Market's Sugar High Won't End Well

| About: ProShares UltraShort (SDS)

What a week.

I feel like Bill Murray in the movie Groundhog day. We just lived through this event earlier this year. After the market ripped higher non-stop for months, in January, the Dow hit 10,750 and then fell for three straight weeks down to 9900. People were worried then. From there - the market raced higher for 2.5 months straight up without ever a thought of a correction. After this straight up period, the infamous flash crash of May in which the market dropped 1000 points at its worst in 1 day was upon us.

Fast forward to August. After hitting 10,750 again, the market in August went down hard for 3 straight weeks. Today brings to close the 10th straight up week in the stock market without a pullback of more than a few hours. I sure hope the next week or two does not mimic the previous time we saw this pattern.

The difference this time is we have a Fed doing all they can to inflate the stock market. Since they have run out of ideas and options, Ben Bernanke has said that he wants to lift stock prices in hopes to create a wealth effect that will cause you and your neighbors to go out and spend money. With larger investment accounts, you are supposed to feel richer and become willing to buy that extra Coach bag. Another New York Fed executive said the Fed wants to "add to household wealth by keeping asset prices higher than they otherwise would be."


So the strategy for getting us out of this method is to artificially raise asset values above what they are truly worth in order create wealth so we will spend?

Based on the performance of the stock market the past 10 weeks, it seems to be working. One problem though: This solution is a short term sugar high style fix. If I don't want my 3 year old to fall asleep in the car before we get to our destination, I guess I could pull over at 7-Eleven and buy her a 40 oz soda. My guess is she will be pretty amped for a short period of time. She might even think she is having a great time while the high is in place. Unfortunately, those parents out there know the crash after the sugar high in a 3 year old can be brutal. Not only do they lose all sense and logic, they get cavities and belly aches.

I would imagine that when this sugar high is done in the markets, the aftermath will be much worse than it could have been.

Now you might be thinking, why not just get aggressive and join the rocket launch ride for awhile and make some nice money in the short term? Well, those who are buying all think they will be able to get out in time, but they won't. History proves this to be true. On the initial pullback, they will feel a strong urge to buy the dip and add to their positions, not thinking the market has topped, but instead feeling like this is yet another great buying opportunity on the Fed-induced, artificial market rally. They then find themselves wishing they were on the sidelines as the market accelerates to the downside, but they won't get out because they don't want to miss out on the rally that will get their losses back. Finally, at the market bottom, they give up and reason that the market will never come back again.

Thankfully, we never went all out at any point during this rally. Unfortunately, we are playing it safer than we could and thus no longer going up as quickly as the market has these past 10 weeks. Fortunately, I am still completely ok with this strategy. One of the main reasons has to do with math. If I invest $100,000 here expecting the market to continue to Asset Price Nirvana, and the market goes up 30% over the next year, I probably feel rich and smart. My $100,000 turns in to $130,000 and I get to tell everyone at the parties how I have been along for the ride the whole time. If the bubble pops and the market then drops 30% from there, I not only lose the $30,000 in gains, but another $9,000. (30% of $130,000 is $39,000 in losses). So I rode it up and rode it down to a value that is worse than when it started, even though the % loss was identical to the % gain that preceded it.

Take a look (click to enlarge images):

This is a chart of the Japanese stock market since their bubble burst. I keep going back to Japan as an example because they have done the exact same things we are doing now for the past 20 years. After the first initial crash of 48%, the market rallied 34% to about 27,000. From there the market dropped 47.3% to about 15,000.

Here is where it gets interesting. From that 1992ish low, the market rallied 50.6% to about 22,500 in 1995. The market then dropped only 32.8% from that point, but brought the market back to its old lows. A 50% rally was wiped out by a 33% decline. Fast forward again to 2003. The low is hit and then the market rallies 135.6% from that low. This was during Japan’s own Quantitative Easing period that was supposed to stoke inflation and demand from an era of easy money. Those who were lucky enough to but at the exact low and ride it all the way up, saw all their gains wiped out very quickly in a drop that was LESS THAN HALF the previous gain. The yellow box on the right shows the drop so far in % term from the bubble top high. So the market has seen 5 rallies of 50% or greater from certain lows, yet the market is still 76% lower from the bubble top.

We could have a long way to go still, even though they are trying their hardest to make us feel like everything is ok. One scenario I have shared with some as the Dow was near 10,000 has been that we will either crash to 5000 on the Dow, or the Fed will devalue our money 50% and the Dow will stay or rise a little, but the outcome will be the same, we will be poorer. The Fed has done a great job fooling most to think they are richer, but as my favorite chart below shows, this is not the case:

This is the Dow Jones priced again in a basket of 17 commodities that are used by most businesses and manufacturers to make products. As you can see – we are only a few % points over the lows that were hit in March 2009. Things sure feel better on the surface though don’t they? Unfortunately, all your gains do not buy you any more goods than they did at the low in the stock market 2 years ago.

Currently the Fed is on a last ditch mission to blow another bubble in assets like they did in tech stocks in the 1990’s and then again in real estate only a few short years ago. One has to wonder, if pumping up the stock market artificially is a great wealth creator and is good for our nation, why would they ever stop? If wealth is made by printing money and forcing it into the stock market and by that, everyone is richer and spending money, wouldn’t it be a great idea to keep doing that all the time? I mean, why stop if you can lift the value of the Dow to 100,000 instead of 10,000? We would all be 10 times richer and spending so much money from the wealth effect that recessions and market crashes would be that of myth and folklore.

The unfortunate thing most people do not see or understand is that these crashes and deep recessions would probably not happen if the Fed were not artificially inflating markets. Investors need to conclude that the Fed did not save us from market crashes, their policies provided the animal spirits that created the bubbles that crashed after reality set in.

This time will be no different. Conservative strategies in an artificial world will lag in performance during the artificial rally. The temptation will be strong to throw reason, logic, and caution to the wind and join the party for most investors. If you can’t beat them, join them will be the mantra. Conservative strategies though will be standing when it all comes apart yet again as it has every time markets were artificially pumped up in the short term.

Be careful out there.

Disclosure: Long SDS against many long individual stocks

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