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The market added to its gains over the last seven months on Tuesday, with the indices up ~1% across the board. The market's rise has been impressive given the economy continues to be stuck around at the 2.1% average quarterly GDP growth we've averaged since it bottomed in early 2009 (the average growth out of the last nine recessions over a comparable time frame is 4.4%), Europe is in a continuous contraction (the longest in eurozone history), and domestic job growth remains sluggish. Even China is not having as robust growth as it has in the past. In addition, revenues were basically flat year over year in the first quarter for S&P companies reporting. Although housing is recovering and auto production is getting close to precrisis levels, the main driver of the rally both in the markets and in real estate is massive easing efforts of the Federal Reserve.

Federal Reserve policies to keep interest rates low and push liquidity into the market are having some interesting results. Junk Bond yields are approximately at where the rate of 10-year Treasuries were five years ago with yields at ~5%. The historical spread between high-yield bonds vs. AAA-rated assets has now become the yield.

In addition, the 25 most heavily shorted stocks in the S&P 1500 are up 6.75% for March as of Monday, roughly triple the overall market. Tesla (NASDAQ:TSLA) has become the poster child for speculative stocks gone wild crushing shorts. The day after earnings Tuesday, the shares had an amazing $16 spread between their intraday high and low after rising some 30% Monday due to better-than-expected earnings. Tesla now has a market value higher than Fiat or Peugeot, which produce millions of vehicles annually. Tesla is set to produce some ~21,000 cars this year. The stock sells at over 75x 2014's projected earnings and has an astronomical five-year projected PEG of (28).

In order to like Tesla's value here, an investor has to believe:

  • The company will achieve and maintain the highest margins in the auto industry, despite manufacturing in high-cost California.
  • It will face no manufacturing ramp-up glitches as it greatly expands production.
  • The major auto manufacturers will not target its niche in the near future and the company will be able to successfully expand its product line.
  • Finally, one has to believe that Tesla will succeed long term where Fisker Automotive, Delorean, Tucker, and scores of others have failed over the last six decades. Chrysler is the "newest" of the major domestic auto manufacturers, and it was founded in 1925.

Note: I am short Tesla with recently initiated deep-out-of-the-money bear call spreads. Shorting straight equities here with the liquidity provided by the Fed is madness and will get you taken out in a stretcher.

One of the ironic results of the Fed's actions and the accompanying rise in the real estate and stock markets is that the primary beneficiaries of these policies are the top 5% to 10% of the population that have the most stock and real estate exposure. The Fed has been much less successful in increasing total employment, which is part of its "dual mandate" and the ostensible reason behind their easing actions.

I am enjoying the rally while it lasts, and it is obviously satisfying to see one's account value grow significantly. However, I continue to purchase cheap insurance (out-of-the-money S&P puts) to protect my portfolio from a sharp pullback. I believe the market still has some room to run given the amount of liquidity coming into the market. A second quarter or summer "hiccup" is also not out of the question. However, I also think eventually all this leads to another inevitable major "bust" probably in 2014 or 2015.

Somewhere over the last 15 to 20 years the Fed has forgotten the adage that its job was to remove the punch bowl just as the party was getting started. As a result, investors are happily getting drunk right now but eventually the partying will lead to one massive hangover once again. Consider that in response to fears about Y2K, the Fed pumped considerable liquidity into the market. Luckily, Y2K turned out to be a non-event much like the recent sequester cuts. Unfortunately, the liquidity that was pumped into the economy/markets via the Fed was a primary contributor to the internet boom and bust of the late 1990s. Once the Nasdaq was cut in half and after 9/11, the Fed again primed the pump and we were off to the races as the housing market exploded for several years and then busted, presaging the huge financial crisis of 2008/2009.

Since then, the Federal Reserve has quadrupled its balance sheet through QE1, QE2, and now QE3. By the end of the year the Fed's balance sheet will approach $4 trillion. Somehow pundits, judging by most of the comments on CNBC, believe the Fed's actions will not lead to a massive bubble this time around. In addition, they postulate the Fed will be able to "unwind" its balance sheet without causing major disruptions to the market and the economy.

Color me skeptical, but I believe we are just inflating the next bubble that will eventually pop with a massive bang. I also have my doubts that an institution that has been responsible for several bubbles over the last two decades, which missed the buildup of the housing bubble completely and started the subprime crisis, was "contained." That it can be trusted to manage a $4 trillion balance sheet effectively is a bit farfetched. But that's in the future. I think I will have one more "shot" while the market is being treated to an open bar, and make sure I have a chair reserved when the music eventually stops.

Disclosure: I am short TSLA. 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.

Source: Getting Drunk On The Punch