The Fed, by setting short term rates at zero, then using trillions of dollars of "Fed money" to keep longer term rates at historic lows, has created a powerfully leveraged and overwhelming financial force. It's so powerful it's actually rational to expect the two bull markets driven by this force -- the stock and commodity markets -- to hit price levels above what is normal or economically justified. We are definitely not there yet.
The correctness of this view, I believe, is confirmed by the current state of three powerful contrary opinion indicators. After the two-year price advance, they are showing the emergence of a large investor "Wall of Worry," a necessary ingredient and an indicator of higher prices.
Is the Fed creating big problems for us later? Probably. But the market should not and apparently is not ready to do anything about that now.
The Commodity Bull Market
Near zero short-term interest rates put inventory carrying costs lower than inflation expectations. This inversion induces most corporations to build huge inventories of non-perishable commodities to get ahead of inflation. But this process eventually becomes self-reinforcing in that it creates the very demand that keeps expectations high.
So both corporate buyers and individual investors have been doing the same thing: Buying and warehousing huge quantities of gold, silver, other metals and commodities, trying to get ahead of the inflation curve. This is the basic story behind the ever-expanding bull market in commodities.
But it should be noted that a large part of this is self-created demand. How much demand is immediate economic need and how much is buying due to this inversion between carry costs and inflation expectation? I don't really know yet. However, I do know this situation is exactly how certain extreme price moves are created, and they are very hard to stop once they get going and begin to grow. They take on a life of their own, so to speak. They can be very profitable.
Stock Market Story
This stock market is being powered by the same force with similar feedback characteristics. As I mentioned in an article last September, the American stock market has a perfect financial storm going (in the good sense). It has high earnings growth from foreign operations and record low interest rates that allow for much higher evaluations (P/E ratios) on those earnings. This creates almost "perfect" or ideal mathematics in the finance equations for stock valuation.
It’s All Happening Because Of Zero Interest Rates
Essentially, the bull markets in commodities and stocks are occurring for the same reason: The holding of interest rates at an artificial and unprecedented lows, for an unheard-of period of time, and reinforcing the situation with "Fed money." Besides the stimulation and higher valuation it provides, it also triggers powerful self-reinforcing price movements that can carry prices beyond “fair value.”
But that's the key idea. The feedback forces are so powerful in these bull markets that investors should actually expect prices to continue past what is normal or economically justified.
This view -- that the two bull markets have further to go and will continue past what is normal or economically justified -- is supported by current investor sentiment. Three classic sentiment indicators confirm that market participants are very nervous and seem to be expecting a market top at any moment. If so, that is very positive. It shows that the market is now climbing against the proverbial “wall of worry” and should go higher.
Signs of the "Wall of Worry"
It is very true that markets always advance against a "Wall of Worry" or doubt. The way to actually "see" the wall is to measure market sentiment against market action. It's indicated when investors start getting more bearish as prices move higher. Two well-known sentiment indicators, and another not-so-well-known, clearly show the "wall's" existence.
The following charts are provided by DecisionPoint.com, a great technical website I've been using for many years.
Puts to Calls Ratio
The first indicator is the puts to calls ratio. It is a classic indicator first developed by Marty Zweig in 1971, using over-the-counter data. It has an official track record back to 1975, when the CBOE was established. It divides put sales by call sales and therefore it indicates overall bullishness or bearishness of these traders.
There are two ratios. One is for equities only (blue curve) and the other is equities plus indices (purple curve). They are plotted against the S&P 100. When the ratios get smaller (go up on the chart), investors are getting more bullish. When the ratios get larger (go down on the chart) investors are getting more negative or bearish.
[Click all to enlarge]
Both ratios point to a rising bearishness of investors (the red dashed arrows) as prices move higher. This action is an indication of the classic Wall of Worry.
This same pattern and conclusion are confirmed by two other sentiment indicators -- one just as well-known and followed, the other less so.
The AAII Sentiment Numbers
The American Association of Individual Investors (AAII) has been polling members since the 1980s to see how many are bullish and bearish over a six-month outlook. It acts as a contrary opinion indicator and has become a classic. The ratio of the weekly numbers of bulls to bears is shown in the chart below, plotted against the S&P 500. The red dashed arrow points to the declining ratio (fewer bulls and more bears) as the market moves higher, confirming the message of the puts to calls ratio.
The Rydex Ratio
Carl Swenlin of Decisionpoint.com developed an indicator (or at least presents it) that I've found very useful over the years, shown below. It's a ratio that compares how much money investors in the Rydex family of mutual funds are directing into their bullish or bearish funds. When the ratio rises, they are bullish; when it declines, they are getting negative.
That ratio is shown by the blue line; the movement toward more bearishness is indicated by the declining dashed red line. This indicator also acts as a contrary opinion indicator and confirms what the puts to calls ratio and the AAII ratio are saying.
The very powerful feedback loops driving prices (the self-reinforcing mechanism that the Fed's financial structure creates) plus the clear emergence of a growing Wall of Worry as prices move higher, points to a very favorable risk to reward ratio, i.e. a very high potential reward at very low risk. In my opinion, investors should take full advantage of it.
Disclosure: I am long SPY.