How The Buy-The-Dips Brigade Prospers From The Fed's Destructive Gift To The Fast Money

There you have it. The S&P 500 graph below does not represent the free market's price discovery mechanism at work. No, its the fast money "buying the dips" with ever greater confidence that the Fed has backstops under the market.

This means, however, that an important mechanism called two-way markets has gotten deeply impaired.  In essence, current Fed policy pushes the markets into one-way trade by punishing the natural short interest that develops in any honest market. When a short offer to sell is driven out of the market and accordingly the short side unnaturally weakens then downside insurance protection----that is, a put on the market----is also unnaturally cheap. In essence, sellers of puts are happy to collect mere nickels as the stock market move up the Fed-supported channel because the risk of exercise on these options is abnormally low.

And that gets to the heart of the real evil of the Fed's stock market levitation policy. The next step in the chain of market impairment has been the rise of the "momo" trade. Here the fast money aggressively chases favored classes of story stocks---takeover plays, earnings plays, hot sectors like biotech recently---in a powerful uptrend. At the same time, it has learned that buying cheap "protection" is the best way to stay in business and to protect momo winnings from periodic broad market sell-offs.

Stated differently, the momo/put protection strategy---which you can hear explained ad infinitum for an hour daily at 5 PM on CNBC---- would not work in an honest market.  The downside insurance would be far more expensive and would eat deeply into winnings from the sequence of hit-and-run momo trades pursued by fast money speculators, thereby making overall portfolio risk higher and returns sharply lower.  The latter, obviously, would mean a diminution of capital trading from the long side of the market, and thereby less unnatural strength and bias to playing the upside channel.

The fly in the ointment, however, is also very evident in the graph below. As the bull market is levitated up the channel by the Fed's  gifts to the "buy-the-dip" crowd---even this artificial dynamic eventually gets long in the tooth, causing the channel to narrow every more tightly. In essence, the fast money is playing the Fed by the white of its eyes, attempting to extract the last upside juice in the market while choking up more tightly on the bat of risk: singles are in; home-runs are out; the last gasp sector rotations come into play.

As this coil tightens and bubble type valuations of the broad market get increasingly stretched, confidence in the willingness and ability of the Fed to support the market steadily wanes. In this final phase, the buy-the-dip traders are searching for the last longs---the remaining believers, especially the retail investor coming in for the shearing. But at this point the market is also  increasingly vulnerable to a so-called "black swan" event like the Lehman failure in September 2008. Then the sell-off is triggered; when the Fed channel is decisively broken, the fast money bid disappears entirely from the market.

Under those conditions there is no dip rebound---only a rapid, violent correction of the one-way market to the downside. Moreover, this artificial boom and bust cycle is exceedingly  asymmetrical. The bubble inflation takes years as it slowly moves up the Fed channel. By contrast, the bust cycle reverses downward in a matter of weeks and days because there is no bid from the fast money and hedge funds which dominate daily trading; the HFT robo-traders only exacerbate the speed of decline.

Thus, during the second Greenspan bubble, the Russell 2000 moved from 300 at the bottom in 2002 to 850 at the top in the fall of 2007----meaning that it took five years of buying the dip to produce a very hefty 20% annualized return without leverage, and far higher returns with portfolio leverage and various options strategies which are inherently levered.  By contrast almost 100% of the gain was given up in about 15 violent trading days between the September melt-down and the market bottom in March 2009 when the Russell 2000 index got back to 350.

This time, the Russell 2000 have been levitated all the way to 1220 where it was trading at 100X reported earnings before it began its recent rollover---meaning that the next violent correction phase could be a doozy.  Needless to say, that's why the Fed's serial bubble and bust policy is so destructive and corrosive. Violent corrections of one-way financial markets to the down-side generate unnatural shocks to business and consumer confidence on Main Street---resulting in a disruption of production and investment and a sharp liquidation of what are now perceived to be excessive inventories of production goods and variable labor.

In short, the "wealth effects" mechanism works in reverse on the downside and thereby thwarts the Fed's entire rationalization for its policy of easy money bubble finance. Ironically, the Keynesian monetary central planners who operate the Fed bubble machine claim that their incessant manipulation of the financial markets is all designed to stabilize and modulate the macro-economic cycle. Obviously, as was made evident by the Great Recession, it does just the opposite. In the long run, constant unnatural macro-economic instability induced by the central bank means less economic growth, lower living standards and slower accumulation of societal wealth. The so-called public welfare effects of Keynesian monetary policy are therefore negative.

One thing is certain. The buy-the-dips channel shown below would not occur in an honest free market where interest rates and the yield curve were set by the interaction of supply and demand for funds and savings; and where the central bank had no dog in the stock market hunt---that is, there was no targeting of the Russell 2000 as Bernanke admitted to, or "put" under the broad market as the Greenspan/Bernanke/Yellen put has established.

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