Russell 2000 Is Overvalued and Set Up for a Crash

Feb. 8.11 | About: iShares Russell (IWM)

The Russell 2000 is trading at over 30 times earnings and 3.5X book value. The index is overbought, and investors are ignoring the risks of owning overvalued stocks right now in some of the more frothy areas of the market.

While Bernanke has taken credit for the rise in the Russell 2000, he dismisses the premise that inflation is hurting Main Street more than the gains from Wall Street are helping from a trickle down perspective. It appears, however, that the bifurcation of two Americas and the easy money Zirp bubbles set us up for a huge crash down the road for either Wall Street, the Main Street standard of living, or both -- and the consequences could be dire, especially in developing countries.

Maybe the market crash comes at a price that is 40% higher from here, but at some point, the whole system becomes unstable and unsustainable for the next President, or "ChairSatan", to paraphrase Bill Gross. In reality, we are soothing the pains of collapse with yet another bubble...which as sure as the sun shines in the morning is only going to lead us to another collapse of some form or another.

Inflationary forces are not helpful to the economy over time, and a basket of raw materials prices form a much better gauge of inflation measures than CPI or PPI because commodities are essential for human survival. As the exonerated Gordon Gekko put it in WS2 -- "when the next bubble bursts, it's going to be very, very bad." Blowing bubbles for rich people has not, and will not, create jobs on Main Street, and likely won't get anyone re-elected in Congress or the White House, either.

Structural reform would have been the solution, ending derivatives and letting the success and failure of business decisions, not bailouts for the well connected, determine market prices. When market rigging becomes a de facto tool of policy makers in Washington, we always end up with the same results -- chaos, calamity, and eventual collapse. Tweaking equilibriums never permanently alters economic reality. In our case, we need to think longer term and in terms of sustainability and integrity.

In any event, I am not one to discuss politics, but as a trader I find more and more that fundamental and technical analysis have become useless in a market that has become essentially choreographed by the major financial companies. Goldman (NYSE:GS) bots, JP Morgue (NYSE:JPM) machines, Morgan Stanley (NYSE:MS) droids, and the other big boy, HFT, buying and selling hundreds of cars in the S&P pits all day long with money they borrowed from the taxpayer. With far better inside knowledge of the game plan and the centrally planned rigging schedule, these bankers can, and do, always make money in the market.

Some would say that this type of short term trading is abusive to the retail investor, who must swim with the sharks hiding in the darkpools and futures pits. One thing is for certain, this low volume ramp up will end someday, and when it does, I think it will end very badly. We have papered over some losses, but the economy depends on a huge amount of debt rolling over and interest rates remaining low. With Ben Bernanke's foot on the gas pedal, the interest rate, or currency valuation, dilemma could easily destroy any lasting hope for a recovery in housing or the nearly worthless credit derivatives and mortgage backed derivatives positions which are currently marked to mythology on bank balance sheets.

As interest rates rise, home prices will drop -- good for savers (for a change), but bad for those already underwater. The increase in debt and leverage heralded by our leaders as "recovery" is threatening to drown the economy in an ever increasing stream of interest payments, entitlement spending, and costly government red tape.

In the end, all the printing in the world can't make the Russell's intrinsic value rise in the longer term because it's remarkably overvalued already. Realistic benchmarks should be set, and the Fed should cede victory now and stop while they can claim that they are ahead. The IWM is trading at over 30X earnings and over 3.5X book value and is set up for a major crash -- the timing of this crash is the part of trading that takes the most discipline.

Cutting a losing hedge position is essential in up markets, but once the froth becomes overwhelming, staying fully to 70% hedged is a good strategy. With options, it can allow you to make money in bull markets while protecting your assets in another flash crash type event.

Disclosure: I am short IWM.