The Bubble that Ben Built: TBT, UUP, DIA, SRS, TLT

November 05, 2010, 08:29 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

As a student of the Great Depression, Ben Bernanke knows what it takes to keep the economy from declining like it did then.  In order to stay afloat, people need to invest money.  Yes, people must also spend money, but we can't force people to spend money.  The chief of the Federal Reserve believes he can force people to invest it instead, and he believes it will be good for the economy.

Without argument, interest rates are so low other asset classes, even though they are much more risky, seem like a better opportunity.  That is the goal of the Federal Reserve and recent monetary policy.  At least, that is one of the goals.  They want investors to look for opportunities in risk based assets, non – Treasury assets (NYSE: TLT), with hope they will change their perception of the economy and take even more risks thereafter.  The other has everything to do with China (NYSE:.

From a political standpoint, the United States believes that it can compete with China if China discontinues its peg to the dollar.  Thus far, China has not been willing to decouple completely, so the political parties in power have requisitioned the Federal Reserve to devalue the US currency to a level upon which China cannot ride any further.  The United States is trying to force China to inflate its own currency by forcing it to de- peg from the dollar.  The US wants to show China that the US Dollar (NYSE: UUP) has little value, China has lost tremendously by holding so much US Debt, and China does not like to lose.  In doing so other countries lose too, lose faith in the US Dollar, but the United States hopes to be in a better competitive position globally by doing this.

The two goals of this QE measure are commendable.  First, we want assets to increase, and second we would like to be more competitive globally.  Unfortunately, for that we pay a price.

Clearly, natural economic growth is out of the question.  The US economy is weak, it could even weaken further, the unemployment rate is high, it could get higher, and global economies are doing far better than the United States.  Money is now flowing aggressively out of the country, to places where growth is not fabricated.  There is a natural reason for that.  I describe that in the Investment Rate, and exactly what the Investment Rate says about the future is causing our government to take big swings with high risks.  Instead of accepting the weakness, and working through it slowly, the United States wants to hit a home run.

A currency is like a stock for the country it represents.  The lower the currency, the lower the value of that country.  The stock market could be higher (NYSE: DIA), but not in real terms.  We may even gain some competitive advantages because costs of labor will have been reduced by such a significant margin.  Could it be that the United States turns into a low-cost manufacturing resource for the rest of the world because the dollar is so much cheaper that foreign nations look to us instead of us to them?  If this keeps up it will be true.

There are two ways to stimulate an economy that is not growing organically.  The first is accomplished using a direct spending program like the one that began two years ago.  The government hires workers, pays salaries, those workers spend money, and the economy is stronger than it would have otherwise been.  In this case, the economy just trudges along, nothing exciting, but less risk exists too.  This is good given what the Investment Rate says.  The second, the one that is happening now, exists when the government requisitions the Federal Reserve to print money, buy assets, inflate prices, and create a wealth effect.  This is the high risk option.  It works when the economy is poised to regain strength, but The Investment Rate says that is not going to happen for many years; now it might even take longer.

The wealth effect is important to understand.  The perception is, if people believe that they have more money they would be willing to spend more or invest more.  Therefore, the declining value of the dollar because it is pushing the stock market higher, is causing people to feel like they have more than they otherwise would.  From there, they take money out of other bank accounts and spend it on goods, services, or other types of investments.  That is the goal of the wealth affect.

Initially, that sounds like a great idea.  Make people feel better, get them to spend more money, and that will fix the problem.  Unfortunately, it is not as easy as that.  In order for that policy to work the government would need to print money endlessly, think Zimbabwe.  In order for a wealth effect policy to work over time assets must always move higher.  Once assets stop increasing the bubble bursts.  Our weak economy suggests that if this QE effort was not happening the economy would get weaker.  Therefore, when they stop, or when the effect is no longer meaningful, the bubbles will burst.

Interestingly, our economy was just weakened by a wealth effect.  The real estate bubble (NYSE: SRS) that ended in 2006-2007 and the cheap money associated with it caused investors to believe that they had much more than they otherwise did.  That caused them to spend more than they otherwise would, and when the hammer dropped those persons left holding the bag suffered dearly.  Those included foreign governments, municipalities, financial institutions, and millions upon millions of US consumers and homeowners.  The wealth effect caused the bubble in the housing market and the result is what we have witnessed since it collapsed.

Here is an interesting analogy.  In California, the governor's race between Meg Whitman and Jerry Brown was well televised, and Jerry Brown ran an ad that I believe won him the election.  The ad showed Meg Whitman and Arnold Schwarzenegger at separate times during their respective campaigns saying the exact same thing.  The ad’s point was, doing the same thing over and over again and expecting a different result was ludicrous.  It suggested that Meg Whitman and Arnold Schwarzenegger had the same policies, the same approach; Meg said the outcome would be different, but the ad suggested the outcome therefore would be the same.  I believe its swayed voters, and it is why Meg Whitman lost the election.  You cannot repeat the same mistakes over and over again and expect a different result.

The issue in the hands of the voters in the California governor's race is no different than what we are facing today with the second round of quantitive easing, except we have no power to decide for or against the actions of the Federal Reserve.  Instead, we are forced to accept the consequences.

Over the past 10 years, beginning with the Internet bubble, then the real estate bubble, the current bubble in treasury bonds (NYSE: TBT), and worse, a contrived purposeful bubble created in the equity market today, the same question begs an answer.  Is it ludicrous to do the same thing over and over again and expect a different result?  This time, the end result will be much worse than any of the prior bubbles.

Equity levels are at two-year highs, based almost solely on the expected quantitative easing policy Bernanke first alluded to in his Jackson Hole Wyoming speech.  At these levels, one would expect the economy to also look much better and shows signs of strength.  There is a disconnect between the economy and the stock market, however.  The stock market seems to be reacting almost solely to the value of the dollar.  If the dollar is lower, the market rises.  If the dollar is higher, the market falls.

At some point, that relationship is likely to decouple.  When it does, when the dollar falls to a level at which investors start to worry, the asset bubble we have been witness to recently will correct itself.  We cannot inflate our way to economic prosperity, but we can prevent the economy from getting substantially worse by offering meaningful stimulus.  There is a distinct difference between the measures being undertaken by the Federal Reserve today and the stimulus policy that so many consider a failed attempt by the Obama administration.  My guess is, if Bernanke could get the Politicians to agree he would encourage more stimuli from them.  Because they will not get anything done, he is forced to take action even though he does not know the consequences.  He knows something needs to be done he is a student of the Great Depression, but because normal measures will not be taken he is forced to enter unchartered waters.  Most professionals admit the repercussions could be severe.

My argument is the quantitive easing measure adopted by the Federal Reserve is false and misleading.  It creates a false perception of value, disguised by temporarily inflating asset prices and temporarily causing a wealth affect; its staying power cannot last very long, and it causes a bubble.  When it stops, all assets classes will be crippled.  When Chinas Starts to sell Treasuries like the US wants them to do, all of those people who would have otherwise thought Bonds were a safe haven will realize that the value of Treasury Bonds would normally also be associated with the value of the dollar, and prices should have declined too.  With conscious effort, the Government has already caused a bubble in Treasury Bonds, and it is now doing the same in the Equity Market. 

When is the last time the end result of a bubble turned out good?  We need to learn; we cannot repeat the same mistakes over and over again and expect a different result.  My advice to the Government is to work through the weakness slowly, build a solid foundation, and do not risk the future of the country in the process.  Unfortunately, my tone falls on deaf ears.  Therefore, my word of advice to investors is do not be left holding the bag this time.  When it gets ugly, is going to get very ugly.  The stock of the wealthiest country in the world is deteriorating every day, they do not care to take prudent measures, another bubble had been blown, and my guess is China is holding the needle. 

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