Andie Xie on the market rally and the Fed

Andy Xie, former Morgan Stanley economist and current board member of Rosetta Stone Advisors shares some thoughts on the stock market rally and the Fed (hat tip DK).

Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves.

When the least informed and most credulous get into the market, the market is usually peaking. A rising economy and growing income produces more funds to fuel the market. But the global economy is now stuck with years of slow growth. Strong economic growth won't follow the current stock market surge. This is a bear market rally. People who jump in now will lose big.

Andy joins the long and still growing list of analysts who think that equities have gotten a bit ahead of themselves, opting for the much kinder description of "least informed" when referring to what others call the "dumb money".

On the Federal Reserve, the outlook is bleak.

The dollar index-DXY has fallen 10 percent from the March level, even though the U.S. trade deficit has declined substantially. It reflects the market's expectations that the Fed's monetary policy will lead to inflation and a dollar crash. The cause of dollar weakness is the outflow of U.S. money, in my view. It is the primary cause of a surge in emerging markets and commodities. Most U.S. analysts think the dollar's weakness is due to foreigners buying less of it. This is probably incorrect.

The dollar's weakness can limit Fed policy options. It heightens inflation risks; a weak dollar imports inflation and, more importantly, increases inflation expectations, which can be self-fulfilling in today's environment. The Fed has released and committed US$ 12 trillion (83 percent of GDP) for bailing out the financial system. This massive overhang in money supply could cause hyperinflation if not withdrawn in time. So far, the market is still giving the Fed the benefit of the doubt, believing it will indeed withdraw the money. Dollar weakness reflects the market's wavering confidence in the Fed. If the wavering continues, it could lead to a dollar collapse and make inflation self-fulfilling.

The Fed may have to change its stance, even using token gestures, to assure the market it won't release too much money. For example, signaling rate hikes would soothe the market. But the economy is still in terrible shape; unemployment may surpass 10 percent this year. Any suggestion of hiking interest rates would dampen growth expectations. The Fed is caught between a rock and a hard place.

He has some unkind words for Alan Greenspan as well - something about too many asset bubbles over the last couple decades and having created a large financial sector where, now, people just "need something to do".

Andy also thinks the U.S. has no way out but to print money and that it doesn't look good for the long-term "buy-and-hold" equities crowd.

Oh yeah, and there's another big crash coming.

Best read with a stiff drink...