Central Bank Fantasy Land vs. Real World Nightmare

Never before have I seen such a divergence between the “fantasy land” world central bankers and their faithful live in … and the real world the rest of us inhabit.

In fantasy land, this was the big week investors were waiting for! The European Central Bank (ECB) met yesterday and decided to buy more sovereign bonds in an attempt to bring down interest rates in troubled European countries.

The program is essentially the same thing the ECB already tried earlier, to only limited results. But never mind — rumors of the plan were enough for traders to throw a party in August and this week!

Meanwhile, in the real world, things just kept going from bad to worse, with the economic data deteriorating from one end of the globe to the other!

Bottom line: The divergences between what’s going on in the real world and the puffed-up stock indices, which have been floating on an ocean of cheap money, are the biggest I have ever seen. The last time these divergences were this severe, was right before the stock market crashed in 2007-2008 … and early 2000 before that.

And THAT has major implications for your wealth!

What the Fed, ECB Are Doing —
and What It Means!

In his closely watched Jackson Hole, Wyoming speech last Friday, Federal Reserve Chairman Ben Bernanke tried to justify his nontraditional approach to monetary policy. He defended QE and pledged to keep interest rates low for longer periods of time, saying (in plain English) that they “worked.”

Me?

I see an economy whose unemployment rate has remained above 8 percent for the longest stretch since the government began keeping track in the 1940s. I see an economy whose GDP is barely growing. I see an economy where confidence remains lackluster and manufacturing is shrinking again. And I see an economy where the only real beneficiaries of easy money are the commodity and stock market speculators who can make money off of it!

Never mind whether QE is a success or utter failure though. What is important for investors is that Bernanke did not go into detail about other FUTURE nontraditional policy options, such as nominal GDP targeting or unlimited, open ended QE.

The fact he didn’t mention those kinds of steps lead me to believe they’re less likely to be used. Bernanke also warned that “the hurdle for using nontraditional policies should be higher than for traditional policies.”

But most importantly, Bernanke himself admitted in the speech (subtly) that newer rounds of QE and Operation Twist were less effective than the first round. That’s as close to the emperor admitting he’s wearing no clothes as you can get without coming out and saying so! It fits precisely with what I have been saying for ages too!

Bottom line: The U.S. Fed will likely NOT engage in a massive new QE program … and even if it does, it could be sold aggressively by investors now that even Bernanke himself is admitting it’s almost completely ineffective.

As for the ECB, President Mario Draghi unveiled plans to buy sovereign bonds with maturities of three years or less. So many leaks came out before the Thursday meeting that the actual news was almost anticlimactic … and now the question is whether or not investors will “sell the news.”

Why should they?

Well, the bond purchases will be conditional — meaning the ECB won’t buy unless the targeted countries (think Spain here) agree to oversight and more supervision by fiscal authorities. The program won’t seek to establish firm yield “caps,” another disappointment.

Most importantly, the purchases will be sterilized. That means this is not an all-in “QE” type strategy that balloons the size of the ECB balance sheet and results in runaway money printing. That is likely reflecting concern among the ECB’s members in Germany and other more conservative countries.

Global Economy Sinking
Deeper into Recession!

So what about the “real world”? There the news is going from bad to worse. Here in the U.S., the Institute for Supply Management’s benchmark manufacturing index sank further to 49.6 in August. That was the third month in a row below 50, which is the dividing line between expansion and contraction in this key sector.

Europe’s benchmark manufacturing index also slumped to 46.3 in August. That indicates the euro-zone economy is sliding deeper into recession, and that the recent rise in unemployment to a fresh euro-era record high is only the beginning!

As for the BRIC countries, China’s services sector index just sank to its lowest in a year. Brazil is slowing so much, the central bank was just forced to cut its benchmark interest rate to a record low of 7.5 percent. And in India, GDP growth slowed to 5.5 percent in the June quarter. That was close to a three-year low, and well-below long-term growth targets in the 8 percent to 9 percent range.

Now I want to update you on those incredible divergences I mentioned earlier. Virtually every indicator of the REAL economy is slumping or stagnating even as the broad stock market averages try to hold these elevated levels.

In the top panel of the chart below, the black line is consumer confidence, the red line is the S&P 500, and the panel on the bottom shows the spread between the two. The last time there was a divergence as huge as it is now was in 2007-2008 — right before the stock market crashed.

Click the chart for a larger view.

The top panel in the next chart below shows the same comparison — only using the ISM manufacturing index and the S&P 500. You’ll see that the ISM index did NOT make a higher high along with stocks this year — a key divergence.

And in the bottom panel you’ll also see the last time they diverged this much was right before the 2007-2008 stock market crash. The time before that? Right before the 2000 stock market crash!

Click the chart for a larger view.

Bottom line? You have the real economy deteriorating sharply. You have key global players in sectors like technology and transportation warning that revenue and earnings growth is slowing rapidly. FedEx (FDX) was just the latest casualty this week, cutting its profit target for the second time since June.

And yet, you have investors clinging to the hope that a few policymakers huddling in conference rooms on two sides of the Atlantic can somehow “save the world.” That’s despite the fact the “saves” they are talking about have already failed repeatedly.

I think that’s a real recipe for trouble. And that’s why outside of a few select situations, stocks look very vulnerable to me.

Until next time,

Mike