This is a stock market completely based on hope. Investors have thrown fundamentals out the window. Most are basing their optimism for stocks on the belief that the U.S. Federal Reserve can manage to inflate asset prices with another round of so-called quantitative easing.
But where does this faith in the Fed come from? Is this not the same Fed that thought the housing and mortgage crisis would stay "contained" back in 2007? The same Fed that believed, in the summer of 2007 when the financial crisis first broke, that we would see 2.5 to 3.0 per cent real GDP growth in 2008? The same Fed that just trimmed its forecast three times in the past four months?
Is this the same Fed that investors now have faith in? Give me a break.
Quantitative easing is simply a policy in which the Fed creates money and uses it to buy assets such as government securities with the goal of driving down interest rates. But quantitative easing - or QE, as it's called - has had mediocre results.
If the prime goal of the Fed's first round of quantitative easing - QE1 - was to bring down mortgage rates, then it was successful. But if the broader goal was to reignite a new credit cycle, then it has clearly been a failure. Even though the Fed stuffed U.S. commercial banks with over $1-trillion (U.S.) of cash reserves, underlying bank credit still shrank by nearly $700-billion.
The U.S. economy has failed to catch fire since QE1 was unveiled back in the opening months of 2009. Yet, a month after unleashing QE1, the Fed was so convinced that the economy was going to embark on a sustained growth path that it was forecasting GDP growth would hit 3.5 to 4.8 per cent in 2011 and the unemployment rate would fall to below 8.5 per cent. Uh oh.
So what are we supposed to have faith in exactly? That the Fed is going to manage to get the banks to lend and generate a sustained revival in the economy with a second round of quantitative easing? Nobody knows what QE2 is going to look like, or how the Fed is going to implement it, or what the size of the bond purchases are going to be. Even Federal Reserve chairman Ben Bernanke has questioned whether it will work.
This is not the time for investors to be chasing hope. There is simply too much risk in the market right now. Unlike March, 2009, sentiment is not washed out, the market is not cheap, and profit expectations are not on the floor, but have actually peaked and are now rolling over.
Many believe that QE2 will be successful in bringing interest rates down even more. But so what? Mortgage and auto loan rates are already at all-time lows. They have fallen a percentage point in the past year, yet housing and car sales are still extremely weak. It's hard to see what another percentage point in rate cuts will accomplish at a time when household debt relative to both assets and incomes is still close to record highs.
Brian Sack, executive vice-president of the New York Fed, has been strikingly candid about the goals of QE2. He says the Fed needs to bolster asset inflation in order to boost people's perception of their own wealth and thus encourage spending. In his words, quantitative easing "adds to household wealth by keeping asset prices higher than they otherwise would be."
Think about that: a Fed official is directly acknowledging that the Fed's goal is to raise asset values above their intrinsic value.
This is an amazing way to run an economy. Whatever happened to skills, productivity, education, job creation, innovation? Or thrift?
Many investors are edging into the stock market because they can't take the pain of being on the sidelines as the Fed reflates the economy. They should think twice about the dangers of investing in a market where economic fundamentals don't seem to matter.
The Fed has been successful in generating asset bubbles in the recent past, including the tech bubble in the late 1990s and the housing bubble in 2001 to 2006. We know from those examples that bubbles never end well. Yet here we are, being suckered into another one. Despite the examples from recent history, everyone seems to think they will know how to time this rally and get out at the peak.
Which reminds me of the remark by Bernard Baruch, the famed financier of a century ago, when he was asked his secret of building wealth. His answer: "I always got out too early." The biggest mistake anyone could make right now would be to chase this market back to its April highs, even if it manages to get there on more speculative fervour. The risks of a fall are more acute than generally recognized.
David Rosenberg