The Stock Market Conundrum

"Don't be afraid of a little opposition. Remember that the "Kite" of Success generally rises against the wind of adversity - not with it." - Napoleon Hill

The stock market is causing many investors a conundrum as to whether to jump on the band wagon and potentially get beaten up in a draw down or whether to take the pain of watching "everyone else" make money while they sit on the sideline.  It is one of the hardest lessons to learn and even seasoned traders can get sucked into the market at just the wrong time.

With the market on a one way ticket to infinity it is hard to sit on the sidelines but honestly I believe that is your best alternative.  Let's start at the top with JP Morgan.  This week's article reiterated their full year projection for the S&P 500 of 1,430.  Currently the index stands at around 1,370 so for the rest of the year JP Morgan estimates that the market will rise another 4.40%.  Hardly something to get excited about, particularly if you consider all the risks of getting that return especially when you know where to go to get a guaranteed 4% return.

Another article I read this week pointed to the rapid price increase in high yield debt, or junk debt.  The investment banks are buying billions of dollars worth of this junk pushing the prices up and the yields down.  One banker was quoted as saying that after considering the risk that a 7% return on these investments was warranted.  It was not long ago that this debt was yielding north of 30%!  This is a big side effect of cheap money and low interest rates.  More and more money is starting to be attracted to high risk investments in search of yield.  The price of these assets is soaring, increasing the risk further.  It appears that we are starting to enter a new bubble that is once again being created by cheap money and this is worrisome.

The stock market is a huge benefactor of cheap money.  Margin borrowing costs drop spurring additional investment.  The risk trade is put on and this drives valuations higher.  Certainly a lot of the expansion of stock prices is based on the assumption that cheap money leads to increased company profits but this argument is starting to lose steam as the market has had the benefit of low interest rates for the past three years.

Another benefactor of cheap money are commodities.  In addition to this oil supply contractions and disruptions have caused the price of oil to spike.  This in turn has pushed the price at the pump up at an alarming rate.  Here in Southern California the cost is rapidly approaching $5 a gallon and this will start to severely crimp consumer spending on discretionary items like entertainment and travel.  It will also start to negatively impact profits at airline and transportation companies.  Weakness in the transporters and materials have pointed to at least a 5% stock market contraction however based on the poor economic fundamentals I would not be surprised to see a larger contraction.

There is some good news to offset all of this poor news and that is the job market continues to pick up steam.  There is plenty of evidence to show that the numbers published by the government are not capturing a large portion of unemployed workers who have given up finding a job.  Furthermore the employment number stands at 63% of the population which is a historic low number, but there does seem to be an improvement here.  Furthermore this should allow the Federal Reserve to keep interest rates at their historic low for the foreseeable future as the inflation number tracked by them does not include oil and food prices.  Therefore the excess capacity of workers will keep wages down for now and that will allow the Fed to continue to stick its head in the sand and pretend that inflation does not exist.

All of this said I would not be a buyer of the market here as I feel that we have come too far too fast on the back of a lot of speculation and little in the way of tangible economic successes.  Furthermore the drag on the economy of the massive government debt levels will continue to be felt for years to come so GDP growth does not justify the recent stock market successes.  With 4% of upside and the possibility of a large downside I believe that your best option is to move to the sidelines once again and wait to see what happens.