Sunday, August 22, 2010

Understanding the Fear in the Markets

With renewed economic uncertainty, American investors have withdrawn a staggering $33.12 billion from stock market mutual funds so far this year, reports NYT.

Over all, investors pulled $151.4 billion out of stock market mutual funds in 2008. The Flash Crash on May 6 of this year resulted in investors pulling $19.1 billion from domestic equity funds in May..

Investors withdrew $14.67 billion from domestic stock market mutual funds in July, the third straight month of withdrawals, according to the Investment Institute.

These withdrawal numbers support the Hindenburg Omen indications that the stock market has been climbing with less and less cash flow to support the advance. This, of course, suggests the potential for severe downside action in the stock market.

Most intriguing however is that much of the flow of funds from investors out of the stock market is moving into fixed income investments. If price inflation begins to creep up, then the fixed income investors will experience some of the greatest losses ever experienced in the fixed income sector.

The money that is now moving into fixed income has to be considered unsophisticated hot money. Remember, this is money that was in the stock market and was scared out by the "Flash Crash" and the ensuing decline in economic indicators. In other words, these are people that watch the news and act quickly once they see what is in front of them. Further, they are very jittery. This is not your great grandmother as investor, who won't move her funds out of bonds, even if Tim Geithner declares them worthless. This, I repeat, is hot, frightened money. If this money is spooked again, it will run again.

Fed chairman Ben Bernanke is not yet pumping enough money to create the type of price inflation that will spook these investors, just yet, but he is getting close. Given the bizarre set of "tools" Bernanke has introduced to "control" money supply, just how quickly and in what fashion money growth could get out of control is not clear to anyone, including Bernanke.

Bottom line: You have a bunch of spooked investors now piling into fixed income investments, where their income from interest payments is negligible. At the same time you have at the other end, a mad scientist as head of the Federal Reserve. His mad concoction has resulted in his holding over a trillion dollars in mortgage backed securities. His introduction of interest payments by the Fed on reserves has resulted in banks placing over a trillion dollars with the Fed as excess reserves. This money could come flowing out and enter the system at anytime. Bernanke knows this. He also knows that no one will buy the junk MBS instruments he has on his books and that he will have to sell off  huge amounts Treasury securities  quickly, to prevent those excess reserves to suddenly flood the markets with huge new money that will be highly inflationary. He knows that execution of a Fed sale of huge amount of Treasury securities will be very difficult. He has enlisted money market mutual funds with assets of just under a trillion dollars to help him drain off the more than trillion dollars in securities the Fed may have to sell off quickly. Got that? The Fed may have to sell off a trillion in Treasury securities and he is, in part, counting on a group of money market mutual funds that cumulatively couldn't even raise a trillion dollars if they sold for cash every other asset they owned. The Fed does have other (shaky) options to sell off their Treasury securities by using their normal buyers, the Primary Dealers, but the Fed knows that there is nowhere near enough money in the primarily dealer network to absorb heavy Treasury selling. That's why Bernanke concocted his most recent tool of money market fund buyers, even though it appears they will be extremely limited as to how much Treasury securities they would be able to absorb. (I estimate that they could buy no more than $50 billion without causing gigantic price swings in other markets, if they tried to liquidate other assets to but Fed offerings of Treasury securities.)

Thus, we have a very spooked crowd holding fixed income assets. At the same time, we have a money supply growth situation that could explode at any time, with a Fed that may or may not be able to bring such a money explosion under any type of control at all.

I have never seen such a combination of elements that could result in such a huge shift from current trends. A shift that could result in a huge inflation and a flight out of fixed income investments that would result in a huge collapse in bond prices and accompanying skyrocketing in rates. Exact timing on when all this could play out is always difficult to impossible to determine, but just know all the elements are there.

This is no time to own any Treasury or other fixed income securities with a maturity of more than six months. And, of course, any liquid fund position should be balanced with long term holdings in gold (even though there may be a short term dip in gold if deflationary conditions remain for the time being) .

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