Strategy to Profit Before the Markets Head South

March 25th, 2015
in contributors

Money Morning Article of the Week

by Michael E. Lewitt

For the last six months, I have been warning that economic growth is faltering. In November of last year, I predicted that the U.S. economy would experience a "growth scare" in 2015.

Follow up:

This week, we learned that the Atlanta Fed is tracking first quarter GDP growth at a mere 0.3% and that the Federal Reserve's Open Market Committee (FOMC) has significantly downgraded its growth forecast.

Bond yields have plunged and commodity prices have collapsed. Only stocks have failed to figure out that low growth is a recipe for coming disaster.

Why the Fed is so Scared

While the Fed is obviously terrified to raise interest rates by even a quarter of a point, stock investors seem to see that as a reason to pour money into already overvalued biotech and social media stocks. But even run-of-the-mill S&P 500 stocks are pushing the upper bounds of sanity as investors rationalize their irrationality by telling themselves that there are no alternatives for their money. The fact that the Fed has destroyed bonds as investments does not justify buying overvalued stocks that are headed for a correction. Another argument that investors use to justify staying too long in the market is that they don't want to pay taxes on their gains. The antidote to that problem will be that they will have much lower gains on which to pay taxes if they stick out the bubble to the end.

Historically, stocks have risen about 9.5% on average in the six month period preceding a Fed rate hike. And in the year beginning after a Fed rate hike, stocks have averaged a 10% return. But history may have to be thrown out the window this time. Valuations are extended, the world is drowning in debt, growth is deteriorating, and the dollar is powering forward in one of its strongest moves in years. History doesn't always rhyme - sometimes it just misleads investors into traps that costs them a lot of money. This may be one of those times.

By the Numbers

Last week, however, cheered on by the babbling class, the Dow Jones Industrial Average rallied by 378 points or 2.1% to close at 18,127.65 while the S&P 500 spiked up another 55 points to end the week at 2108.10. The Nasdaq Composite Index added 155 points to close above the hallowed 5000 level at 5026.42, just below its all-time high of 5048 set back in 2000 but far below its inflation-adjusted all-time high of 6900. Lost in all of these numbers is the fact that the currency in which all of these stocks are traded - the dollar - is being actively debauched by the Fed and is worth less by the day.

European bourses are also reaching new highs as the European Central Bank works even harder to destroy the Euro and dollar-based investors who chase those stocks without hedging out currency risk are engaging in a fool's errand. Then again, all investors are currently chasing the illusion of paper wealth that is going to be swiped away from them first when the market comes to its senses and corrects and later when they are left holding beaten down stocks denominated in devalued currencies. At least the stocks will have an opportunity to recover in value; the currencies are being permanently destroyed by the incessant printing of trillions of dollars of funny money.

The huge rally in the dollar that started last summer is a major factor in the Fed's reluctance to move sooner on rates. The dollar has risen by 25% over the last ten-months against other major currencies and has contributed to a crash in commodity prices, slower US growth, declining exports and lower corporate profits. The problem is that the move is likely in its early stages barring a sudden change in monetary policy either in the U.S. or in Europe, Japan or China - something that is not in the cards. As a result, unless the Fed wants to initiate another round of QE, which is highly unlikely, all it can do is forestall rate increases and slow the dollar move and all that follows from it. A stronger dollar will force U.S. companies to become more competitive, but that will likely translate into deflationary pressures such as wage suppression and job cuts. The U.S. economy is going to have to take its medicine. So are the markets - it's just a matter of when that happens. The longer stocks rally, the worse the correction is going to be.

The market's reaction to the Fed's statement should serve as an emblem of just how dependent investors have become on the kindness of the denizens of the Eccles Building. With year-over-year S&P earnings and revenues now expected to be negative for the first time since the financial crisis, there is simply no rational basis for stocks to rise other than a belief that the Fed will support equity prices with low interest rates.

After the Fed let it be known that it would not be "impatient" in raising rates, the S&P 500 rallied by 1.9% off its low. But after the smoke clears, and the attention spans of investors come to exceed the half-lives of fruit flies, it would behoove everyone to take a more intelligent look at precisely what they are buying when they pour money into stocks at this point of this cycle. It is a lousy bargain.

The S&P 500's dividend yield is just 1.7%, well below its average of 2.6% from 1983 through 2013, according to Research Affiliates. This may be competitive with 10-year Treasury yields but it hardly blows them away. Earnings are projected to grow at a 1.3% clip, half of the 30-year average of 2.8% - and remember, those earnings are artificially inflated by massive stock buybacks (often debt financed), low borrowing costs, phony stock option accounting, and other factors that overstate them. Finally, valuations by any variety of measures are extremely high. Most models - including those from highly respected firms like GMO and Rob Arnott's Research Affiliates - project that U.S. stocks will produce virtually no return over the next decade. And that assumes that we do not experience another financial crisis or that if we do experience a crisis that the powers-that-be will have the tools to resolve it.

Biotech is Soaring

Not surprisingly, the most speculative sectors of the market skyrocketed last week. One of those sectors is biotech. One stock in particular, Biogen Idec Inc (NASDAQ: BIIB), saw its stock soar by 9.76% on Friday on news of a promising new Alzheimer's drug. The iShares NASDAQ Biotechnology Index (ETF (NASDAQ: IBB) has jumped by 20% year-to-date and by a ridiculous 70% since last April as money has poured into the industry. It may prove ironic that investors are losing their minds about a drug that treats memory loss because they are going to beg to forget what they did when the market regains its senses. Investors should be shorting the IBB, not buying it. These stocks have completely detached from reality.

Here's What to Do to Profit

Investors should also be taking immediate steps to protect their portfolios from losses. If they can't bear to sell their stocks, they should hedge their portfolios by buying ProShares Short S&P 500 ETF (NYSEARCA: SH) to soften the blow of an inevitable correction. They should also be buying gold now that it has sold off due to the stronger dollar. The debauchment of the U.S. dollar continues even though it is disguised by the greater debauchment of other fiat currencies like the Euro, the Japanese Yen, the Canadian and Australian dollars, etc...

Buying gold is a prudent way to protect your future wealth. With every passing day, markets are moving closer to the day when the Fed will have no choice but to start raising rates, an event that will add to a toxic mix of a weak economy, unsustainable debt burdens, and rising global instability. Those who wait too long to act will regret their indecisiveness.

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