can't pump up money supply and credit to goose "risk trades" in stocks and commodities without inflating asset bubbles and triggering runaway input-costs, i.e. inflation that destroys profit margins and impoverishes stagnant-wage households.

But if the Fed takes its hands off the game controller and allows the dollar to rise, then equities crash anyway.

In other words, the dollar is at a point where either path leads to stocks crashing.Go ahead and destroy the dollar, and the rising-input-costs monster will gut stocks and impoverish households. Back off and let the dollar rise, and the risk trades (equities and commodities) will plummet.

Take your pick: the result is the same.

Disclosure: I opened a long position in UUP, the U.S. dollar ETF yesterday, and added to my QID short against the NASDAQ 100.


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