The Liquidity Rally Is Over

 | Apr 04, 2012 | 12:00 PM EDT
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This commentary originally appeared at 7:24 a.m. EDT on April 4 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

"When economies stumble, public policy (fiscal and monetary) comes to the fore and defends against an acceleration of economic and corporate profit weakness and often inhibits natural price discovery."

-- Doug Kass, "In Defense of Short Selling" (April 2, 2012)

Over the near term -- stock, bond and gold prices are now in jeopardy of falling after the FOMC minutes were released yesterday afternoon. Those minutes emphasized that unless the economy cools, there will be no more (immediate) cowbell in the form of QE3 or Twist III.

From my perch, the liquidity rally, which has been in place for several years now and is responsible for some of the rally off of the generational bottom, is now over.

The U.S. monetary cliff at June's end has grown ever more pronounced with yesterday's announcement -- and ever scarier for investors in many asset classes. (The ECB's full allotment policy also ends this summer.)

Absent more easing, investors are about to experience natural price discovery in stock prices. (While the Bernanke put is still out there, it now far more out-of-the-money than the markets believed prior to yesterday's release of the FOMC minutes.)

I fully recognize that the market rally has been based on more than liquidity; it has been based on a slow (but steady) emergence out of the 2008-2009 recession.

Where I have disagreed with bulls (recently) is that, though now several years of age, the U.S. recovery has been subpar in a "new normal" challenged by secular headwinds (of structural unemployment and fiscal imbalances). And what makes me even more concerned over the next few months, is that there are growing signs of ambiguity with regard to the trajectory of future domestic economic growth:

  • Warm weather has pulled forward retail sales.
  • The 100% tax credit (which was reduced to 50% on Dec. 31, 2011) has likely pulled forward business spending.
  • Though labor growth is healthier, weak (relative to expectations) industrial production, durables, personal income, high manufacturing, burgeoning automobile inventories and so on all point to moderating domestic growth.
  • Current political gridlock and likely continued gridlock following the November elections could result in undesirable, growth-deflating and higher interest rates, as bond vigilantes rebel against deficit inaction. Rising interest rates will continue to hurt the refinancing market (already refi applications are down seven weeks in a row), which serves as a source of consumer comfort (and spending) and could hamper the nascent recovery in housing.

Worse yet is that a potential growth slowdown could be occurring at a time when U.S. corporate profits are trending at all-time highs and in which profit margins are vulnerable at 57-year highs.

And over there in Europe, the so-called recovery is much more fragile and more vulnerable than in the U.S., serving to adversely impact those U.S. multinationals that serve that market.

Finally, yesterday's announcement has occurred following a persistent and record-breaking rally in world equity prices that has worn out just about every short-seller and has led to expanding long exposure out of the hedge fund community (but has not yet brought in the retail investor).

In summary, the forward looking outlook is not pretty for the U.S. stock market, as the liquidity rally is now over.

Get defensive as investors face the newfound reality of natural price discovery.


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