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Permanent Portfolio Investing

Your Portfolio is Controlled by the Fed!

Written by Geoffrey Pike
Posted October 24, 2014

U.S. stocks have been on a roller coaster ride lately.

After the major downturn in late 2008 and early 2009, stocks began going back up starting in March 2009. And it has been a bullish ride up over the last five years — until just recently.

This ride up for stocks has coincided with low interest rates and an extremely loose monetary policy from the Federal Reserve. The Fed has gone through several rounds of quantitative easing (QE), or in simpler terms, money creation.

The Fed has been buying a combination of U.S. Treasuries (government debt) and mortgage-backed securities (MBS) with money created out of thin air. The purchase of MBS is a new thing for the Fed since 2008. It has essentially served as a quiet way of bailing out the major banks from bad loans.

The adjusted monetary base, which the Fed directly controls, has gone up by a multiple of five times since 2008. But much of this newly created money has gone into bank reserves and has not multiplied through the economy in the form of lending, as has typically been the case in the past.

Consumer price inflation has stayed relatively tame according to government statistics, but that doesn’t mean asset bubbles can’t occur.

It is kind of scary, but this is similar to what occurred in the U.S. in the late 1920s just before the market crashed, starting what would later be known as the Great Depression. In the late 1920s, the loose monetary policy was not showing up in the form of consumer price inflation, but stock prices were hitting all-time highs.

Fed Support Required

Stocks declined heavily last week, making many wonder about the so-called recovery that we are supposed to be in. Right on cue, a Federal Reserve member came out and spoke to give investors some assurance.

James Bullard, the president of the Federal Reserve Bank of St. Louis, said the Fed might pause its current tapering. He even said it has the option of ramping up QE in December if it needs to do so to help the economy.

Perhaps not coincidentally, it wasn’t long after these comments that stocks turned back up from the lows of the week.

Last year, the Fed’s policy was to create $85 billion per month in new money — about $1 trillion per year. In 2014, the Fed has been “tapering,” meaning it is reducing the rate of monetary inflation. It is now down to “just” $15 billion per month and was set to finish off the taper at the end of this month. In other words, investors are expecting the money creation to stop soon.

The Federal Open Market Committee (FOMC) is set to meet next week and announce its latest policy statement on October 29. Just before Halloween, investors aren’t sure whether to expect a trick or a treat.

Matt King, the global head of credit strategy at Citigroup, is estimating that the major central banks need to inject about $200 billion per quarter in order to keep markets from selling off.

I’m not sure there is a magic number in this, but his idea that reduced monetary inflation will lead to stock selling is philosophically correct.

Artificial Business Cycle

I believe the Austrian Business Cycle Theory — a theory that comes from the Austrian School of Economics, which is really just free market economics — is correct.

According to the theory, when a central bank has a loose monetary policy, along with artificially low interest rates, it misallocates resources and, in the process, causes bubbles and something of an artificial boom. People experience a false sense of prosperity, but this cannot last forever.

If the central bank does not keep increasing its rate of monetary pumping, then the misallocated resources will attempt to correct, which will pop the artificial bubbles. The housing bust of 2006/2007 is a great example of an unsustainable bubble that had to eventually pop.

Of course, if the central bank keeps increasing its rate of monetary inflation and never stops, then it eventually leads to hyperinflation and a complete destruction of the currency.

In other words, a correction has to happen at some point when there is an artificial boom. It is just a question of timing and how bad it will be.

It can be surprising how long bubbles can go on before actually popping. China’s current real estate bubble is a good example of this. And the longer an unsustainable boom goes on, the more painful it will be when it comes to an end.

But the key here is that U.S. stocks are being supported through the Fed’s monetary inflation. We should not fool ourselves into thinking this is due to some kind of great prosperity where our standard of living is increasing rapidly.

Stocks Without Inflation

We live in a world of central banking and fiat currencies. Therefore, inflation is the norm. It is hard for anyone in today’s world to imagine a world without inflation.

Imagine a society with a central bank that never creates money out of thin air. Or imagine a society without a central bank that uses a form of money that cannot increase in supply. What would happen?

As technology and productivity increase, prices would go down. Many people today, especially politicians and central bankers, fear price deflation. But falling prices are a good thing for consumers.

The problem is that deflation is a threat today only because it would be a popping of the Fed’s bubbles. It is only a potential problem because of prior monetary inflation.

It is hard to believe, but in a society with a constant money supply, stock markets would not really go up much, if at all. Certain individual stocks would go up and down, but the overall prices would remain somewhat constant.

People would own stocks because the companies pay dividends. They would also likely experience an increase in purchasing power over time just due to productivity gains.

In our world today of corporate taxes, dividend taxes, capital gains taxes, regulations, and inflation, the whole concept of owning stocks is distorted. But we can be certain that much of the broad stock market gains we have seen over the last five and a half years have been primarily due to a loose monetary policy.

Follow the Fed

If you are trying to figure out where the market is headed, my best advice is to follow the Fed.

It will be interesting to see what the FOMC announces next week. If it puts the so-called taper on hold, then we may see another run up from stocks.

On the other hand, if the Fed finishes its taper — meaning no more monetary inflation for now — then we should not be surprised to see stocks fall more.

Also important will be the language for future expectations. It will be important if the FOMC suggests that it could ramp up its quantitative easing again if things get bad.

Personally, I am investing in a permanent portfolio that is designed to weather any storm. I can’t stake my future on what a small group of people decides in a committee meeting.

We can’t predict what the Fed is going to do, but we can predict that stocks are going to react in accordance with its monetary policy and expectations of monetary policy. Stocks have lived by the Fed, and they will die by the Fed.

Until next time,

Geoffrey Pike for Wealth Daily

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