For the last several weeks, the expression “retarded potential” has been rattling around in my head, without having any idea what it means. So I Googled it, and it turns out that it has something or other to do with the physics of electromagnetism. Lots of equations and Greek letters are involved. You don’t want to know.
But the reason why that phrase has been stuck in my mind, I think, is that “retarded potential” precisely describes the state the stock market is in. As far as I’m concerned, the progress of economic recovery has been spectacular, and the S&P 500 ought to reflect it, by trading 10% higher than it is by now. The fact that the market is mired in a stubborn trading range — with new highs made only tentatively, and punctuated by violent drops — reflects “retarded potential.” We deserve better.
Here’s an updated version of a chart that we’ve seen several times in this column over the last year. It makes today’s retarded potential all too evident.
The black line is a daily chart of the S&P 500, starting with the bottom of Oct. 10, 2002 and continuing through yesterday. The red line also is the S&P 500, starting at the top of March 24, 2000 — but this line is plotted upside down.
S&P 500 From the October 2002 bottom, and from the March 2000 top (upside down)
The black line and the red line match almost perfectly. The precision is eerie — and it has given me comfort over the last year that we’re making the perfect market bottom to complement the market top that launched the second-worst bear market in history.
And why shouldn’t this be the perfect bottom? We’ve been doing everything absolutely right. Alan Greenspan finally made the Fed’s monetary policy accommodative enough to guarantee an end to deflation. And the president’s dramatic tax cuts have lifted the economy and the markets, and ushered in a wave of restructuring and new investment.
But look at the last couple of months on the chart. After 10 months of perfect synchronicity, it seems that the bottom (the black line) has gotten out of synch with the top upside-down (the red line). We’ve lost the pace. If we were still tracking the pattern of the top, we’d be about 10% higher than we are.
What has gone awry? It’s very simple. We spent 10 months doing everything right — and now we’re doing a lot of things wrong.
The exact timing of the disconnection of the red line and the black line reveals the culprit. The disconnection corresponds perfectly to the time in early January 2001 when Alan Greenspan started the Fed’s easing cycle with a surprise 50 basis-point rate cut. The comparable date in the present is July 24 — a day on which the Fed didn’t raise rates. But it should have. And that’s what’s gone wrong.
The Fed is obsessed with deflation — a problem that has already been thoroughly solved. To fight nonexistent deflation, the Fed says it will keep rates at today’s low levels for a “considerable period.” But that’s a mistake, because the market is starting to flash warning signs of just the opposite of deflation — inflation. Look at the surging price of gold, energy products and commodities. Look at the fall of the US dollar on foreign exchange markets. Look at the expansion of the spread between Treasury bond yields and the yields of inflation-protected Treasury securities. Look at the steepness of the yield curve. They are all screaming “inflation risk!!”
At first, when the red line and the black line got disconnected, it was all to the good. The market liked the idea that the Fed wasn’t rushing into a new regime of rate hikes. But then something else happened, and the market has gotten very nervous about it.
What happened is Treasury Secretary John Snow’s effort to get the Chinese and the Japanese to strengthen their currencies, which is tantamount to calling for a weaker dollar (all the while proclaiming that he advocates a “strong dollar policy”). The market doesn’t like the uncertainties created by Snow’s tinkering in the infrastructure of global trade, just when the world economy is starting to recover. And it’s worried that a campaign to weaken the dollar will lower global demand to hold dollars, which will worsen the risk of inflation unless the Fed tightens right away (which it won’t do, apparently).
If we get a bout of inflation, there’s going to be a catastrophe in Treasury bonds. The Fed will have to scramble to raise rates to squelch the inflation its negligence will have triggered, and at the same time an inflation discount will whack bonds prices. That will force mortgage-backed securities traders — whose market, in the aggregate, is worth more than all the Treasury bonds in existence — to dump Treasurys to keep their hedges in place, and that will drive Treasurys even lower.
And don’t believe that inflation is good for stocks. It’s not. Inflation slows real economic growth, erodes the quality of earnings and squelches the willingness of investors to take risk. That’s a recipe for contracting multiples — which would be devastating to today’s pricy growth and tech stocks that are still betting on recovery.
It’s not too late. An inflationary outbreak is still just a risk, not yet a reality. We can still head off a new round of inflation if two simple things happen. First, John Snow has to shut up (about the dollar). And second, Alan Greenspan has to start talking (about raising rates).
If those things happen, there’s still a chance to get the red line and the black line back together. But if they don’t, for a while we’ll be in a world of retarded potential. And then, soon enough, we’ll find ourselves in a world of hurt.
Originally published on SmartMoney.com