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Reality or Illusion? -Can wanting to believe, make it so?

May 19, 2011 3:59 PM ET
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Not since the Civil War has the country been this split, with half believing that the economy is fully recovering and the other half insisting that calamity is just around the bend. 

For the past two years the Federal Reserve has been pumping money into this economy through QE1 & 2 and other direct stimulus programs, and there is no doubt they all helped avoid catastrophe. However, what happens when it’s withdrawn is the lingering question. It’s certainly been good for the stock market, and if the market is an indicator of the economy, we are on the right path… but is the recovery a reality or an illusion?

All along, Ben Bernanke and Federal Open Market Committee (OTCPK:FOMC) have readily admitted that a primary goal of the stimulus programs is to push the stock market higher, which creates the “wealth affect”. That’s when people see their portfolios and 401k’s going up, so they feel richer and are likely to spend more money. To a large extent this has worked, or at least created the “illusion” that it has! Unfortunately, this truly only helps the top few percentage of society which is evident in the skyrocketing earnings of companies like Tiffany’s and Sacks Fifth, while those of Wal-Mart and Kohl’s have languished.

The concern is what happens when the free money goes away. On balance, there has been direct correlation of stimulus money and rising stock prices. When money comes in, stocks go up. On the other hand, when it looks like the spigot might close, the market goes down. We witnessed this last year when QE1 ended and the market plummeted. We saw this yet again, a few weeks ago, when the current correction began right after the Fed announced that QE2 would end.

There is no doubt that people feel better, but whether reality or illusion, we all must be aware that we are clearly in a bubble, and you have to know how to play with bubbles. As much as I want to believe we are in the beginning stages of a new multi-year economic expansion and subsequent bull market, the economic reality points otherwise. The combination of the aging baby boomer, which is in their natural demographic cycle of spending less as they get older while saving more for retirement, and an extremely over-indebted/over-leveraged consumer, will make it impossible until the country deleverages. After all, the answer to more debt and leverage is NOT more debt and leverage! 

Recently, we have seen economic data starting to come in much worse than expected. First quarter GDP was not just anemic but a pathetic 1.8% and that was after trillions in stimulus. In addition, industrial production, capacity utilization, manufacturing data, jobless claims and housing starts all disappointed, which is clearly pointing to a slowdown. And, although Corporate profits have been strong, they are now making up the largest share of GDP since 1929 and 2006, and those years preceded the past century’s worst two financial collapses.

Given that rates are still low, which allows the Fed to borrow cheaply and not to mention that we have an election coming up, QE Mini-Me will not be enough. Another full blown QE program is likely, whether by that name or a horse of a different name. Recent statements by William Dudley, the New York bank president and vice chairman of the powerful policy setting committee of the FOMC have cautioned against removing the stimulus too early, which is most likely the early rumblings.

Whether they bring in another program right away or not, the market still has life in it. Earnings are what drive stocks and they have been phenomenal, as more than 75% of companies have beat or met analysts’ earnings estimates. However, what makes stocks jump is positive surprises and there just aren’t many surprises left. Technically, stocks look good too. The Advance/Decline (A/D) line hit new highs last week, even though the S&P 500 did not. This is a positive divergence. Typically, the A/D line is a leading indicator, and has been for this entire two year old bull market. It is simply signaling that the overall trend remains higher, probably for several months, and then we fall off the cliff again.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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