Irrational Exuberance: 2013 Edition

Includes: DIA, SPY, VXX
by: Wall Street Trading

By Joseph Morrison

The Dow Jones Industrial Average (NYSEARCA:DIA) has broken 14,000 for the first time since 2007. The S&P 500 (NYSEARCA:SPY) has been comfortably trading above or slightly below 1,500 since January 24. The VIX (NYSEARCA:VXX), which is a measure of fear in the market, has been trading at or near 2007 levels. All of this is occurring in the same week that the United States unemployment rate missed 7.7% expectations and instead ticked up to 7.9% and the United States GDP shrunk 0.1%. However, these numbers have been shrugged off and rationalized. The unemployment number, despite showing an increase in unemployment has been shrugged off due to an increase in construction employment as well as revisions to 2012 employment numbers. The GDP number has been dismissed due to decreased defense spending as well as the effects of Superstorm Sandy.

In order for this rally to continue in the face of these two reports, a lot of factors must be ignored in addition to the reports. The explanation for the poor GDP result should precipitate more fear not less. The automatic sequestration, more than $1 Trillion in spending cuts, is still scheduled for March 1 and the nation must rely on a broken Congress to solve that problem. If a cut in defense spending is to be blamed for a GDP contraction, how could anyone look at the March 1 deadline and still be bullish? In addition, the GDP number is now in the territory of prior recession indicators. As Art Cashin points out, "There has never been a time since measurement commenced in 1948 when the annual pace of real GDP has fallen that low without the economy ultimately slipping into recession. Sub-2.0 percent readings are historically the warning signal."

The global outlook is not much better. The eurozone crisis is not yet resolved, according to German Finance Minster Wolfgang Schaeuble. Exacerbating this problem is that unemployment remains at 11.7% in the eurozone. In addition, China is on the cusp of a financial crisis and what this could mean for U.S. debt is uncertain given that China is the second largest holder of U.S. debt.

With all of these facts and uncertainty, there is not a clear reason for the stock market being as high as it is. That is, until the Federal Reserve is examined for the market being irrationally inflated as a result of the Federal Reserve. The Permanent Open Market Operations [POMO] which the Federal Reserve has undertaken have been the main impetus for the market going up in parabolic fashion. Looking at the schedules for the POMO, which began August 17, 2010 in correlation to the S&P 500 over that same time frame, it is clear what is going on. The Federal Reserve has been driving down bond rates, which leaves nowhere for investors and institutions to put savings except for stocks. This is expected to continue as long as unemployment stays above 6.5%. However, Chairman Bernake is in his final year and he will not return as the Federal Reserve chairman. It is uncertain if a new Fed chairman will bring the Fed to a more neutral stance than the extreme position the Fed is in currently. Additionally, despite the Fed's purchase of $45B in Treasury securities in January, the rates have increased. The 10-year is now yielding 2.02% which is above the estimated inflation from the Federal Reserve.

My recommendation is to take this period of rapid rise in stock prices as a time to sell out of positions and look to get short by mid-2013. I do not have faith in the U.S. government to fix the sequestration issue by the March 1 deadline. If anything, I envision a situation where the government delays this issue further. I do not have faith in the U.S. government to take appropriate action on the mounting debt in time for a new debt ceiling showdown in May 2013. I believe that the global economy is in a tenuous position and while I do not believe that a "worst case scenario" will occur, I do believe that it will create more uncertainty for the markets which will precipitate sell-offs. I am not saying that these situations will end poorly, I am not a fortune teller, but I think they will create uncertainty and that will precipitate the market giving back gains.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Business relationship disclosure: The article has been written by Wall Street Trading, a group of junior market analysts. Wall Street Trading is not receiving compensation for it (other than from Seeking Alpha). Wall Street Trading has no business relationship with any company whose stock is mentioned in this article.