Fast Forward To The Hangover

Includes: SPY
by: Weighing Machine

The headlines will read something like this:

"Investment Banks agree to record $3 billion settlement with SEC"'

"Retirees moving in with children surges in wake of stock market bust"

"Corporate profits remain depressed as excess capacity thwarts pricing"

With every boom comes a bust. Through monetary maneuvering, we avoided the last bust but alas it will prove to be only a short-term solution. 2013 has been quite a party thus far. Ben Bernanke's Federal Reserve has succeeded in manipulating equity markets upward in an effort to 1) lower the hurdle for capital spending decisions and get businesses to "invest" and 2) generate a "wealth effect" whereby the upward movement in prices of equity prices (401ks) and houses induces households to increase their spending, thus stimulating the economy.

In some ways, Bernanke has been successful - low interest rates have certainly stimulated investment, particularly in the technology and biotech sectors. We have witnessed upward of 30 biotech IPOs this year and many have soared to even greater heights in the secondary market -here is a quick recap. Similarly all things cloud and SAAS have soared. There have been smaller booms in fast food restaurants and trendy grocery stores. As in past technology booms we've been encouraged by brokers (which have investment banking brothers) to cast aside old metrics, like GAAP net income, in favor of more "relevant" comparisons. Beyond the IPOs, we are seeing additional capital flow into start-ups in these sectors - particularly in the software/cloud/SAAS space as VCs seek big IPO paydays. To be fair, this influx of capital is creating many skilled jobs in the U.S., which is stimulating consumer spending.

There has also been a wealth effect. Those owning homes and/or having a portfolio of stocks feel richer and have shown some willingness to spend. Coupled with bargain financing rates we have seen a rise in home sales, a fall off in home inventory and a surge in new car sales:

Again, this has stimulated the economy as factories and dealerships hire workers and real estate agents are back to earning large commissions. Wall Street too is benefiting from the party. Individuals with investable cash are pulling money from bond funds and splitting it between savings deposits and equity markets: see here. This is worrisome. As bond markets have swooned, investors have pulled cash. Similarly, as equity markets have risen, investors have added cash. This is the opposite of what we saw in 2008 - investments seem to be the one item that people hate to buy when they are on sale. Now that they are no longer on sale (and in some cases are getting very expensive - ala the Russell 2000 at 22x forward P/E, or the technology and biotech sectors), equities are becoming attractive to people. Mr. Jones next door has been profiting handsomely from the stock market, why not me. This behavior explains why over the past 20 years, on average, mutual fund investors have earned about one-half the market return - they buy stocks when the are expensive and sell them when they are cheap - precisely the opposite of 'buy low, sell high.'

This is very concerning in the context of today's market environment. I can't count the number of times in the past few months I've been asked by people (who previously seemed to want nothing to do with the stock market) if now is a good time to get in. Even more disturbing is that a number of these people are over 50 - if we are in a Fed-induced bubble, they won't have time to earn it back prior to retirement. Many of these uninformed investors are interested in buying Tesla or shares in a biotech company recommended by their neighbor. As when the housing bubble burst, we will look back and say how could this have happened?

Similar to the housing bubble we have people looking to make money in an environment where the Federal Reserve has robbed them of the opportunity to earn a reasonable rate on their savings at the bank and has essentially forced them into risky assets. Investment banks and brokers are taking advantage of this bringing forth a number of IPOs every month, few of which are actually earning money and all of which are selling at very high prices. While the research they publicly disseminate lauds each new issue as the second coming, I wonder what they really think of these companies. I imagine we will find out in fewer than two years.

Paradoxically, as capital is made overly abundant by Bernanke & Co, it reduces the overall rate of return earned by existing and new businesses as it brings to life excess competition. Similarly, low interest rates prevent over-levered, uncompetitive businesses from dying as their lenders decide the opportunity cost of not collecting on the loan is miniscule (no interest collected vs. 2-3%) causes them to forebear in hopes of a miraculous recovery in asset values (which seems possible as asset values everywhere are soaring). This hasn't worked out well historically - see Japan's economic performance over the past 24 years. So, in addition to inducing people to make poor investments, the Fed is actually also reducing the ability of companies to earn profits by bringing in excess competition.

Like a drunk teenager driving a Ferrari, this might be fun for awhile but it will inevitably end badly. Bernanke isn't an idiot - he's a smart man who has continually made terrible long-term decisions. While Wall Street (and some on Main Street) are enjoying the party, the hangover is going to be worse than expected and last longer than expected. Invest with caution my friends.

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.