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Kass: Equities Edge Toward a Top

Throughout the market's rally over the past six weeks, I was reminded something Milton Friedman's once expressed, which I have taken the liberty of paraphrasing below to emphasize my concerns with regard to the efficacy of QE 2: If you put the Federal Reserve in charge of the Sahara Desert, in five years, there would be a shortage of sand.

We have embarked on a slippery slope of policy, and, from my perch, there is too much confidence regarding a favorable outcome.

Is it really a good idea to put our investment trust in the successful policy of the Federal Reserve in its ability to fine tune inflation and stimulate growth? After all, in the past the Federal Reserve couldn't find their way home and failed to identify the stock market bubble in the late 1990s, the housing bubble in 2003-07 and the recent credit bubble.

In a recent interview with Fortune Magazine's Carol Loomis, Warren Buffett said that he "can't imagine anybody having bonds in their portfolio." (I continue to believe that short bonds is the trade of the decade.) At the same time, Fed Chairman Ben Bernanke is hellbent on buying U.S. bonds ad infinitum. As my buddy/friend/pal, Jeff Matthews, recently wrote, Who do you have more confidence in making your investment decisions -- Berkshire Hathaway's (BRK.A) Warren Buffett or the Federal Reserve's Ben Bernanke?

Most market participants are fixated with the potential for QE 2 to boost asset prices and generate organic economic growth, however, without a subsequent rise in aggregate demand and productivity, the program will ultimately be deemed a failure as prices readjust over time to reflect the real underlying fundamentals. Mr. Bernanke is making the same blunder that we made with the past bubbles busts -- if we can create paper profits and convince consumers that they should spend those paper profits, then we'll be on our way to economic prosperity. The problems arise when asset prices readjust lower to meet their true fundamentals. It's Ponzi finance and nothing more.

-- "Northern Trust: QE 1 Failed, Why Will QE 2 Work?" from Pragmatic Capitalism

As I have written previously, I don't believe QE 2 will meaningfully move the needle of domestic economic growth and will only have a limited impact on:
  • the jobs market, which is plagued by structural unemployment;
  • housing, which that is haunted by a large shadow inventory of unsold homes and in which mortgage credit will likely be further reduced by the moratorium on foreclosures; and
  • confidence, which is still mired in uncertainty regarding regulatory and tax policy (and that is undermined by high unemployment).
Conditions are far different for QE 2 than QE 1. Interest rates have already fallen to very low levels, and the benefits have already been felt on mortgage rates and in refinancing. Also, unlike QE 1, when the world's central banks were all-in, differing policies now dominate the global landscape.

Meanwhile, our fiscal imbalances multiply, our currency craters (as a worldwide rush to currency devaluation is offsetting some of the normal trade deficit benefit), and the bulls rationalize these concerns by suggesting that the consequences "are beyond our investment time frame."

Importantly, there are a number of other possible adverse consequences from the inefficient allocation of resources that is the outgrowth of the next tranche of monetary stimulation.

While the immediate response to the likelihood of QE 2 has been to buoy asset prices, the domestic economy is stalling at around 1.5% to 2.0% GDP growth, and little improvement in the jobs market has been seen. This hesitancy makes the anemic slope of the current recovery vulnerable to the unforeseen (e.g., trade wars, policy errors, etc.) and could place the generally assumed self-sustaining economic cycle at risk. As well, the long tail of the last cycle's abusive use of credit looms large, as demonstrated by mortgage-gate.

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