What's Behind the Market's Rise?

I saw an article in the Financial Times a few days ago about how the Fed is considering discarding Greenspan's philosophy of not targeting bubbles before they pop. That is probably a good idea, in my opinion. But if the Fed does change its view on its ability to identify bubbles, such a change in policy is unlikely to occur anytime soon.

(As an aside, the thinking at the Fed has been that it is impossible to identify a bubble, that the proper response was to act only after the bubble burst, and even if they could identify bubbles, raising interest rates could damage the real economy. However, for such a course of action to be the best course of action, one must assume that the Fed can identify the secondary and tertiary unintended consequences of responding to the aftermath of the bubble, and that not reacting to the bubble before it gets out of hand creates less damage to the real economy than acting to stop it. Its hard to say, but the creation of the housing bubble, the mess in the credit markets today and the nascent inflation that is brewing all have their seeds in the policy responses, or lack thereof, of the Greenspan Fed, despite Easy Al's protests to the contrary. But I digress.)

In the meantime, however, its same-old, same-old at the Federal Reserve Board, with the government willing to bail out excessive risk taking by financial institutions that pay their employees ungodly amounts of money. One might say that the Fed had no alternative to bail out the financial system. However, there can be no doubt that the $900 billion of liquidity the central bank has created over the past several months is now working its way primarily into the assets that need it the least.

Consider this week:

On the day that Research in Motion (RIMM) announces its new super-cool product to compete with Apple's iPhone, Apple's (AAPL) stock rises.

The moment CPI is announced as coming in less than expected, both stocks AND gold ticked up. Stocks wound up having a good day thereafter whereas gold gave back a few points. However, one minute after the CPI was released, gold was trading $5 an ounce higher than it was just moments prior.

On days that oil goes higher, the Toronto Stock Exchange goes higher. On days that oil goes lower, the Toronto Stock Exchange goes higher.

As is usually the case, the main benefactors of the creation of excess liquidity are not the asset classes which were targeted for improvement. Yes, credit spreads have come in, but most spreads are still higher than normal. In the mean time, Research in Motion hits a new high, Apple nears a new high, oil hits a new high, the solar stocks hit highs, etc.

Many commodities are off their highs and have not been moving. However, I think that is in reaction to the dollar moving higher. My guess is that when the dollar levels off, the oceans of liquidity will find their way back into commodities.

Right now, however, while the shorts are covering madly and all the hedge funds whose long-term horizon is tomorrow jack up the stocks, we have a market that cannot stay down.

It should be noted that over the past two years, we have experienced tremendous credit problems that prominent economists have described as the worst since the Great Depression, nearly $300 billion in financial write-offs, a collapse in profits, rising unemployment, a collapse in the housing market, a corporate community that has been leveraging up its balance sheets to buy back stocks, an implosion of the private equity market, the disappearance of the CDO market, a consumer tapped out with records amount of debt, rising inflation, the collapse of a venerable Wall Street firm, and stocks are up. The S&P 500 was at 1280 two years ago. Today it sits at 1420, an increase of 11%.

Nor are stocks cheap, as I will demonstrate in a few days. They are not overly expensive either, but Wall Street is spinning valuation in the best light when, in fact, valuation is not particularly compelling.

As Jim Cramer stated: The fix is in. The Federal Reserve has been flooding liquidity into the system for some time, and the market is rising on that liquidity, and not, in my opinion, on fundamentals.

But for now, the path of least resistance is higher.

Comments

[David White]

Above you state that the Toronto stock exchange goes up when oil goes up and when it goes down. Did you mean it to come out this way? Or did you mean that the Toronto Stock exchange mimics oil (i.e. follows it up and down)?

[CrossProfit]

Nice article.

David White,
The gist of the article is that markets are going higher no matter what due to excess liquidity, so according to the context the author wrote what he meant - in other words it should mimic oil but it doesn't - just up all the time.

Saul Sterman
CrossProfit

[syndicat]

This is a recurring theme, the Fed creates liquidity to address a major problem in the economy and that causes prices of other asset classes to rise. The "law of unintended consequences."

The excess liquidity of 2001-2003 which followed the Tech Bubble and 9/11 went into residential real estate.

I think this time it will be commodities, not stocks, that turns out to be the bubble, although the crash may come from a much higher level.

[vaduz]

only too right. also the 3 comments. unfortunately one doesnt know when a bubble bursts- but this time it will be earlier than later because there are too many fundamental problems unresolved

[punk_ash]

The article seems to be suggesting that Market should be going down not higher due to fundamentals. May I need to remind you Dow has gone from around 12000 in year 2000 to 6500 in real terms (if you cnsider the 50% or so value that $ has lost), so fundamentals do work.

[Brewer]

"On the day that Research in Motion (RIMM) announces its new super-cool product to compete with Apple's iPhone, Apple's (AAPL) stock rises."

Maybe that is because the 'bold' is a sad joke, and shows RIM running scared.

[windy cityman]

You're spot on in your assessment. The liquidity provided by the Fed has been to help the brokerage houses prop up the stock market and postpone the inevitable collapse. Expect that to happen after the elections in November! The higher the top the harder the drop!

[adan]

re: "...the worst since the Great Depression" - near the end of the 1929 run, aren't there all kinds of stories and histories how "trusts" and other groups ganged up to drive prices up to suck the little guy in?

hasn't progressed made it possible for the modern day "trusts" to now be financed with public monies via the fed?

and so it will continue until trust itself is so broken, when the big money beasts will have to burp and lick themselves clean til the next chance they get

yikes, can't believe i've gotten so cynical :-)

[bearfund]

"As is usually the case, the main benefactors of the creation of excess liquidity are not the asset classes which were targeted for improvement."

This is a very important observation. The creation of money and the creation of value are entirely unrelated. Collapses in prices of a particular asset class are usually due both to past overvaluation of those assets and a trigger event demonstrating for the market that the value of those assets has fallen materially. In other words, value is declining and the assets were overpriced. Creating liquidity does not make the assets more valuable, so it is unlikely to make them more desirable (and thus more expensive), either. Instead, excess liquidity will flow to whatever assets are growing in value or perceived to hold their value best. Hence the big run-ups in gold and crude and, perversely, Treasuries - over the past 6 months, the market has believed that those assets provide the greatest value. That would always mean their prices would rise, but they rose much faster than they otherwise would have because of all the excess money looking for a home.

The corollary to this is that flooding the market with liquidity is always the wrong response to a bursting bubble. It will *never* slow the bursting of that bubble and *always* begin inflating another one elsewhere. The problem is value, not prices, and central banks cannot and do not create value. If the Fed wants house prices to rise, they should shut off the printing press, grab tool belts, and start renovating homes. Giving more money to people who want to borrow (while destroying the assets of savers) isn't going to achieve that because they're going to buy what they want, not what you want them to buy - probably for good reason.

[fabien hug]

Good article. Thank you.
It seems that we are in a "don't fight the fed" type of mood/market.
Let's ride the wave with an hedgy feeling. How long is it going to last is difficult to say, of course.
I am looking for the following signs; great optimism of the masses and pundits and cautious articles like this one and "don't believe Paulson" by Reggie this day.

[JohnPseudonym]

You can bet that with this being an election year (and with both political parties at the helm) the government will hold no punches to make sure we make it to December with a higher price for stocks.

[whidbey]

I think there is much liquidity and the market will absorb it, but when we finish we will have another bubble to work off. Add to that risk is being repriced and there will be considerable suffering in 2009.

[mythreecents]

bear: u r right of course. and i am right that 2day is friday. here's hoping u got as much from my post as (we) did from yours.

[OJO Zafado]

Bear fund has it right. The problem in terms of defining what has value is truely a threat to the US currency itself. "Shut off the printing press..." Well that is the way to look at it, but does not fully state the severity of what is going on. Last week the FED incresed it's TAF from $50 to $75 billion and the TRCA with the ECB and SNB from $75 to $100 billion. There are no printing materials or costs. It is only a few key strokes and a pressing of the "enter" button. People are closing their money market accounts and moving to brokerage accounts so they can put the $2500 min balance into GLD, SLV,DBP,or PMY. Those along with something like a FNM-PrP that has inflation protection and pays 6.3% tax advantaged. The ETF has become a great danger to the currency as they allow anyone to have something of value instead of linen fiat currency. A 1979 10 Pound Sterling note is now worthless as they were replaced by new currency and are no longer honored. Same for any Guilder or Lire. In 1979 you could have gotten about 10 gallons of gasoline for the value that was in that ten pound note. Today if you have a one ounce silver coin minted in 1979 irreguardless whether Mexican, Canadian, US or other nation it would buy 4 gallons of gas. You might have to shop it around a little but would get +$16 in your pocket. In 1979 that ten pound note would buy 3-4 of those one ounce silver coins. If you had the silver coins....and not a worthless piece of paper. The War on terror has been extended to the war on drugs on the American people. Now we see the gov't trying to manipulate the energy futures market. +$5 gasoline now seems a certainty, as does $5-$6 heating oil. Now we see the Gov't trying to head off the hundreds perhaps thousands of deaths that are now likely to occur as young children and the elderly die next winter of hypothermia. The nation of drunken sailors has finally put their own ilk into the control of our gov't and financial institutions. I am continuing to lighten up in partial positions my energy stocks and funds.. I am letting the rest run. RJI,DBA,MOO,GLD,GDX,IE... SNG,BTE etc are all working for me. I think the fundamebntals SU@K! We are heading for a retest of the March lows as we head into the "Summer Doldrums" market. The effects of +$4 gasoline, road diesel, and heating oil is starting to really scare the mob. They sleep unaware of a clarion call from the US Treasury. The Treasury this week reported the March TIC. It was more bad news for the US dollar and lower interest rates in the real market. With a couple exceptions last year when it also went negative the TIC has consistently been about PLUS $60 billion a month. There was a $100 billion in reversal in the TIC as last months $65 Billion surplus was replaced by a $46 billion Negative flow of cash out of the US. If this persists for several straight months it will put some major pressure on US Treasury prices. You can get out in front with a PST or DXKSX. These are the times that try men's souls. Fortunes will be made and lost! Forget invading IRAN. How about aiming a few cruise missiles at the TATA Motors factory kicking out those "NANOs"!

[Jason T]

Great stuff,article and comments. I've been watching the VIX and I'm a bit surprised it has come down as low as it has. I found myself to be a buyer of short funds, SKF, SRS and DXD these last 2 weeks. I do think that this momentum will reverse.

Investor psychology Vs. economic reality will cause stocks to go up and down over the next 3 years as it ultimitely comes down at least 50% in my opinion.