While the Fed’s plan has sparked the reflation trade and buoyed risk assets, it’s too soon to declare victory over deflation.
As we roll into 2011, Bernanke’s all-in bet on Treasury purchases seems to playing out according to plan. Apart from the most recent back up in yields, risk assets in general have rallied nicely since he initially indicated that the Fed was willing to turn up the juice on asset purchases late last summer.
But I’m not sure it will be enough to beat the laws of diminishing returns some fear the Fed is facing with its monetary policy. I wrote about that very possibility last summer in a column titled “Is The Fed’s Muscle Weakening?”
Still, if there’s one thing investors and traders alike learn, it’s that trends and themes can last longer than you think. Investors like George Soros have made a killing based on this concept. I’ve been surprised by the most recent equity rally—both the extent of it and the fact that there have been virtually no pullbacks throughout.
That said, ever since David Tepper’s CNBC appearance in September, the “animal spirits” he talked about have been “awakened” enough to lift the SPDR S&P 500 ETF (NYSEArca: SPY) 12 percent and the SPDR Gold Trust (NYSEArca: GLD) 10 percent. More impressively, the CRB Commodity Index has jumped 16 percent, and the iShares Silver Trust (NYSEArca: SLV) has led with return of roughly 40 percent in that period.
But this revival of risk appetite is largely derived by the fact that roughly $75 billion in liquidity hits the market every month via Fed Treasury and mortgage-backed security purchases. Paul Tudor Jones took note of this liquidity injection in his annual letter to investors last year, referencing a similar phenomenon in the late '90s when banks were worried about the Y2K switch. Then, as now, central banks pumped money into the system.
Ultimately this liquidity has lifted optimism to unsustainable heights relative to what I see as substantial risks that still remain in the global economy.
For retail investors, the AAII sentiment survey has hit its highest reading since November 2004. Furthermore, it’s been elevated at bullish levels for four straight months. On the institutional side, the State Street Investor Confidence Index Rose from 96.4 to 104.4 in December—also matching levels seen in November 2004 and those in January 2010, just before Greece’s sovereign debt problem started to spoil 2009’s rally.
This off-to-the races mentality that seems to be back in the market brings up another reality that’s typically learned the hard way: Markets get ahead of themselves and can make investors forget or discount risks that remain in the markets. Right now, I think overly bullish stock investors could be hurt by both Europe’s debt problems, which are still very much alive, as well as ongoing risks of deflation, such as in housing.