I want to present a chart outlining my biggest mistake of 2013.
This is a chart of the S&P 500 (yellow line), the CRB Index (white line) and the Fed’s balance sheet (green line).
During 2013 I made a spectacular error in judgement by assuming that as the Fed printed money, inflation would arise in things that the Fed did not want (like energy and food) instead of assets that the Fed did want to go up (like financial bonds and stocks).
Never in my wildest dreams did I think that the Fed would be able to control what assets the money chased.
I believed that the inflation was going to occur in things we need instead of things that we want. Therefore I did not expect financial assets to be the sole beneficiary of the Fed’s largesse and instead expected inflation to show up in food, energy and other every day items.
Much to my surprise, over the last couple of years, the Fed’s balance sheet expansion has largely confined itself to reflating the financial asset bubble. Stocks in particular seem to be on a direct linear correlation with the Fed’s balance sheet.
During the first three years of the QE programs, the Fed’s monetary expansion effected both stocks and commodities somewhat equally. The Fed was in essence reflating all assets.
But then something happened in 2012 and from then on, financial assets were the only beneficiary of the Fed’s easy money:
Only recently over the past few months has the CRB showed any signs of life.
I understand that commodities sank on the whole “Chinese economy rolling over” situation. I get it that commodities had experienced a massive bull market that was due for a pause.
But I would have never guessed that the Fed would be able to reflate without experiencing more pain.
It still astounds me that as markets participants have been forced out the risk curve, they have repeated all the mistakes they made in the 2002–7 period.
I am not sure if this is simply a case of testing Keynes theory about markets staying irrational longer than you can remain solvent, or if something has fundamentally changed, but even though I have a big scar from this trade, I can’t break my thinking that it is simply not this easy. The Fed cannot simply magically levitate financial assets without there being adverse consequences. Nothing in life is that simple.
Right now corporate profits are hitting all time highs as a percentage of GDP:
Although some might argue that with profits at these levels and interest rates this low, stocks are reasonably priced, I question the sustainability of both of those situations.
We seem to be in a state of nirvana where the Fed’s monetary expansion lifts only financial assets – bypassing any other more malignant price rises. This financial inflation has resulted in its own set of problems with the exacerbation of societal inequality, but on the whole, it has not yet caused any major financial system problems.
I don’t know when, and I don’t know how, but I am confident that the Fed’s magical levitation has massive costs that we have not yet experienced.
This might take the form of a complete collapse of financial assets as the Fed stops adding liquidity to the system. Or it might be the ignition of inflation as the giant Fed balance sheet finally works its way into the real economy. But either way, I suspect that this massive dislocation between financial assets and real assets has run its course.
At the risk of repeating my mistake of 2013, in the coming weeks, I am going to start putting on a long term short financial assets long hard assets trade. This trade’s time frame should be measured in quarters (or maybe even years) as there is no real catalyst. I am going to put it on in a size that enables me to sit through some real pain if I am early.
I am not sure of much in life, but I know that nothing is this simple. The Fed has so far not experienced any real negative consequences from their reckless policies. You can’t solve all of economic problems with printing. It just ain’t that easy…