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posted on 23 March 2016

How To Make Sense Of A Pathological Rally

by Michael E. Lewitt

Money Morning Article of the Week

Stocks rallied for the fifth consecutive week, erasing the losses suffered by the Dow Jones Industrial Average and S&P 500 to start the year. Fears of recession have receded and investors are now fretting that they may miss out on the next big thing if they don't dive back into the markets.

They should be careful what they wish for.

While it may be gratifying that the market didn't fall completely out of bed in the first quarter, there is still ample reason to believe that we are in a bear market and that recent gains are going to reverse sooner rather than later. One reason stocks rallied last week was that the Federal Reserve once again refused to take an opportunity, when market conditions were relatively stable, to raise interest rates. That leaves only investors to worry about when it might actually decide to do its job.

Bets are rising on that time arriving in June with the employment improving and inflation rising. The Fed, however, has plenty of company in terms of central banks continuing the easy money regime that has dominated markets since the financial crisis.

In recent weeks, the European Central Bank, Bank of Japan, People's Bank of China, Bank of England, and Norwegian and New Zealand central banks have also made new easing moves. This has resulted in negative interest rates in many of these regions, a catastrophic policy result that destroys capital and weakens economies. Investors may be celebrating now but they will be mourning these policies later. The world remains on an unsustainable path of massive debt creation and slow growth that is going to end in tears.

The Dow Jones Industrial Average gained 389 points, or 2.3%, to 17,602, last week. And the S&P 500 jumped 27 points, or 1.4%, to 2049.58. Incredibly, both are now only 4% below their record highs, signaling record complacency and cluelessness on the part of investors. The Nasdaq Composite Index added 1% to 4795.65.

Markets are in Denial Now

Many analysts are pointing to the fact that the Dow Transports are now in bull market mode -having risen 22% from their low on January 20. The fact that the transports are rallying while oil is also rallying is odd because higher energy prices are generally considered bad news for airlines and railroads.

Positive data on port volumes and container shipping looks better than it is due to the impact of work stoppages last year at West Coast ports. In fact, shipping data is still lower than 2014 in many cases. But in markets where 75% of the trading is driven by computers, such things are overlooked and momentum wins the day...Until it hits a wall. Look for the transport rally to end sooner rather than later.

Markets have also been encouraged by the rally in oil prices, which corresponds to a weakening dollar. The dollar is weakening after the Fed failed to raise rates, but the race to the bottom among central banks will soon resume and the dollar is expected to resume the rise that began in early 2014.

When it does, oil will find it hard to keep rallying regardless of supply/demand factors, which may not be deteriorating further but are only improving marginally. The outcome of the upcoming OPEC meeting in Doha, Qatar may give oil a further boost, but King Dollar will prove decisive in determining how much farther oil can run.

U.S. stocks also rallied despite the hand-wringing in the Republican Party regarding the potential candidacy of Donald Trump in November. The fact that markets don't seem bothered by Mr. Trump leading the Republican ticket suggests one of several things: they don't believe he will survive a brokered convention this summer; they don't believe he can beat Hillary Clinton in November; or they think he will get his act together and start acting more presidential in the near future.

Markets also may be in denial - an exercise in which they often engage when the facts don't fit their predilection to dive off the cliff. They tend to only try figuring things out once they are lying in a heap with their bones broken.

Based on his behavior and comments since he declared he was running for president last June, a Trump presidency should terrify markets. The problem may be that a Clinton presidency is hardly more reassuring. That should also lead investors to be battening down the hatches rather than chasing overvalued stocks to higher levels. Not to put too fine a point on it, but investors are acting like idiots.

Don't say I didn't warn you when the bear market resumes.

The Hedge Fund "Masters" Have No Clothes

One of the more comical aspects of the current rally is the parade of know-nothings touting the recover in the junk bond market. This market has seen large inflows over the last month into junk bond mutual funds and ETFs as the average spread and yield on the Barclays High Yield Index have dropped from over 10% and 800 basis points to just over 8% and 640 basis points, respectively. But this is happening as the default rate is starting to rise significantly. And more energy and commodity companies are lining up at bankruptcy courts around the country. Only the strongest issuers can raise new capital.

Investors should not be tempted back into this market. There will be higher defaults, poor liquidity and lousy returns in the months ahead.

It will be interesting to see how much investors are actually profiting from the market recovery. In February, many hedge funds continued to perform poorly. Last week's news was dominated by the crash-and-burn of Valeant Pharmaceuticals International Inc. (NYSE: VRX), which continued its well-deserved slide into oblivion by dropping to $27 from $70 after announcing more bad news on Tuesday.

Readers will remember that the stock peaked at $260 last summer. Hedge fund manager Bill Ackman accomplished the rare feat of losing over $1 billion in a single day on this stock - along with The Sequoia Fund, which lost even more.

At some point, investors may figure out that paying so-called Masters of the Universe 2 and 20 to buy stocks that they can buy on their own - without paying such egregious fees or locking up their money for years - doesn't make a lot of sense. Until then, they will surrender their money to the egos of people who only think they are smarter than everyone else.

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