In early 2010 as the stock market rally was approaching a year old, the concern became rising rates.  At that time, I argued that perhaps interest rates would stay lower longer than most thought.  Although the economy was starting to grow again, it wasn’t growing at such a fast clip that rates would go up.  In addition, investors were so scared from two bear markets in just ten years that treasuries would have a bid underneath them for some time (investors would continue to buy bonds) keeping interest rates low.  Lastly, there was evidence (and there still is) that for every $1 the Fed creates in stimulus, there is a negative multiplier effect and only $.86 is actually going into the economy.

Since the spring, not only have rates not gone up, they’ve fallen even more.  Interest rates on 10-year treasuries have fallen from 4% to under 3% pushing bond prices up.    Is there another bubble about to pop?  Many of you think so.  I think so.  I just think there are a lot of people who may have the timing wrong.  Bubbles can get bigger and last longer than we originally think.  But, eventually, they do pop.  So, just how expensive are treasury bonds?

Below is a picture of the “P/E ratio” on 10-year treasuries.  Assuming the interest you receive on treasuries are your earnings, the P/E ratio on treasuries is currently 35.  In comparison, the P/E ratio on the S&P 500 currently is around 15.

The picture above I created shows the “P/E ratio” on bonds from 1962 to present.  In 1982, bonds were very cheap as were stocks at that time.  Now, bonds are very expensive while stocks I think are not.  This is one main reason why stocks can rally further.  It’s not that stocks are dirt cheap.  But, asset allocators and managers out there are comparing bonds versus stocks using the above metric to determine where there is value.

I’m not calling for an immediate rise in rates but you better have a plan for when they do start to rise whether it’s selling treasuries short or some other tool.  It will happen eventually.

This morning GDP QOQ (Annualized) was released at 2.4% vs. the estimate of 2.6%.  At first glance, you think uh oh.  Then, there was the revision to last month’s number.  It was a big revision UP.  You put it all together, and it shows a economy that slowed down very fast last month.  As you know, I watch this number carefully because it correlates so well with the S&P 500.  (Below is the picture including today’s data).

As you can see, really what we need right now is some stabilization.  I believe that if the economic data that continues to be released over the next few months is mediocre, the stock market can rally further.  What the market has been reacting to over the past 3 months has been the sharp drop in all the leading economic indicators.  Some stabilization in the Europe & the U.S. combined with continued growth in the emerging markets could be just what the bulls want.

The market was off to a reasonable start this morning after great earnings by Apple last night. But, for most of the day, the major indices were basically flat. Then, Ben Bernanke began to speak to Congress giving his semiannual monetary policy report. The more he spoke, the more equity prices fell. I immediately flashed back two years ago when I used to see some politician on television and down we’d go. I’d look on my Bloomberg machine and see that a speech was scheduled later in the day and you’d watch the put options. The speech would start, the market would fall, and S&P 500 put options would fly. Maybe that trade is back on. It sure was today.

I was able to listen to most of the speech and watch the reaction tick by tick in the markets. And what I heard was Ben Bernanke (who I do like) give ALL his various options if the economy gets worse. This wasn’t in his statement but rather in response to a question. Remember, the complaint has been that the Fed is out of bullets. “Helicopter Ben” confidently said there are plenty of tools in his belt. First, he said he can change the language to let people know that the Fed will be more accommodating for a longer period of time. This will give the market more confidence that higher rates aren’t in the cards. Second, he said he could lower interest rates. Third, he said he could buy more bonds to keep rates down and inject more into the system.

Let’s analyze each of these options. First, he can change the language. So, basically that means do nothing. It’s jawboning and cheerleading with no real action. Second, he said he can lower interest rates. ALL the way down from .25% to 0%. Really? Remember when the Fed had rates at 5% or 6% back in the day? We would all wait to see if they were going to drop rates by .5% or .75%. Now, does he really think dropping rates from .25% (basically nothing) to 0% (literally nothing) will do any good? Last, he talked about buying bonds. That’s legitimate and certainly gives us a green light to buy more bonds. But, these different tools don’t sound like tools to me. They sound like the Fed is running out of bullets. I first thought to myself no wonder the stock market is falling. But, then I thought wait a second. This is the problem. We’re still relying on the government to fix everything. Hasn’t the Fed done enough? They’ve done their job. They’re finished. They’ve injected more capital in the last two years than we’ve ever seen. They’ve lowered rates to practically nothing to encourage activity. They’ve purchased bonds to keep rates low for longer than we had originally anticipated. And, they purchased all the “junk” that bank couldn’t sell. What more should we want? But, we saw the market sell off because the Fed wasn’t giving us any new information and inventing any new tools they could whip out of their belt that would surprise us and get the economy back on track any faster.

All those smug politicians asking questions to Ben Bernanke as if they have a clue about finance always cracks me up. I wish he would have asked them “What are you guys (& gals) going to do to get the economy back on track?” How about lowering taxes to stimulate small business growth which in turn creates jobs? But, no. What I saw was Congress cutting Ben Bernanke off in mid sentence so they could look smart and act like bullies.

This evening, I heard a politician say in an interview the Fed has a lot of options because they have so much on reserve. However, it’s not about the reserves. That’s like buying a stock because the company has a lot of cash. When a company has a lot of cash, that’s great but it’s what they do with that cash that’s important. We’re relying on the management to earn a return on that cash, not just sit on it. If the Fed has reserves, that doesn’t help anybody.

Again, I’ll reiterate. The Fed has done their job and it’s time for Congress & the President to step up to the plate and figure out how to grow our economy. All I see right now is other countries growing and the U.S. is about to embark on massive tax hikes which will drive capital offshore to these faster growing countries. America has a tremendous opportunity in front of it. We can capitalize on emerging market growth if we choose helping those unemployed find work and grow our economy. Instead, I think we’re wasting that opportunity.
Today’s drop wasn’t Ben Bernanke. It was a reminder that the Fed isn’t going to really do anything else. It’s up to someone else to take over. Ultimately, that’s not good in the long run.

For well over a year now, the economy’s been recovering, the stock market’s been recovering, confidence has been rising, and the perception of risk in the stock market has been dropping at a rapid rate.  Just look at the VIX (the volatility index), or the price paid for options.  It’s dropped over 80% since the fall of 2008.  Money’s begun flowing back into the stock market.  If you’re in cash, you’re an idiot (not really but that’s how they want you to feel).  The pressure to own stocks has been extremely high.

A couple of weeks ago, Goldman Sachs (GS) got hit with a lawsuit from the SEC.  The market fell but bounced right back up like a championship fighter getting a cut and shaking it off.  But, the combination of Goldman Sachs testifying and getting grilled by Congress, Ben Bernanke saying our deficits could mean higher taxes, interest rates, & lower benefits, and Greece & Portugal’s debt being downgraded was too much.  The Dow Jones was down over 200 points (the biggest point drop since January) and volatility index spiked up over 30% on Tuesday.  It was like the market had been in a trance and someone snapped their fingers in front of its eyes.  Oh yeah, stocks do have risk.  They can go down.  It’s amazing how sentiment can change so fast.  The world felt like it was ending on Tuesday.  It’s not ending but we could have a meaningful correction.  After all, there hasn’t been a 10% correction in the indices since the rally started in March of 2009.  Is this normal?  Partially.

After a major collapse and recession like we had in 2008, it’s common for the Federal Reserve to pump money in the system and “put America back to work”.  With that comes a rebound not only in the economy but the stock market.  We’ve had plenty of rebounds over the last 100 years.    This one isn’t necessarily longer than most (over one year now) but the trajectory of the recovery has been amazing.  The persistent buying has been rather remarkable.  It’s akin to the late 1990s bull market.  Stocks aren’t necessarily as expensive as they were then, but I don’t think they’re dirt cheap either.  In fact, when looking at how expensive stocks are measured by the P/E ratio of the S&P 500, investors are still paying less and less for stocks.  This is a common trend where investors will continually pay up for stocks for several years and that is followed by several years of investors wanting a better deal.  Instead of looking at the P/E ratio on a daily basis, below is a 10-year moving average of the P/E ratio on the S&P.  Before you send me e-mails about how P/E ratios don’t really matter.  I’ll agree that it’s not the end all be all of valuating a company or the stock market.  But, it’s one metric and its part of the overall equation.

You’ll notice that investors had a big headwind during the 1970s because while stocks went up and down, the P/E ratio continually pushed lower making it difficult to buy and hold stocks and see them appreciate.  The 1980s and 1990s were just the opposite.  Not only were corporate profits rising, but investors were more willing to assume risk and pay more for those profits.  However, after peaking around 23 or so in 2002, the 10-year moving average P/E ratio on the S&P 500 has been falling and is now down to 19.  It would not surprise me if this continues to fall over the next several years based on history.

The point of showing you this is not to assume you won’t make money in stocks but to show you how valuations do matter over a long period of time and it’s like a freight train.  Once it starts moving in one direction, it’s hard to slow it down.  Combine that with higher tax rates and potentially higher interest rates, and it could be an interesting decade for stocks.  One that begs we pay attention and don’t assume.  Those are the longer term challenges.

Getting back to the current market action, the lack of a correction doesn’t guarantee one.  I’ve heard the argument for lack of volume for over 12 months.  I’ve heard the argument that it’s been XX days since a correction, therefore we have to have one.  Does it feel like we’re due for one?  Sure.  In fact, it seems like everyone is now agreeing on the same story.  The economy’s recovering, we’re due for a correction, and once we have that minor correction, we’re off to the races again.  Heck, I agree with that, which is where the contrarian in me comes out.  Everybody agreeing with each other does concern me.  However, instead of getting into the psychological games with myself, I’ll rely on the same several indicators that have helped me make money during this run.  I can still see that there is more demand for stocks and less supply overall.  That points to higher prices over the medium term.  If you’re holding some cash, continue to average in which I’ve been advocate of for several weeks.  If you’re 100% invested, cull out weak stocks and sectors and take profits on specific positions.  We are still overbought in the very short-term and I certainly don’t have a problem with those wanting to short for hedging purposes or a trade, but I think hanging on to shorts too long might be a losing battle.

Click here to listen to Through A Trader’s Eyes Podcast #15 – March 23, 2010

Click here to listen to Through A Trader’s Eyes Podcast #11 – February 23, 2010

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Late Thursday, the Federal Reserve announced they had the raised the discount rate to .75% from .50%.  The discount rate is a rate that the Fed charges banks that borrow directly from the Fed.  Basically, an emergency loan if need be.  You can see from the chart below going back to 2003, the discount rate has been flat or dropping since the middle of 2006.

The question of the day:  Is the Fed changing its easy monetary policy?  They (the Fed) claim they are not.  They still expect to keep the financial system loose and rates low for an extended period of time.  This is a significant move but at the end of the day, I don’t think it will have a big negative effect on stocks.  For all of you worried about “printing too much money” and inflation, this is the first step in trying (key word trying) to remove some of that extra stimulus. But, I don’t think its the end of an era of easy money.  It’s going to take a lot more than a .25% hike in the discount rate to end an era of easy money & over leverage.  But, it’s a start.

The trade here remains to be long the dollar.  For full disclosure, I remain long UUP calls.

Everyday, I receive some comment either in an e-mail, a comment on this blog, or a comment on my radio show regarding future inflation.  When will it come?  What will it look like?  Why hasn’t it started already?

The Fed has injected more money in the system (along with other governments) than we’ve ever seen.  The monetary base (basically the amount of money in the system) which goes up about 6% per year has risen over 130% in just the last 12 months.  TIPS have risen in price.  Gold has risen dramatically this year.  Other commodities have followed suit.  So, why is everyone still worried about deflation?  I think it’s interest rates.  Interest rates have stayed low for some time while all of these other inflationary indicators have been rising.  They have been artificially held down by the Fed through their bond purchasing program.  Remember, when bonds are purchased, rates go down.  When bonds are sold, rates rise.  The Fed is slowing down their purchasing of all different types of bonds from treasuries to mortgage bonds.  In addition, they’ve started testing reverse repos to remove some of the liquidity.  We’ve seen rates begin to slowly rise.

On Tuesday, there were several pieces of economic data released.  the Producer Price Index was much higher than anticipated.  We knew these numbers would be high because they are being compared to an abnormally low number last year at this time.  But, they were even much higher than the estimates.  This caused rates to move up even more.

You can see above that we’ve broken the downtrend that had been in place since early summer.  This may be the beginning of rates rising at a faster pace.  Once this starts, I believe it’ll be like a freight train.  It’s going to be very hard to stop.  This is the time to look in the portfolio and see how much is in interest rate sensitive securities.  This could not only put a damper on bond prices but equity prices as well.

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Two weeks ago, investors were worried about the removal of stimulus (i.e. Australia, Norway, & India), rising U.S. rates, and a strengthening dollar.  On Monday, investors woke up to news that the IMF was quoted as saying the dollar was still overvalued, G20 finance ministers were saying they were committed to more stimulus, and the dollar was weakening.  In fact, all that talk about the dollar strengthening, the call buying, buying in the ETF UUP (bullish dollar ETF) all went away Monday.  In fact, you can see that as I mentioned in my video newsletter, unless the dollar index breaks above the 50-day moving average, there was nothing to worry about.  Well, it failed at the 50-day moving average once again last week and is headed down further.

Weak dollar, more stimulus, and low interest rates.  This is the recipe for owning pretty much anything.  Risk assets moved up once again.  Commodities, stocks, materials, emerging markets, U.S. stocks, etc. all moved up.  We may be entering the more selective phase in the rally where not everything goes up but if this reflation recipe is still being served, the coast is clear.  But, let’s watch for underlying weakness even though the indices are moving higher.
That’ll be a sign that this rally is getting tired.

I got back yesterday from a 5-day vacation to Colorado.  What a beautiful state.  Still can’t believe that I can leave the door completely open with no screen and enjoy the breeze with no bugs and no humidity to interrupt dinner.  It was nice for once to take a vacation and not really worry about the market.  I arrived in Colorado Springs on Thursday evening.  I was on the golf course early Friday morning and I tried my hardest to not look at the market.  Even though I wasn’t worried about it, I had to still check it.  Technology got the best of me.  I had my Bloomberg machine on my phone right there on the golf course.  Between horrible shots, I checked my phone only to see the market moving higher.  I was sitting there on hole #2 when I read that Ben Bernanke said “economic activity appears to be leveling out, both in the United States and abroad.”   He also said “prospects for a return to growth in the near term appear good”.  I had to laugh.  I’m glad he’s finally acknowledging what I’ve been writing about and talking about on my radio show for a few months.    The economy is getting better and the stock market is reflecting that.  That’s why we continue to rise.  Persistent buying.  This is the complete opposite of the fall of 2008 sell off where every day there was persistent selling because investors wanted to reduce risk.  Now, they are assuming more risk.

Remember last Monday when it looked as if the market was going to roll over?  We opened down 2%.  China was weaker, consumer confidence was weaker.   But, that bad day was followed by 5 straight days of gains.  I’ve been preaching for a few weeks that we need to give stocks more room to move.  In other words, put up with more volatility.  Last Monday was a perfect example.  A few months ago, I wrote about the bully in school that would flinch.  When he flinched, you’d better duck because one of those times, he might just take a swing at you.  That was then and this is now.  Now, I’d say when he flinches, don’t move.  The summer has come and gone and now you’re bigger and stronger.  He might hit you but it’s not going to hurt.  When he flinches, relax.  I’m suggesting moving out your time frame a little bit.  If you’re looking a osicllators to trade from, use a larger number.  If you’re using stop losses (which I’m not), use a longer moving average.  This would have saved you from selling last week and having to buy back in at higher prices or better yet sitting out right now while the market moves higher.

Given the economic backdrop, I still believe we have another 15-20% left in the averages over the next few months.  I’m not sure it’ll be in a straight line or not.  In fact, I’m starting to see some negative divergences building for the first time in a while. You can see below, I’ve got a picture of the S&P 500 (SPY).  On top of the price, I’ve got the RSI indicator.  It’s been going down while the price of SPY has been making new highs.  This is a negative divergence.  Just one, but it’s something to watch.

Now, this isn’t the first red flag we’ve had since March.  There have been others.  In fact, I have people telling about Elliott Wave patterns and that we’re at a critical level.  I’m not dismissing all the technicals.  But, using anything other than the economic improvement in the past few months hasn’t been as profitable as plain old fundamentals.  There are a ton of traders that are either short or not invested right now.  They’re frustrated and confused.  As I’ve said before, that means there’s plenty of cash on the sidelines ready to come in.  It’s the ammunition to move us higher.

I’m watching these technical divergences just like I always have but as long as the internals remain strong and the economy continues to improve, I’m slowing down my day to day trading and focusing on the medium term (the next few months).  That doesn’t mean I won’t hedge from time to time if I really think we’ll have a reasonable correction similar to the June correction.  But, for the most part, I’m still playing it from the long side.

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