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The Fed always has a big effect on the stock market. Twenty-five years ago Marty Zweig was a regular on Wall Street Week, (see him on YouTube here) which was the most popular television program on the stock market for a generation. Zweig's tome on the market was called Winning on Wall Street. In a chapter entitled "Don't Fight the Fed," he detailed his Federal Reserve strategy. For example, if the Fed dropped the discount interest rate that was +1, dropping reserve requirements was a +1. A rating of +2 was extremely bullish.

But his program would not work particularly well in the current scenario where interest rates have been so low for so long. I'm sure he would be adding by now a new section about Fed bond buying because his old tools of the discount rate and reserve requirements were no longer quite as relevant. I'm sure Zweig would have us in full bull mode, and indeed we are in a bull market, as the Fed has stepped up to take an even bigger role in the economy, perhaps its biggest ever, building a huge balance sheet with unknown consequences in the process. Hence, my title. This is Ben Bernanke's market, he owns it. So far, he has decreed stocks will go up.

He does not do this straightforwardly, he does it through bond buying, what has been called Quantitative Easing. There have been two such programs completed so far, QE1 and QE2. We are now into QE3 with the Fed buying $85 billion in bonds a month.

So, how does this affect stock market prices? Bond holders end up with a big wad of cash when he buys their bonds, and because Bernanke has also decreed that interest rates will be tiny, investors find they can earn nothing on their money, so some of that cash has gone into the stock market in search of a better return.

It's hard times for anyone requiring a return on their investment, which includes nearly every retiree. They're in the soup. Money is chasing the best returns it can get, which has been a boon for AT&T (NYSE:T) shareholders and a few others. But the impact of these persistent low returns is not really well-known. We are in new territory. Unhappy territory for pensioners, Bill Gross of Pimco recently speculated in his Investment Outlook about these persistent low returns. He thinks we can expect less risk-taking, which might mean less innovation, and I think less innovation means a stagnant recovery. And with persistent, low interest rates and low returns on investment, he says you can expect "corporations to resort to financial engineering as opposed to R&D and productive investment." After just experiencing a financial debacle with the rest of the nation, I can only say - oh, brother.

The Fed is taking all these steps but inflation is still low

The thing that lends credence to Bernanke's actions and his pioneering into new territory is that the usual way these scenarios play out when the Fed buys bonds and puts money into investors' hands is that inflation increases.

Not happening this time.

Why is CPI not going up? Well, there is still a lot of unemployment (read excess labor capacity), which is keeping wages down. Notice that there was no decline in unemployment in the recent report even though the number of jobs increased. Why? Because workers came out of the wood work, and left the long term discouraged group. And all the unemployment has also kept wages down; and as consequence, demand has also been tame, and that means prices are still in line, except for...

P/E ratio

Except for the stock market, which is where we are seeing price inflation. To get a standard sense of what stocks are worth, we use the P/E Ratio, the stock price divided by the earnings. Using Robert Shiller's data, we find that over the broad expanse of time that the average P/E ratio is 16.49. We are currently at 23.20, which puts us well above average. Not anything like the 44.20 of the stock market peak of December, 1999, or the 32.56 of September, 1929. But by way of comparison, in 1966 the P/E only got up to 24.06, but from which it did not recover for nearly thirty years. It climbed above 24.06 in 1995.

So, it's high enough to make me a bit nervous, and I'm thinking Bernanke is not that crazy about it either, he shouldn't be, but here's what he's hoping for: that as consumers see their brokerage statements increase, they will feel richer, and they will spend more. That's the thinking. The Wealth Effect.

Ben Bernanke is a student of the Great Depression, and so he and Hank Paulson made all the right moves to prevent a run on the banking system. And for this he has our admiration and thanks. He began the quantitative easings by buying mortgages to ameliorate the real estate situation. But what began as a good idea has certainly ended up in a stock market bubble as money Bernanke has turned over for the mortgages has looked for a decent return.

Why the new stock market highs are hard to believe

Typically at stock market highs, unemployment is much lower. In 2000, we had 7% unemployment (using U6) as opposed to 13.4%. Unemployment in 1966 when the P/E got to such a high level that it did not get back there until 1995 was only 3.9%, and that was before 1994 when long-term discouraged workers were defined out of the stats.

I believe it requires nearly a psychotic break to believe you can have new stock market highs with 13% unemployment. Either we are in a new era, or I take this to mean that an important confirmation point has failed to meet its test.

New Territory or New Warning?

Year--------------------1929196620002013
Unemployment Rate-----3.1%3.9%7%13.4%
P/E Ratio----------------32.5624.0643.7723.2
Years until PE reached again6829Not YetNot Yet
National Debt/GDP-------14.9%33.7%34.5%70%

Notes:

(1) P/E Ratio from Robert Schiller's Yale data

(2) Unemployment Rate - Bureau of Labor

(3) National Debt/GDP link/U.S. Congressional Budget Office

A QE too far?

The first two Quantitative Easings did not have this strong, deliberate effect on stock prices. But by now, the effect of QE3 is clear. Bernanke seems willing to make the swap of high stock prices for continued stable economic conditions.

With QE3 Bernanke is purchasing $85 billion in bonds a month, and after its policy meeting ended recently, Bernanke made it plain that easing is still at the forefront of his mind, though talk of paring the program gave the market the chills.

The high National Debt-to-GDP ratio I take to mean that the Fed's storehouse of options is running into a dead end. Other tools must be used to supplement the Fed's actions.

What could be done? These are big questions. The conservatives would have you believe that if you just lowered tax rates and did away with health care, that the great machine of liberty would drive us all to a much improved economy. And supposedly that is what Reagan did.

Bernanke would like Congress to help

But together with lower tax rates, Reagan also spent huge, nearly Keynesian, sums on the national defense. I have already written on the issue of unemployment. With a new class of workers in Silicon Valley whose sole purpose is efficiency (read "job destruction"), unemployment may well turn out to be very stubborn indeed, and this does not take into consideration the new citizens (read relatives) that the new citizens may bring into the country with immigration reform.

Infrastructure improvements could create many jobs. In Chicago, where I live, they could finally build the crosstown from the Edens down Cicero Avenue next to Midway airport, and then on to I-80. And beyond creating new jobs, many displaced homeowners would be looking for another house. This is the kind of thing that many cities would benefit from.

It was clear to FDR that even though he had tried to move heaven and earth to get the economy going during the 1930s, it was only the massive stimulus spending of World War II that really changed things, and this idea was also road-tested by Eisenhower with the interstate highway system, and as mentioned above by Reagan with military (but warless) spending.

Unfortunately, a lot of money has been spent without effect. Let's see: shall we give folks money (unemployment insurance), or shall we employ people to build this road or bridge as they did with the WPA in the thirties? Or improve the electrical grid? Or figure out how to save some of that fresh water we pejoratively call "floods." Farmers might have use of it. My point is that you gain something from unemployment benefits, but perhaps not really that much, whatever Krugman says. That public money really needs to be targeted, focused, and not blandly given away. That represents a lost opportunity.

It is isn't just monetary or fiscal policy, it's innovation

Government people like you to think it's all government - fiscal policy and monetary policy, but three important drivers of the boom from 1980-2000 were innovation-driven: (1) the personal computer, (2) cell phones, and (3) the build out of the internet.

A great driver of the 1920's boom were automobiles, and radios, and toasters, and other modern marvels. By 1929, saturation had been achieved with many of these new miracle inventions. And we achieved saturation with our new technologies in 2000, when the real crash occurred (2007-08 is an after-shock).

So it has been twelve years at least since we reached that saturation point. We need more innovation. Some will come from the biotech field, but landing a man on Mars (versus another war) would be great for innovation. It might create all manner of new patents and inventions. But for now we come down to earth.

Investment Advice

Ultimately, bonds are a horrible buy at this time. As yields go up, which they certainly will when the economy begins to improve, bond prices will go down, possibly quite a lot. If you must buy bonds, steer clear of bond funds, and do the ladder thing with individual bonds, buying several with maturity dates for successive years, so that you can take advantage of higher rates as they come along.

Stocks for the next year or two may do quite well under the Bernanke-directed scenario described above, which is in place for the foreseeable future. But investors should be wary. Jeremy Grantham called a stock market peak three weeks before the peak actually occurred, but even though he was early, he was most certainly correct about the formation of an insupportable peak, a bubble, and its subsequent decline.

But beware of stock inflation

You can see stock inflation, for example, in the price of Microsoft (NASDAQ:MSFT). Nothing really dramatically good has happened at Microsoft. Windows 8 is under the gun, and has already gone through revision. The growth of tablets is eating into laptop sales. Moreover, Microsoft is failing in its main business, operating systems. It should have secured a dominant share in smartphones and tablets. It has taken only a very tiny piece of the market. Its search engine is a distant second, and it is not clear how profitable it will be to move its Office applications to the cloud. Moreover, it took over eBay's distraction into the telephone business, Skype. eBay found its customers did not need to connect over sales, and wrote it down before finding a greater fool.

And Microsoft may well find that adding telephones to Windows is not the same as adding networking (goodbye Novell), a spreadsheet program (goodbye Lotus 1-2-3), or a browser (goodbye Netscape). Telephones are a different kettle of fish. I see write-off in its future. And it probably needs to clear the decks as soon as possible, and knuckle down in its main business, operating systems, unless, of course, it can't do that anymore. Ford (NYSE:F) dramatically sold off all its foreign acquisitions, borrowed to the hilt, and bet the company on its own domestic products. Take note, Microsoft.

But here's the takeaway for investors, the stock is at a five year high, but nothing has really improved for the business. That's inflation. My advice to Ballmer is to sell some more of your shares like your pal, Bill, who has diversified greatly over the years. Same goes for all other Microsoft investors.

Look at the corporate treasury cash

Probably the best stock advice is to find real, non-inflationary stock gains and to pay attention to the huge treasuries of corporations. GE (NYSE:GE) has said that it wants to get into the fracking business, and has also said it will buy its way in. Oracle (NYSE:ORCL) recently bought Acme Packet, which makes it appear as though it may wish to get into the telephone software and equipment business. Cisco (NASDAQ:CSCO) is in that same internet/telephone business, has a huge treasury, and has made a career of acquisitions, so I'd be looking there, too. For my followers, I expect to have some ideas here.

Apple (NASDAQ:AAPL) tends not to make so many acquisitions, so that may be a dead end, and IBM (NYSE:IBM) just made an acquisition of a kind that does not help those of us in the stock market, a privately-owned company, SoftLayer for $2 billion.

In the short run, summer dole drums are coming up. Bernanke needs to keep this bubble under control. Maybe we'll hear more about paring down the bond buying. What is it they say? Sell in May and go away? If it's June, it's time to prune? To bring the stock market into line with the long time P/E average of 16.49 would call for a decline of 29%. Bernanke's bond buying is likely to prevent such a violent decline, but even healthy markets in the course of an extended bubble can see declines of 10%. This would be a healthy thing, and like a weatherman, I'd say there is a 60% chance of it this summer. There are plenty of funds you can use to short the market.

Rydex Inverse funds: Inverse S&P 500 (RYURX), Inverse Russell 2000 (RYIUX), Inverse Nasdaq 100 (RYACX). There are ETFs that can also be used: Short Dow 30 (NYSEARCA:DOG), Short S&P 500 (NYSEARCA:SH).

Source: Ben Bernanke Owns This Bubble, Baby