Flood of Government Supplied Liquidity Props Up Stock Market

The Dow Jones Industrial Averages popped through the psychologically important 11,000 level this morning and is trading at 11,020 as I write. Almost as if an alien force field of some sort has been pulling it along the S&P 500 has not closed down for more than two consecutive days in 10 weeks. The S&P 500 index is now nearly at the 1200 level.

In my opinion, the discrepancy between the recovery on Wall Street and in the stock market from the March 2009 lows to present levels and the struggling recovery, if you can even call it that, for Main Street has never been more pronounced. Clearly, even as stock market analysts and the usual crop of talking heads and market cheerleaders talk up a new bull market in the making something out of the ordinary is occurring. No doubt, some of the extraordinary amount of government supplied liquidity, well into the trillions of dollars, has found its way into the stock market and is propping up stock market evaluations around the world.

The fundamentals for the economy are still rather grim. With unemployment hanging tough at near the official 10% level, with another round of real estate foreclosures coming on stream as 2010 progresses, with the commercial real estate market sinking fast with little hope of recovery as capital, especially refinancing capital, remains scarce, and with the sovereign debt issue growing, 2010 and 2011 will likely prove to be very tough years for many world economies. In a world where financial problems associated with excessive debt and excessive leverage are being addressed by the issuance of even more debt and by the use of even more financial leverage it is difficult to see how long-term results will be anything but disastrous.

To be clear, I’m not suggesting that the US government has set up its own secret trading room and is directly manipulating the market by trading in stocks and indexes. I am suggesting that the government has made an extraordinary amount of very low cost capital available to Goldman Sachs, J.P. Morgan, and other government supported firms enjoying cozy relationships with the government, and that a significant amount of the low-cost capital being extended to those firms is being recycled back into stock markets. However, a day of reckoning is probably not too far away.

In the United States the Federal Reserve Bank’s balance sheet has deteriorated markedly as in an effort to stabilize banks and the financial markets the Fed has exchanged trillions of dollars in newly created cash for toxic assets of questionable, if any, value. The United States Treasury is increasing the nation’s debt burden at an unprecedented rate as it continues to auction off treasury notes and treasury bills. How long can the US government and other governments, such as the UK, get away with this confidence game and continue to find investors who are willing to continue to invest in securities of nations with increasing sovereign debt loads?

My guess, is not for much longer. Long term interest rates are beginning to increase which will only add to the problems of servicing and refinancing trillions of dollars of debt backed only by the promise of the debtor nations to repay. China and Japan, two nations currently participating in the United States debt issuance auctions that supply most of the capital, are already beginning to scale back their purchases as they worry about the soundness of US financial matters.

Sometime, probably in the not too distant future, long-term interest rates will begin to increase at alarming rates as it becomes more difficult to attract investment capital into US government securities. As it becomes more difficult for the US government to borrow money you can expect that the flood of government liquidity that has been propping up the stock market will suddenly end. When that happens, a stock market that is already extremely technically overbought will prove that indeed it is still a bear market, and that the rally from the March 2009 lows was only a bear market rally.

In my opinion, the worldwide deleveraging process still has a very long way to go before it reaches an equilibrium point. Current financial conditions around the world are unprecedented and will result in a transition to a new world, not a return to the old. It seems to me that Robert Prechter is correct in forecasting a long term period of deflation. The fact that it has not yet extended to the prices of stocks doesn’t mean at all that a long-term period of stock price deflation will not suddenly and violently appear. It is not a good time to be going long stocks.