Friday, December 21, 2012

That's not why the market tanked

Everywhere I look, the conventional wisdom is that the market tanked today because of the government's inability to act to avoid the fiscal cliff.  The problem with this explanation is that by now most people should realize that the government isn't going to act until they've milked this latest "crisis" for all the political gain they can get from it, and so the lack of action should have come as no surprise to anyone.  I think the real reason for the drop is much more subtle and complex than that.  In a nutshell, though, today's market action had more to do with the upward revision of GDP as well as the unemployment figures.

Why?  A while back, the Fed announced it would be buying $40 billion a month in MBSs.  More recently, the Fed announced they would buy another $45 billion a month in long bonds.  This is effectively driving all the low risk investment returns down to such low levels that the only rational thing for anybody with some money to invest can do is to invest in riskier assets, like stocks.

The Fed has said that it will keep easing until unemployment gets down to 6.5 percent, and unemployment has remained stubbornly high, so it may seem a bit premature to be worried about the end of quantitative easing.  But I suspect that the smart money is already pulling some out, to avoid the last minute rush when it becomes apparent that we have reached the end of easing.  Unemployment has been edging down, and if GDP growth is even a little better than expected, the drop in unemployment could happen relatively quickly.

The take-away from all of this is that I would expect to see more of the same irrational investor behavior as we say before the Fed started the recent rounds of easing, i.e. rallying on bad economic news and and falling on good news.

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