The now famous quantitative easing ("QE") being employed by the United States Federal Reserve is credited with causing historically low interest rates reflected in higher bond prices and higher stock prices as money shifts out of bonds and into stocks. Janet Yellen, about to be installed to replace Ben Bernanke as the Fed chair, has all but promised to keep the QE program in place at current levels at least until there is evidence the economy is performing closer to its capacity and the so-called "output gap" shrinks.
There is no doubt QE has had a major effect. Both bond and stock prices are at record levels, borrowing costs are low by any measure, and real estate prices are showing signs of a steady recovery after the meltdown of only a few years ago.
The yield on 10-year treasuries has fallen dramatically since the peak in the 15% range in the 1980's to a current level in the 2.5 to 3.0% range.
Real Gross Domestic Product ("GDP") is growing again albeit a rate less than the Fed would like, and the United States government deficit is falling as a percentage of GDP to the 7% range from about 10% in 2010.
It sounds like Fed policy is working as it should, but there are some warning signs investors should consider. Public debt continues to rise with total public debt approaching $17 trillion more or less equal to GDP.
The Fed's bond buying program has increased money supply very sharply.
Public debt held by Federal Reserve banks is approaching $2 trillion.
The Fed's actions have increased the money supply to almost double the level at the beginning of the crisis of 2008-2009.
The velocity of money has dropped to historically low levels.
I have covered a lot of data and a lot of terms, many of them foreign to average investors. The charts in and of themselves don't seem so alarming. So what is the problem?
The velocity of money is a term of art. It is nothing more than GDP divided by the money supply. It is a proxy for how fast money turns over in the economy. You get your pay check and buy groceries, the grocer pays rent on the store, the landlord pays interest to the bank, the bank lends money to a borrower wanting to buy a new car.
Expanding the money supply should stimulate economic activity if behaviors do not change. More money supply times the same velocity equals higher GDP. This is grade school arithmetic.
Fear tends to contract the velocity of money. Afraid of losing a job or concerned about the rising costs of university for a teenaged son or daughter, a person might slow down on current consumption and save a bit more. Seeing a risk that their pension income might be insufficient as they approach retirement, they might put more into their Roth or IRA.
The paradox of thrift is a term made popular by John Maynard Keynes that expresses the outcome of a greater savings rate on economic activity. If most people save more and spend less, economic activity declines.
The 2008-2009 crises definitely made people afraid. The decline in the economy at that time had many roots and approached panic levels after the Lehman collapse. Slow growth ever since despite massive stimulus can be attributed in part to a rise in the savings rate from about 2.5% in 2008-2009 to almost 4.9% today.
But confidence is coming back. Stock markets are roaring ahead. House prices are rising again. More people are finding jobs. Companies are reporting higher earnings and their balance sheets have never been stronger.
With rising confidence, the velocity of money will tend to rise. When it does, nominal GDP will rise in parallel. The challenge facing the Fed is to manage the money supply so that the rise in nominal GDP is not much greater than the rise in real GDP. The difference between the two is that hackneyed term "inflation".
The management tool available to the Fed to bring that about is the opposite of QE. Often termed "tightening", it amounts to the Fed selling bonds to both shrink the money supply and simultaneously drive up interest rates. The pace of that activity will depend on the degree to which it is necessary to maintain stability. The risk is runaway inflation like the early 1980's with very aggressive tightening to keep things from a catastrophic result.
The Fed's balance sheet now approaches $4 trillion. Janet Yellen is expected to keep increasing it by at least $85 billion a month for the foreseeable future. And markets like this?
Any rise in rates will cause a decline the carrying value of the Fed's holdings which include $2.1 trillion in treasuries and $1.4 trillion in mortgage backed securities. It will not take much of a rise in rates to cause its assets to collapse in value faster than Lehman's. Supported by only $54 billion of capital, the Fed's almost 80 to 1 leverage ratio makes Lehman's balance sheet seem conservatively financed. Any losses incurred by the Fed will no doubt add to the government's deficit.
The longer QE goes on, the more difficult it will be to find the right balance. I listened to Janet Yellen's testimony at her confirmation hearing. It did not inspire confidence. Her comments were consistent with an academic review through the "rear view" mirror rather than a look ahead in an economy where giddy investors are already paying billions and billions for unprofitable companies whose future profitability is by no means assured; where multiple offers are being made on real properties in some housing markets; and, where analyst upon analyst is calling for the Dow Jones and Standard & Poor indices to carry on to ever higher levels at expanded earnings multiples calling the current market "inexpensive".
I have seen this movie before. I know how it ends.
As a result, I have a sizeable cash position and a large short position on the one hand, and the bulk of my long positions are in resource stocks in energy and mining. For the first time ever, I also hold a small portion of my portfolio in gold stocks.
My thoughts as to how investors should react are simple. Don't drink the Kool Aid. Use common sense. And, if your plan is to make a short term gain by buying momentum stocks today and finding a greater fool to sell them to tomorrow, the greater fool may be you.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.