This Rally Is On Thin, Thin Ice

| About: SPDR S&P (SPY)

The stock market, as measured by the S&P 500, has been trading in about a 265-point range for the past two years. It set an all-time high about a year ago and then went significantly lower. But thanks to the recent rally, the index is back near that all-time high. Money invested in the index a year ago is worth about the same today as it was then.

Stocks are doing well.

Companies are not.

And as we've seen many times before, the reason for this latest rally has nothing to do with corporate profits. It is simply the result of a wrong-headed monetary policy.

Many investors, including myself, believed that the Federal Reserve was planning to raise interest rates on June 15, but last Friday's labor report threw a wrench in those plans. Nonfarm payrolls for the month of May were much worse than expected. There has been a noticeable slowdown in job creation over the past several months. When the labor report hit the wires, the probability of a June rate hike (as implied by the futures market) plunged.

Most investors now believe that there is no way the Fed will raise rates in June. In other words, stocks are going up because investors believe the economy is in such bad shape that the Fed can't take the risk of increasing interest rates even by a marginal amount.

In last week's post, I explained why I thought the Fed would raise interest rates in June. I still think there is a reasonable chance that the Fed will proceed with a June rate hike. I say this for a number of reasons. Many economic indicators are doing just fine. For example, hourly wages are up 2.5% year over year, which suggests that the labor market is tighter than the recent nonfarm payroll figures indicate. It could simply be that we are approaching full employment. (Full employment is the point where almost everyone who wants a job has a job.) In addition, GDP growth for the second quarter is on track to hit 2.5%. That's not a great number, yet it's good enough for the economy to absorb a small rate hike. Housing is another part of the economy that is doing just fine. Housing prices are getting close to the highs set in 2006 just before the housing bubble burst.

Here is one more thing to consider. The June Fed meeting is associated with a press conference. The July meeting is not. The Fed is more likely to raise rates on a date on which Janet Yellen can explain her thinking and take questions from the press. Of course, the Fed could wait until September, but that would be cutting it very close to the presidential election, and the Fed would be accused of playing politics by raising in September unless economic signals were completely unambiguous then - which is unlikely. This Chairman and this Committee don't want to give that impression, in my opinion. As a result, it makes the most sense for the Fed to raise rates in June and get it out of the way. I think it is wrong to assume that a June rate hike is off the table.

I believe Janet Yellen tried to get this message through on Monday when she delivered a speech to the World Affairs Council of Philadelphia, but investors ignored that part of her speech. While she stressed that uncertainties are considerable and that the Fed is not on a preset course, she also outlined why the Fed should continue on its path of increasing interest rates at a moderate pace.

Given the strength of the rally ever since Friday's labor report was released, the markets are clearly betting that the Fed won't raise rates in June. Perhaps some investors are even hoping that economic conditions worsen so that the Fed won't be able to raise rates for a long time. It really worries me that the stock market rallies on the hope that the economy won't improve. I like rallies as much as anyone, but I would be much happier if stocks were going up because corporations were generating more sales and making more profits. Because that isn't the case right now, I see this as a soft market that is very vulnerable to giving back its gains. And if the Fed does raise rates in June, we could be in for the second 10%-plus correction of this year.