Stock Market: It’s Time for a Reality Check

We’re on the verge of something big here.

What we’re on the verge of may surprise you.

We’ve been waiting for the economy to show signs of life for a while now. We expected this to happen before the year was out. There were just too many catalysts for a short-term economic rebound.

The amount of direct government spending was going to help out. The direct stimulus spending may be slow, but there has been a lot more spending from other sources. For instance, the $700 billion TARP bailout didn’t disappear into thin air. A lot of it went straight into reserves to offset losses, but a lot of it was simply cash handed over to banks, automakers, and AIG.

Then there were plenty of indirect incentives to get spending going again too. The Cash for Clunkers program has been having an impact on auto sales. Tax breaks for real estate have helped get volume back into the real estate market. And its volume that matters most over the short-term. Prices may go up and down, but its transactions and the accompanying fees which are good for real estate agents, mortgage brokers, banks, and every other part of the real estate-dependent economy.

Finally, the Fed’s quantitative easing can’t hurt either (we’re talking short-term here). Its’ purchases of all kinds of debt have helped keep interest rates low and pumped hundreds of billions of dollars directly into the system.

Although none of these are a solution to the needed – and perfectly natural – economic restructuring, they will mask all the problems. As we’ve seen throughout history, they mask the problems just long enough to sucker the herd back into the markets.

So we’re right on schedule. Actually, we’re probably ahead of it. But with the S&P 500 up 10% in two weeks, it’s time for a reality check. Because when we take a step back we can see how much this rally can continue to run, what will put a halt to it, and how to position ourselves for safety and profit.

Sounding the All Clear

Back when the mainstream media was lambasting the “green shoots” crowd, we surmised record levels of money printing, tax cuts, and government spending would propel GDP growth before this year is over.

We noted the one indicator to keep a close eye on for when it will come grinding to a halt. That is when governments, economists, and the mainstream media start claiming the recession is over.

Over the past few weeks there have been more than a few “all clear” signals sent out.

Yesterday, Canada’s central bank said the recession is over.

Bank of America Merrill Lynch (that’s the official name of the firm which clearly was on the wrong side of the housing bubble) was getting in on the action too when it proudly proclaimed the recession is over this week.

The mainstream media, not to be left out of the trend, jumped on too. A Wall Street Journal headline today declared, “The Economy Has Hit Bottom.”

Brian Wesbury, chief economist at First Trust Advisors, is probably most aggressive when he said, “I don’t think it would be surprising to see [Dow] 12,000 six months to a year out…I think that over a couple of years you’ll see 15,000 on the Dow.”

It’s amazing what a string of up days in the markets will do to otherwise rational people, right?

One of the big drivers of all this excitement is not what it seems though. China, the economic miracle most folks hope is able to pull the rest of the world out of the recession, has been attracting a lot of attention recently thanks to its “success” during the downturn.

Take It Or…Take It: China’s Bubbly Solution

China stocks have been on a tear this year. Many are heralding the rebirth of the China boom. On the surface, it looks like they’re right too. China’s official GDP growth was 7.9% last quarter and they’ve been aggressively buying up oil and other commodities.

Once you delve a bit deeper though, a much different picture starts to appear.

Last December China’s government set a goal for its banks to loan 5 trillion yuan ($735 billion). It didn’t really matter to whom the money was lent, China just wanted the money out there. They didn’t want to risk a deflationary spiral.

So here we are eight months later and China’s banks have performed “spectacularly” well. They originated 7.37 trillion in new loans ($1.08 trillion). That’s more than 25% of China’s GDP!

Just imagine if U.S. banks made $4 trillion (a little more than 25% of GDP) in new loans in eight months? There wouldn’t be enough decent businesses to invest in. The loans would be made to people who have no shot at paying them back. And we’ve already saw how that system works.

Well, that’s exactly what is happening in China. The country has taken the loans and is putting them to work. Since it already has too much production capacity, the easiest place to earn a decent return is in stocks. And the Chinese have moved back into stocks in droves. Last week more than 500,000 new brokerage accounts were opened.

Wu Xiaoling, former People’s Bank of China vice governor, summed the eventual implications of the lending boom best when she said, “Under conditions of overcapacity, excess money supply will not lead to rises in price indexes, but it could generate asset bubbles.”

This is not a solution. It’s merely a Band-Aid. And it will be looked back on how you create a lending bubble in short-order. There’s no way it can last. But hey, this is Wall Street and anything beyond next week is too long term. But if we look beyond a week or two, we can see the reality behind the headlines.

Stage 3 of a Bear Market Rally

We can’t forget we’re still in a bear market. Sure, the rally has been a strong one. The markets are going higher and there’s no news bad enough to stop the rise. But all signs point to this being the third and final stage of a bear market rally.

If you recall, Stage 3 of a bear market rally is when we see potential panic buying. As we stated back in early April in when will this rally end:

Panic buying is the inverse of panic selling. Panicked sellers dump stocks at any price because they think they’re all going much lower. Panic buying, on the other hand, is when investors rush back in because they’re afraid they’ll miss the rest of the rally (the dot-com bubble is the perfect example of this). If that starts, watch out. Dow 10,000 or 11,000 – followed by a sharp downturn – will shortly follow.

We’re on the verge of panic buying right now.

The Investment Company Institute reports more than $6.6 billion of new money flowed into long-term stock and bond funds last week. That’s more than double $3.15 billion from the previous week.

It is clear individual and professional investors are getting concerned about they’ll “never be able to get in.”

Knowing how bear market rallies act, I wouldn’t be so sure of that.

The Next Reality Check

This recession may technically be over. China, on the surface, appears to have reignited the great growth engine of the world. Millions of investors have embraced a, “Buy stocks now because there will be no opportunity later” mentality.

It’s great – over the short-term. But the stock market always reverts back to reality. That’s why, despite the recent rally, I encourage investors to look at the “reality checks” coming up.

In the short-term, we have the monthly employment numbers set to be released in two weeks. Over the past few months these numbers have driven everything. There’s no relief in sight for the unemployment situation. And I’m sure today’s minimum wage increase won’t help at all. Sure, the government will argue this will increase spending because minimum wage workers will have more income. But if that were true, why not raise the minimum wage to $50 an hour and end the recession once and for all?

Over the medium term, there’s another giant speed bump. One that no one is talking about yet. That’s the expiration of the 15% long-term capital gains tax and the low dividend tax rates. This is an automatic tax increase which will reduce the value proposition for investing in stocks.

In the end, the short-term euphoria is nice – volatility helps create opportunity. And, quite frankly, it’s not something to bet against yet. But if you look at what’s really driving the markets and the roadblocks ahead, you’ll be able to avoid the herd mentality and invest much more successfully in the years ahead.

By Andrew Mickey

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