Monday, February 3, 2014

The Selloff Is Rational

Thesis: The selloff indicates that the economy is much weaker than the recent growth data would suggest, and that the data will have to catch up with reality.

The Dow is off by 1200 points or almost 8% since the beginning of this year, and is down 600 points in just the past week. The official explanation for the selloff is investor doubt about the growth outlook, as signalled by the December jobs report and the January ISM report. Which is strange, considering that the markets received very bullish news from the 3Q13 and 4Q13 growth numbers, which were both quite strong.

It would appear that the market is currently ignoring good news and focusing on bad news, whereas before Christmas it only noticed good news. Have the facts changed or has sentiment changed? I think sentiment is catching up with the facts.

As readers know, I have been talking bearish since mid-December. I discounted the strong 3Q13 growth number and pointed to the weak December jobs number. I have no explanation for the 4Q13 growth number aside from the fact that it is inconsistent with my bearish outlook, and that the market agrees with me.

Although we have conflicting data points about the current rate of economic growth, there is nothing ambiguous about the current rate of money growth: slow and getting slower. The markets are unable to fight the Fed, and the Fed is the villain in this story.

Money growth has been declining for 18 months, from above 10% in the first half of 2012 to below 6% today, a 40% drop. A big chunk of that drop occurred in late-2013. Now, we know from Econ 101 that when both the money supply and velocity are declining, nominal growth must decline. And nominal growth has declined--until the last two quarters, which is why they look fishy to me.

From the monetarist perspective, the independent variable in the economy is M2 growth. M2 growth has declined to a dangerously low level, particularly given the ongoing decline in velocity, the transmission mechanism to the nominal economy. (Yes, I understand how V is calculated, but it is clearly declining.) We are in the midst of a low growth period as a direct result of Fed policy. (It is unacceptable for any central bank to argue that it can’t control the money supply, as Bernanke has explained to the Japanese and others on many occasions.)

Economics says that either the strong growth numbers are wrong, or else the weak money numbers are wrong. They are mutually incompatible. Being forced to decide between the bearish money data and the bullish economic data, I go with the stock market: I agree with the bearish money data.

Here is the Commerce Department’s reported real quarterly growth at seasonally-adjusted annual rates:
4Q12: 0.1%
1Q13: 1.1%
2Q13: 2.5%
3Q13: 4.1%
4Q13: 3.2%

There is certainly nothing bearish there.  But I don’t doubt the money data: when I look at the aggregates, they are all going in the same direction: M1, M2, M3 and M4. (The first two are from the St. Louis Fed, and the latter from the Center for Financial Stability). All of the aggregates show declining growth rates.

In my opinion, the selloff is rational and reflects a weak growth and earnings outlook. We will learn the answer as further growth-related data is dribbled out.

Conclusion: The selloff is rational and reflects weak growth. It won't reverse until the FOMC takes control of money growth.

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