Investors Stay Away from This Irrational Indulgence

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MoneyMorning.com Michael E. Lewitt writes: When I see the market rally mindlessly -as it did on Friday, after the jobs report pushed the jobless rate down to 5.4%- I ask myself a set of questions like the following….

Do investors really think it's going to matter if the Fed raises interest rates by a quarter of a point in September instead of June? Do they really think it's normal that €3 trillion of European debt is yielding less than zero? The Swiss National Bank (Switzerland's Federal Reserve) owns $100 billion of stocks…Is that considered normal?

Do investors really think stocks aren't over-hyped when Tesla Motors Inc. (NASDAQ: TSLA) is a buy at $236/share (infinity-times earnings)? What about Amazon.com, Inc. (NASDAQ: AMZN) at $433/share (also infinity-times earnings)? Netflix, Inc. (NASDAQ: NFLX) is at $575/share, or a "mere" 150x earnings. And theiSharesNasdaq Biotechnology ETF (NASDAQ: IBB) has risen from $230/share to $350/share. Are these reasonable prices?

To be honest, I really don't know how to answer these questions anymore. Any sentient person would answer with an emphatic "NO". Yet investors' behavior signals their answer is a resounding "YES".

I can't be any more direct than this – sometimes the plane hits the ground before people have a chance to parachute to safety. Investors trying to ride this market to the bitter end are going to find the end is bitter, indeed.

Bond Markets Start to React

Of course, investors are just following the lead of policymakers. Over the past year, a number of Fed officials have warned that they are going to raise interest rates. But their actions have revealed that, in reality, they have no intention of doing anything to remotely upset the stock market.

Last week, Fed Chair Janet Yellen offered her opinion that "equity market valuations at this point generally are quite high". That suggests to some that she was trying to invoke the actions of former Fed Chairman Alan Greenspan who famously warned, in late 1996, about "irrational exuberance" in the stock market.

Mr. Greenspan then acted to reign in this exuberance by raising the Federal Funds rate from 5.25% to 5.5% in March 1997, leading to a 10% drop in the S&P 500 from its February 18, 1997 peak (perhaps this reaction should serve as a warning about what investors might expect to happen when the Fed finally does move this time). Upon seeing this reaction, Greenspan didn't raise rates again until 1999.

Fed officials are clearly dancing to the tune of the stock market. So why should investors heed any warnings about future rate increases? The problem with all of this is that eventually markets do catch on. Despite the appearance, investors can only retain the veneer of idiocy for so long before realizing that, if they don't restore their cognitive functions, they are going to lose a lot of money.

This started to happen last week in the European bond market where German bunds, which had traded down to a ridiculous yield of around 0.05%, finally started selling off and ended the week at a still ridiculous but much higher yield of 0.54%. While it's hard to know how many hedge funds and private investors were betting on bund yields moving lower, those that did got their heads handed to them – and deservedly so.

The rest of the European bond market is also in turmoil. For example, Spanish sovereign bonds have given up all of their post-QE gains. ECB President Mario Draghi continues to stick to his QE plan and tell the market that everything is going according to plan, but even he knows that he is wreaking havoc on the market. Bond market conditions in Europe are highly abnormal and investors ignore them at their peril.

What the Jobs Report Doesn't Tell You

Back in the USA, investors read into the April jobs report exactly what they wanted to read into it – that the Fed will wait until September to raise interest rates (like it matters). The economy allegedly added 225,000 jobs, but this number is subject to revision – March's weak 126,000 number was revised downward to just 85,000, for example.

The unemployment rate dropped to 5.4%, hourly wages moved up by 0.1% and aggregate hours worked rose by 0.2% after dropping by 0.3%. In a word, the economy is stuck in the mud. It's struggling to grow at 2-2.5% with the help of zero interest rates and after trillions of dollars of bonds have been purchased by the Fed and other central banks around the world.

There are still a near-record number of people out of the work force and U6, which includes discouraged and underemployed workers, was 10.8%. The problem with these latter two numbers is that they reflect structural rather than cyclical (i.e. transitory) features of the economy that cannot be addressed by monetary policy. Accordingly, keeping interest rates at zero isn't going to fix them.

Disappointing economic growth should not surprise students of financial history, who understand that recoveries from financial crises like 2008/9 take many years (at least a decade). What should appall if not surprise these students and everyone else, however, is that the Fed and other central banks continue to double down on failed policies… long after the evidence is in that they aren't working.

Instead of adopting effective policies, European, Japanese and now Chinese central bankers are adopting massive QE programs that demonstrably do not stimulate sustainable economic growth. Instead, they create trillions of dollars of new debt, which can never be repaid, suffocate economic growth, increase wealth inequality, and lead markets and economies straight into new crises.

For the moment, however, stock investors continue to hug their 401Ks like Teddy Bears and pray that illusory markets will go up forever. Last week, the Dow Jones Industrial Average gained 1% or 167 points to close at 18,191.11. The S&P 500 rose 0.4% or 8 points to close at 2116.10, just below it all time high of 2117.69. The key resistance level on the S&P 500 has been 2120. If the market can break that, it could see a further upward move. The Nasdaq Composite Index was flat and closed at 5003.55. Ten year Treasuries saw their yields hit as high as 2.3% before ending the week only slightly higher at 2.15%.

Here is a bulletin for everyone: limit your exposure while you can. This market is going to blow and when it does your Teddy Bear isn't going to keep you warm.

Source :http://moneymorning.com/2015/05/10/stay-away-from-this-irrational-indulgence/

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