Liquidity Trap

by Larry Levin

The most recent letter from the Hussman Funds, written by John P. Hussman, Ph.D., is lengthy and a little technical but is worth the read at Bernanke Leaps into a Liquidity Trap.

In essence, Mr. Hussman proves that the idea of QE1 or QE2 is ridiculous; like pushing on a string, not much is accomplished. But that won't stop Benron-Ben Bernanke. No sir. His egghead friends in Universities across the country, like Paul Krugman, are demanding insane levels of new QE and fiscal spending.

From the report...

Simply put, monetary policy is far less effective in affecting real (or even nominal) economic activity than investors seem to believe. The main effect of a change in the monetary base is to change monetary velocity and short term interest rates. Once short term interest rates drop to zero, further expansions in base money simply induce a proportional collapse in velocity.

Look at the price of gold since 1975. When real interest rates have been negative (even simply measured as the 3-month Treasury bill yield minus trailing annual CPI inflation), gold prices have appreciated at a 20.7% annual rate. In contrast, when real interest rates have been positive, gold has appreciated at just 2.1% annually. The tendency toward commodity hoarding is particularly strong when economic conditions are very weak and desirable options for real investment are not available. When real interest rates have been negative and the Purchasing Managers Index has been below 50, the XAU gold index has appreciated at an 85.7% annual rate, compared with a rate of just 0.1% when neither has been true. Despite these tendencies, investors should be aware that the volatility of gold stocks can often be intolerable, so finer methods of analysis are also essential.

Quantitative easing promises to have little effect except to provoke commodity hoarding, a decline in bond yields to levels that reflect nothing but risk premiums for maturity risk, and an expansion in stock valuations to levels that have rarely been sustained for long (the current Shiller P/E of 22 for the S&P 500 has typically been followed by 5-10 year total returns below 5% annually). The Fed is not helping the economy - it is encouraging a bubble in risky assets, and an increasingly unstable one at that. The Fed has now placed itself in the position where small changes in its announced policy could have disastrous effects on a whole range of financial markets. This is not sound economic thinking but misguided tinkering with the stability of the economy.

Commodity hoarding? Oh, that's great isn't it? When gasoline reaches $6/gal I wonder if Helicopter-Ben will rethink his mad ideas? Not so much, I'm sure. When gasoline reaches $10/gal...Backstop-Ben better hide, because I believe the riots in Greece and France will have reached the shores of the USA and many will be looking for him.

Previous Day's Trading Room Results:
Trade Date: 10/25/10
E-Mini S&P Trades*
(before fees and commissions):

1) No "Secrets" trades filled today.

2) Algorithm positions (2)

3) “Reading the Tape” positions (5)…combined Secret’s, Algo, & “Reading the Tape” total… +1.75

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