Stock Market Rally Surges Back, But There's Trouble Ahead

By: Money_Morning

Michael E. Lewitt writes: The week was dominated by news by central banks as the Federal Reserve ended QE and the Bank of Japan pushed its QE program to new heights.  The result was another rally in stocks around the globe that made the mini-correction earlier this month seem like a dream (or a nightmare).

The question is what happens next, and all indications are that markets will continue to ride the wave of central bank liquidity as far as it takes them.  Markets were also boosted by a strong initial third quarter U.S. GDP report showing the economy grew at 3.5% and strong corporate earnings reports.  With over 360 companies in the S&P 500 having reported third quarter results, profits are up 7.2% and revenue is up 3.9%.

The fact that much of these gains are attributable to non-organic factors such as stock buybacks and low interest rates doesn't seem to bother investors since they expect these factors to continue indefinitely.  But the markets only look like they got more attractive.

Particularly in view of news that came out of Japan on Halloween, they just got far more dangerous.

A Strong Showing on the Big Indexes

The Dow Jones Industrial Average rallied another 585 points or 3.5% to close at 17,390.52. The S&P 500 gained 2.7% or 54 points to end the week at an all-time closing high of 2018.05.  The Dow closed the month up 2% and the S&P 500 up 2.3% after both were sharply down mid-month.  The Nasdaq Composite Index added 3.3% or 147 points to climb to 4630.72. The small cap Russell 2000 rallied by 4.9% to close at 1,173.51, a very strong showing as well.

The Fed's announcement accompanying the end of QE provided stock market bulls with ammunition for further gains.  The Fed stated that it believed that QE had worked in helping improve the jobs market and also appeared to be relatively sanguine about the outlook for inflation.  Had the Fed given in to the fears that shook the market two weeks ago and delayed the end of its bond buying program, it would have sent a much different signal to the markets that the economy was too shaky to stand on its own two feet.  But the Fed made it clear that it believes that the economy is ready to start being weaned off central bank support and that was taken as a positive sign for investors.

Quantitative Easing Winds Down in the U.S., Ramps Up in Japan

The Bank of Japan (BOJ) sent a completely different signal about its view of the Japanese economy yet global markets read it as positive for markets nonetheless.  On October 31, the BOJ announced that it would increase its purchases of Japanese Government Bonds (JGBs) to ¥80 trillion yen ($720 billion) per year from ¥60 to ¥70 trillion yen.  As David Stockman points out, this would amount to nearly $3 trillion per year if applied to a U.S. scale GDP.  According to J.P. Morgan, this means that the BOJ will be buying the equivalent of more than twice the amount of new bonds issued by the government, a level well beyond anything done by the Federal Reserve during its QE programs.  In addition, the BOJ will triple its purchases of ETFs and Japanese REITs and create ETFs that track the JPX-Nikkei Index 400. This was not an uncontroversial decision within the BOJ – the vote was an unusually close 5-4, something that rarely occurs in such a consensus-minded institution and culture.

"A Critical Moment" for Japan

BOJ Governor Haruhiko Kuroda said as he announced the decision that "We are at a critical moment" and that the fight against deflation was at risk.  In its formal statement, the BOJ said that "there is a risk that conversion of [a] deflationary mindset, which has so far been progressing steadily, might be delayed.  To pre-empt manifestation of such risk and to maintain the improving momentum of expectation formation, the Bank judged it appropriate to expand the quantitative monetary easing."  In other words, Abe-nomics isn't working and the authorities are doubling down.

Later in the day – though they claim the moves were uncoordinated – the government pension fund announced plans to shake up the $1.2 trillion investment portfolio for the Government Pension Investment Fund.  As of June 30, 2014, this portfolio was invested as follows:  Japanese bonds – 53.4%; Japanese stocks – 17.3%; foreign stocks – 16.0%; foreign bonds – 11.1%; Short-term assets – 2.3%.  The new plan is to increase the holdings of Japanese and foreign stocks by more than 10 percentage points each, which would equate to about $100 billion each based on the size of the fund.

Ten-year JGBs now yield 0.43% and 5-year JGBs yield 0.11% and the government has effectively destroyed any meaningful price discovery in these markets.  The immediate effect these policy had was to further weaken the yen – yesterday the currency moved sharply lower to 112.48 against the dollar, down almost 3%.  The Nikkei 225 skyrocketed by 4.8% on the news as well.  These trends should continue although whether the underlying economy actually improves remains to be seen.

This Interference Won't End Well

Needless to say, I do not share the market's enthusiasm at the BOJ's and government pension fund's actions.  Central banks' interference with natural market mechanisms is not going to end well.  One prominent commentator wrote after the news was released that every person in Japan who can afford to do so should move out of the country immediately since the value of the yen is going to be decimated.  My response was to ask if he knew of a planet the rest of us could rocket off to?  We live in an interconnected world and unlike Las Vegas, what happens in Japan will not stay in Japan.  The distortion of the Japanese bond market is problematic for global investors as it helps drag down all global bond yields.  But now the Japanese pension fund is going to be interfering with the natural price mechanism not only of its home equity market but of global equity markets as well.  This is ultimately a severe threat to global market stability and one has to wonder whether the Fed and Treasury are having any conversations with their Japanese counterparts about these policies.  Markets may celebrate the entry of a new buyer of stocks today, but will come to rue this day sooner or later.  The vote to approve this policy was unusually close and could be changed by a single official changing his or her mind.  The problem is that the world at large and not just Japan would pay the consequences now that Japan will be intervening not only in its own markets but in everybody else's as well.

The Important Numbers Are "Cooked"

Based on these concerns, investors should hedge their investments in order to protect themselves from the potential risks that are building as the markets reach ever higher levels of valuation.  Gold sold off sharply on the news out of Japan which only makes sense for investors with short-term time horizons.  On a long-term basis the Japan news is extremely bullish for gold.  The BOJ announced that it is going to do everything in its power to debauch its paper currency.  While that might provide a boost to other fiat currencies relative to the yen, it still confirms the inexorable fate of all fiat currencies in a world dominated by activist central banks.

This is an extremely important time for investors.  The markets have recovered remarkably well from a mini-correction and have moved to new highs.  Headline data appears to be very strong, but a detailed reading under the surface shows that everything is not as sanguine as it appears.

Corporate earnings reports are flattered by massive stock buybacks, phony accounting for stock options, low borrowing costs and other factors that disguise unimpressive organic business growth in many companies.  And the businesses that are growing the fastest may be of questionable value in terms of boosting long-term productivity since they reside in social media and related fields.

The third quarter GDP report was also boosted by an increase in defense spending to deal with the threat from ISIS but was short on consumption and investment.  Furthermore, many economists have already reduced their estimates for fourth quarter growth and a number have dropped their 2015 estimates for S&P 500 earnings.  There are serious questions about whether QE succeeded in creating sustainable economic growth or inflation expectations even if it did save the world five years ago.

Even the positive employment numbers are shaped by the 100 million people who have left the work force, raising questions about just how effective Fed policies were in boosting job growth and whether other factors were responsible for whatever recover in employment occurred.

Investors may have gotten ahead of themselves with this latest rally.  Investing in stocks is not supposed to be this easy.

Editor's Note: Michael Lewitt publishes the highly regardedThe Credit Strategist, and was recognized by theFinancial Timesfor forecasting both the financial crisis of 2008, and also thecreditcrisis of 2001-2002. His 2010 book,The Death of Capital: How Creative Policy Can Restore Stability(John Wiley & Sons) was included in the curriculum at the University of Michigan and Brandeis University.

Source : http://moneymorning.com/2014/11/02/the-rally-surges-back-but-theres-trouble-ahead/

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