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And What Happens When The Tide Of Liquidity Ebbs? at Trader’s Narrative

This is a guest post by Bud Conrad, Editor of The Casey Report:

While no two economic situations are identical, one likes to think that, all things being somewhat equal, if the monetary authorities do “A,” then “B” should result. For example, if you massively inflate the money supply, then history has shown time and time again that a serious price inflation is almost certain to follow.

Likewise, if the politicians decide to turn on the monetary taps to help soften the blow of a crash, one should not be surprised if the stock market begins to recover. Especially, as has been the case in the current crisis in the U.S., when much of the money has flowed into the financial sector. As discussed yesterday, that sector has shown the biggest bounce in profits.

Looking for answers, we might restate the question thus: “Does quantitative easing result in a stock market bounce?”

With that, I would like to enter into evidence the following chart from the January 2009 edition of The Casey Report. As you can see, with their first experiment in quantitative easing, the Japanese were able to buy a bounce that helped the Nikkei crawl about halfway back toward its pre-crash high.

But what happens once the monetary props are removed?

As you can also see in the chart, when the quantitative easing ended - and it ended because, like the America of today, the piling of debt on top of debt was speeding the country toward bankruptcy - the stock market ran out of steam and plummeted to its crash lows:

excess reserves compared to Nikkei Casey Research Apr 2010

So, where do things stand here and now in these United States?

I don’t have the time and the resources - our Mr. Wood is taking a much-needed holiday, and I am running late anyway - to duplicate that chart for the U.S., but a back-of-the-envelope calculation shows that from its 2007 peak, the S&P fell about 875 points, to a low of about 675.

If, as was the case in Japan, “B” followed the “A” of quantitative easing, then we would expect the US market to rebound by about 437 points, which would take it back up to the area of 1,112 before hitting a plateau. That is the general level of where it is now trading.

And once the government pulled the plug on the quantitative easing - which it is making noise about doing - then we would expect the market to retest the low of 675.

Now, as you don’t need me to tell you, there is nothing scientific about that analysis (ergo the “back of the envelope” caveat). And there’s no question the situation in Japan then was different from that in the US today. For one thing, the Japanese have run a trade surplus throughout the period, whereas the US has run year after year of massive trade deficits. Even so, I think a certain amount of logic supports the basic premise.

If the premise is correct, then today’s stock market is running on vapors - the vapors emanating from the government’s burning of stimulus dollars. In time, for political reasons, if no others, the quantitative easing is going to have to moderate - at which point, watch out below.

I would like to leave you with a final bit of homework, a press release just out of the International Monetary Fund regarding a ten-fold increase in its lending facilities. Why, if the world economy were on the mend, would the IMF look to increase its lending capabilities ten-fold?

The answer, I strongly suspect, is because they see what we see - and what anyone paying attention is now seeing: that the worst of the sovereign debt problems are still ahead.

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