Is the Market Really Insane?

Stop the Market Insanity

That’s what a CNN headline demanded over the weekend.

On the surface, the call certainly seems justified. Just take a look at what’s going on in the markets. In August three of the top performing stocks had to be a shock for anyone who can read a balance sheet. Shares of AIG (NYSE:AIG) soared 290% outpacing spectacular runs of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) 250% and 270% respectively.

The last month it seemed the worse the company, the better the shares did. These companies are on the hook for hundreds of billions of dollars in bailout money. They’re essentially worthless, but the market didn’t seem to care.

But if we take a step back, we can see how one person’s “insanity” actually makes a lot of sense. All of the recent market action does make sense if you look at what’s going on in the markets. More importantly, the run in these “garbage stocks” signals a very, very big opportunity is just around the corner.

Unprecedented Action, Unprecedented Results

Over the past year we’ve witnessed unprecedented intervention in the markets and economy.

In the economy, Congress passed the $787 billion stimulus package. It was filled with programs like Cash for Clunkers to spark consumer demand. Congress also passed the Troubled Asset Relief Program (TARP) to purchase bad loans from banks at above market values. At least that’s what they told us. Here we are a year later and TARP hasn’t bought any troubled assets and has essentially turned into a 12-figure slush fund for bailouts of all sorts of favored parties.

In the markets, the Fed has taken moves which were unthinkable a few years ago and the Fed Chairman himself considered “inappropriate” before last fall. The Fed has openly acknowledged its monetizing government debt, buying hundreds of billions of dollars of mortgages directly from banks and other mortgage industry players, and guaranteeing trillions in private sector obligations.

Basically, the Fed printed anywhere between $4 and $10 trillion in new money and back-stopped trillions more to get banks lending freely.

All that money has to go somewhere…

Money for Nothing

So far that money has been making it into all sorts of places.

Some of the money has made it into the real economy. ISM Manufacturing Index reading of 52.9 reveals manufacturing activity is increasing. The index shows expansion above 50 and contraction below 50. Monday’s increase was the first in 19 months.

It doesn’t stop there. The American Trucking Association recently reported its For-Hire Trucking Tonnage Index increased 2.1% in July. And last week the American Association of Railroads reported carloadings are at their highest level since March.

This all isn’t necessarily great, recovery imminent-type of news, but it does show some of the money is making it into the real economy.

A big chunk of the money went directly to banks to offset mortgage losses and to help restart the national mortgage lending machine. Once you combine that with the expiration date on the $8,000 housing tax credit, just a few months away, and you’ve got the makings of the sharp rebound in housing demand. In June new home sales increased 11%. Add in the limited number of housing starts during the recession and the number of new homes on the market dropped to its lowest point in 11 years.

Finally, a big chunk of the money has made its way into financial assets. Case in point is the $185 billion in new assets pumped into mutual funds in the past four months. That has helped spark a rally in everything. Stocks, bonds, oil futures…it’s going everywhere.

Short-Term Fuzzies and Long-Term Worries

In the end, the Fed has proven that it is willing to print its way over every short-term problem with near-complete disregard for the long-term costs.

And now the market is getting ready for it. The impact of high inflation will make the price of everything higher. The price of oil, gasoline, food…everything everyone wants or needs will steadily increase. One of the big benefactors of high inflation will be house prices. Houses will be worth more in dollar terms. Much fewer homeowners will have “underwater” mortgages. And, as an explanation to the “market insanity,” all of those loans made or guaranteed by the banks and AIG, Fannie Mae, and Freddie Mac will have a much better chance of getting paid back.

The way I see it, we’re right on track. Almost four months ago I explained to Prudent Investing readers:

Over the next year, the government spending and inflation will help keep corporate earnings up. Unemployment will begin to level off. We’ll even see GDP growth in at least one quarter.

The inflationary effects of the Fed’s money printing combined with the deflationary effects of slower money velocity will keep official inflation numbers at a standstill. Just today, the latest inflation numbers for April were flat.

But the hidden inflation, which is merely offsetting the increase in savings, has a great shot at making the GDP uptick in the second or third quarter.

Add to that some encouraging signs from the much more nimble emerging markets and you have the recipe for S&P 1,000 to 1,100.

It will all end though. At some point, probably in 2010 or 2011, the real economic problems will start to show through. The demographics of the U.S. and many other countries, the impact of new tax policies, impact of cap-and-trade carbon trading scheme, and the second wave of mortgage defaults will bring a quick end to the party.

Now, I was probably a bit aggressive in trying to nail down exactly when the party will end, but so far everything we expected is right on track. The major bubble has burst. The new Fed-inflated micro-bubble is inflating.

Right now, we’re in the short-term, warm and fuzzy period. Hope is strong. Everything seems to be going OK – for the most part. And it’s showing signs of slowly getting better. Those will be proven to be short-term fuzzies which will, in time, be outweighed by the long-term worries.

You Will Lose Money and That’s OK

The strategy I have for the current market is simple. I’m going to continue to buy the dips (it looks like one may have started a few days ago). The market has proven to be very resilient. And with trillions of dollars still floating around, it could be resilient for a long-time to come.

Now, the important thing is I’m using smaller trailing stop-losses. I can tell you right now, when this party is over, I’m going to get dinged for 15% in most positions. It’s not going to feel good. But I’m prepared and it’s part of my plan. There’s basically no way around it.

But as long as you can get 20% ahead in what easily could turn out to be an unprecedented stock market rally fueled by unprecedented government and Fed intervention, you’ll still be well in the green.

It’s strategies like that, which put the odds in your favor and leave you safely prepared for whichever way the markets go. And you will not have to worry about too much “market insanity” and will be a much better and more successful investor.

By Andrew Mickey

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