For the past six months the US market has straight-lined from 1,050 to 1,350 almost without taking breath. That's a 30% rise:
(Click to enlarge) Source: Google Finance
Central bank money-printing will do that to the stock market.
Since August, the US Federal Reserve has spent USD$431.3 billion buying US government bonds. All of it done using freshly created electronic cash.
Why would that push stock prices higher?
A few reasons. One is as bond holders sell bonds to the Federal Reserve some of the fresh cash is moved into the stock market where yields and capital growth are potentially higher.
Another reason is that traders and speculators are trying to pre-empt a future movement from bonds into equities. As more money is created, traders foresee that this will filter into the economy – to improve company earnings – and will cause asset prices to rise.
Simple.
But the past week shows you that even central bank money-printing can't stop the market from falling when investors panic.
If you look at the S&P500 volatility index (VIX) you can see investors have started to panic:
Source: Yahoo! Finance
Last night the VIX jumped 26%!
If you're not familiar with it, to put it simply the VIX measures expected volatility in the US market. It's based on the price of call and put options.
You see, volatility is one of the price determinants of a call and put option. If traders expect volatility to be higher sellers of an option will demand a bigger premium. And if volatility is expected to be high, buyers of an option will expect to pay more because they see a greater chance of prices moving by a bigger margin.
In other words, if an options buyer believes a stock could move from $20 to $25 within the next month then they'll pay a bigger premium for an options contract. Whereas previously if the options buyer believed a stock would only move from $20 to $22 within the next month then they'd only be prepared to pay a lower premium – and the same goes for falling share prices.
The boffins at the Chicago Board of Options Exchange take this data, feed it into their super-computer and hey presto, out pops the VIX index.
If you don't understand it, don't worry. All you need to know is the higher the index level the greater the expected market volatility.
A longer term view of the index will show you what I'm talking about. As you can see on the chart below, the VIX index spiked above 80 in late 2008 as markets crashed:
Source: Yahoo! Finance
Today it is above 20, following the 26% move last night.
Now, it doesn't necessarily mean the market will fall. It just means investors believe the market will be more volatile over the next thirty days.
And they've every reason to believe that. Recently I wrote to you about the spread between West Texas Intermediate crude oil (the North American benchmark oil price) and the Brent crude oil price (the European benchmark oil price).
Historically WTI trades at a premium to Brent because WTI is the preferred oil for refiners. But since the action started to kick-off in the Middle East and North Africa, Brent has taken off. So that today Brent is trading at a USD$12 premium to WTI. And that's even with an 8.5% rally in the WTI contract last night!
Interestingly, crude has outperformed all other commodities.
Trading days like last night show you just what's in the mind of investors.
In recent weeks, punters have loaded up on risky assets – small-cap stocks, base metals, and soft commodities.
They've mostly backed those assets because of the inflation trade – the central bank money-printing I've mentioned previously.
But when punters get scared… they get out.
Soft commodities, which have rallied hard, took a bath last night. The Chicago Board of Trade (CBOT) wheat futures contract dropped 7% as it went limit-down. Many futures contracts have a price breaker. It means the price can't move up (limit-up) or down (limit-down) by more than a certain amount.
In this case the wheat contract dropped by as much as the exchange would allow and therefore trading stopped. The soybean contract took a beating too, falling over 5%, while corn was down 4%, cotton down 3.6% and rice down 3.3%. This tells you punters have dropped off the broad inflation trade in favour of the oil supply risk trade. And don't forget, even though Libya only exports about 1.4 million barrels of oil per day, if this supply is cut or reduced, it will have an impact on oil prices – that's why futures prices have jumped. Normally, the difference between supply and demand is tiny. Where supply is no more than a few hundred thousand barrels per day more than demand.
But take a look at the charts below to see what's happened through 2010.
First the supply chart from the International Energy Agency (IEA):
Source: IEA
I've highlighted the most recent quarter and the 2010 average with a green box.
You'll note the world supply for the last quarter was 88.2 million barrels per day. And the average for 2010 was 87.3 million barrels per day.
Now look at the demand chart. Again I've highlighted the most recent quarter and the 2010 average:
Source: IEA
The last quarter average demand was 88.9 million barrels per day and the average demand for 2010 was 87.7 million barrels per day.
If you do your sums you'll figure out that demand exceeded supply for the first time since 2007. In the last quarter by a whopping 700,000 barrels per day.
In other words, based on these averages, the market had to dip into reserves to keep up with demand. And the last time demand exceeded supply we saw crude oil prices jump to nearly USD$150 a barrel. Could we see a repeat?
Who knows, but if supply doesn't pick up then there sure is a chance that the price could spike further, regardless of whether things hot up in North Africa and the Middle East.
And it's the high commodity prices that create a problem for the Federal Reserve. The more money it prints, the higher commodity prices will go. But the higher commodity prices also increases costs for businesses and individuals. That makes it harder for them to save. And it makes it harder for businesses to take on more staff. Plus it also means a greater proportion of income going towards energy costs rather than other items.
The upshot is the Federal Reserve needs to print even more money to try and prop up the economy, which… as you can guess means even higher commodity prices.
That's how inflation harms the individual. Because the individual is always the last to receive the inflated dollars – governments, bankers and vested interests get the cash first. By the time individuals get their hands on the new cash, prices have already risen. It's why the so-called economic recovery is a sham. Remove the monetary stimulus and the economy will fall in a heap. Yet keeping the stimulus won't help.
It only results in increasing further the living costs of individuals. And increasing the costs for businesses. Within the next few months the global economy will reach another potential turning point. If the Fed believes its own spin about the recovery and stops printing money, the descent into a recession will soon follow.
Yet if the Fed continues to print money asset bubbles could blow out further, resulting in an even bigger recession (or even depression).
The fact is, it's a lose-lose situation for the Fed whatever it does.
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