These themes of deflation and a second half recovery are echoed almost daily in print and on the air. The second half recovery theme is responsible for giving us a spectacular bear market rally since the end of the Iraq war. We got the war rally which just kept on going on the basis that earnings and the economy were going to pick up in the second half of the year, even though there has been little evidence that this will become fact as more companies warn of second half problems. The second quarter rally has been driven more by hope and hype than anything else. The surprising thing about this rally is that the managing of perceptions is working. The degree of bullishness today has never been greater as evidenced by the following sentient indicators.
AAII Investor Survey: 71.4 % bulls on June 25th
Ned Davis’s Wall Street Strategist: 71.0% bullish
Magazine Covers Declaring New Bull Market (Barron’s)
10-day put/call ratio hit .66
VIX at 21.69
VXN at 31.23
While many financial and non-financial publications have unilaterally declared that the bull is back, insiders are rushing for the exit gates.
This pattern has been repeated consistently since last summer’s July rally. The four-step process is as follows:
1) Intervene in the market (done by buying futures).
2) Higher stock prices through intervention forces short covering.
3) Stock prices that lurch higher bring in momentum players.
4) If the rally lasts long enough, John Q. may move money into mutual funds. This happens just about the time the rally fades.
Mutual fund inflows have increased as a result of the individual investor coming back into the markets. As the individual investor has rushed back into stocks, Thomson Financial’s insider sell-buy ratio has skyrocketed to 37-1. That means for every insider decision made to buy stocks, 37 sell decisions have been made. Think of it in this way--you are on an airplane sitting in coach. Since takeoff the flight has been smooth without as much as a single bump or air pocket. There has been very little turbulence. Viewing the clear sky outside your window you see a distressing scene. The captain and crew have just parachuted out of the plane. The plane is pilot less. This, I would think, makes you a bit uncomfortable. Yet today’s individual investor remains clueless as to the danger on board.
Yet Wall Street keeps the myth by telling the public that there is going to be a big bang in the second half of the year. The big bang will be the result of an explosion in capex and consumer spending. However, with tech sector utilization rates barely over 60 percent, and industrial utilization at around 74 percent, what, pray tell, is going to drive this explosive increase in spending? Instead of seeing all of the malinvestments of the tech mania washout and cleansed, many of these companies have been given a second lease on life thanks to low interest rates. The Fed has lowered the cost of capital driving rates down to the lowest level in half a century. Companies have been furiously tapping the bond market with new junk bond financing. With fund managers and investors becoming yield-starved, investors are buying anything. All this has done is postpone the cleansing process. As long as the economy is plagued with over capacity there will not be a sustainable recovery. That is why layoffs are still forthcoming from just about every sector. All companies can do is cut costs which means cutting payroll.
While there is still a high degree of confidence by investors in the policies of the Fed I tend to wonder how much longer the Fed can keep the people fooled. In its effort to prevent the bubble it created from deflating (when the Fed mentions the word deflation it is referring to asset deflation), it has destroyed all incentives for saving and investing. At a time risk levels are extremely high in the financial markets, risk premiums are dismally low. If we begin with the stock market and take current P/E multiples and translate them into percentage returns the returns are absolutely minimal.
You have to buy a stock at a very expensive price hoping there are other idiots directly behind you that are willing to pay even more. It also necessitates a strategy of exiting the markets before the last person standing is right behind you.
That is why the stock market has become a casino and why the average investor should stay away from the gambling tables. This is a market for traders only. The kind of trader I have in mind is the cold, calculated kind that has complete control over their emotions. Even then the astute and disciplined trader may fall prey to an unexpected rogue wave or series of rogue waves, or the ultimate rogue wave: a ten-sigma event. This isn’t your grandfather’s market nor is it your father’s market. This is one gigantic bubble greater than any in history that have gone before it. When it ends it will end tragically destroying a lot of wealth and people’s lives when it bursts.
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