An Unjustified Rally Justifies Some Insurance

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 |  Includes: DIA, QQQ, SPY
by: Vahan Janjigian, CFA

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Just five years ago, the entire U.S. financial system was on the brink of collapse. Thankfully, the crisis is over, yet the economy hasn't shown much improvement. The federal debt has ballooned and it now exceeds GDP. While real GDP growth is positive, it remains extremely weak. Housing has come off its lows, but there are still plenty of folks sitting on underwater mortgages and the most recent data on housing sales was disappointing. The unemployment rate has come down, but the improvement is illusory since so many people have dropped out of the workforce.

Of course, one thing is very real. The stock market has surged since its March 2009 low. Stocks keep setting new highs. The Dow Jones Industrial Average closed well above 16,000 and the S&P 500 closed above 1,800 on Friday. Even the Nasdaq has awakened, hitting its highest level since the year 2000.

The problem is that the Federal Reserve's easy monetary policies get most of the credit for the rally in stocks. The Fed has set the fed funds rate at virtually zero percent; and its policies of quantitative easing have driven long-term rates to unprecedented lows. The Fed is particularly worried about inflation. To be precise, it is worried about the lack of inflation. In fact, it is worried about deflation. Other than the obvious inflation in asset prices, inflation everywhere else appears to be nonexistent. Deflation, on the other hand, is becoming a serious global issue.

Japan is the poster child for deflation. Japan suffered from what is known as the Lost Decade. Actually, it's more like two Lost Decades. The current prime minister, Shinzo Abe, has been trying to revive the Japanese economy by devaluing the yen in order to make Japanese goods cheaper for the rest of the world. Despite its long-term economic problems, Japan remains an export-driven economy. It is currently the world's fourth-largest exporter. As a result, Abe's strategies are not just exporting Japanese goods; they are also exporting Japanese deflation.

Most American investors would say that their biggest fear right now is tapering. The Fed has already signaled a number of times that quantitative easing would not continue forever. However, how likely is the Fed to taper when it is so worried about deflation? The latest figures for consumer and producer prices came out just this week. Once again, they showed virtually no evidence of inflation. I don't think we need to worry so much about tapering until inflation picks up significantly from current levels.

I have been saying for some time that this rally in stocks makes me uneasy. In my view, the fundamentals don't justify it. It's nice that money is cheap, but who is that benefiting? Savers are getting clobbered, business confidence is weak, the growth in bank loans has been falling, and so has the growth in nonresidential fixed investment. These problems cannot be fixed by driving interest rates even lower. But stockholders are definitely benefiting. Corporations are not using cheap money to invest, but they are certainly using it to buy back their own shares. Strategas Research Partners estimates that since 2009 share repurchases have more than quadrupled in value to $118 billion.

There is a lot of money floating around the economy, but as shown in the graph above, it has no velocity. In other words, money is not turning over. All in all, I have to conclude that the rally in stocks makes no sense. It looks like the "greater fool" theory at work. You might want to consider taking some profits and trimming some positions. Alternatively, buy some insurance with put options. Volatility is extremely low and so are option premiums.