Dow Jones Industrial Average: Are Investors Completely Delusional?

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October 16, 2013 10:51am NYSE:DIA NYSE:SPY

bearbull21Bill Hall:  I warned in last week’s column that the Dow Jones Industrial Average (INDEXDJX:.DJI) and markets are nearing a top and recommended that investors prepare for an unraveling of the financial markets.

U.S. stocks have gained 23 percent this year, propped up mainly by the perception that the Federal Reserve’s $3 trillion-plus quantitative-easing program is boosting the economy.

To be blunt, many investors just don’t get it. They trust that the central bank will prevent stocks from falling. That’s what appears to have happened over the past five years. But the truth is that the Fed is causing a stock-market bubble.

What’s the disconnect here?

Collective belief can create its own reality, and the collective belief here is that the Fed’s actions are making stocks rise. The problem is that there’s no link between the size of the monetary base created by the Fed to stock prices. In fact, QE has been ineffective because of the lack of velocity and a declining money multiplier.

The impact of QE on investors has been quite real, even if it will ultimately be futile and destructive.
The impact of QE on investors has been quite real, even if it will ultimately be futile and destructive.

QE has really been just a confidence game. It’s not based on any financial principle other than to make investors uncomfortable storing cash in Treasury bills, CDs and money-market accounts. In fact, QE has no theoretically valid or empirically supported transmission mechanism to the real economy at all.

What’s surprising to me is that so many supposedly sophisticated investors have placed their confidence and risked their clients’ financial security on what is the economic equivalent of a cheap parlor trick.

Along with fund manager John Hussman, I believe that much of the impact of QE is based on superstition — the result of investors misattributing the 2009 market rebound to monetary policy. It’s certainly true that replacing $3.6 trillion of interest-bearing securities with zero-interest cash encourages everyday investors to reach for yield and hedge fund managers to speculate in riskier securities. But that’s not what ended the crisis.

As an experienced financial analyst and CPA, my extensive research shows that the risk of widespread financial-system insolvency ended in early 2009 when the Financial Accounting Standards Board relieved banks of any need for balance-sheet transparency and abandoned mark-to-market accounting, not because of the Fed’s easy money policies.

Of course, it seems more heroic to attribute the recovery to a courageous Fed chairman and bold monetary policy rather than to congratulate a handful of accountants who caved into Congressional pressure and instituted a bookkeeping gimmick that, in effect, moved the U.S. banking system close to a Ponzi scheme.

For investors, the perceived impact of QE has been quite real, even if it will ultimately be futile and destructive.

Observing how the Fed is loved when stocks are rising and hated when they’re falling, financial market historian Robert Prechter aptly notes: “The Fed’s brilliance does not determine the market; the social mood behind the market determines the Fed’s brilliance.”

Fund manager Seth Klarman recently observed: “The government’s effort to pump stocks higher is expensive and distortive. And if the impact will only be ephemeral, if what goes up is certain to come back down, then the consequence is bound to be increased volatility, more financial catastrophe, and possibly an endless cycle of propping up followed by collapse.  … ”

And John Mauldin, a financial analyst, says the Federal Reserve’s trickle-down policy — giving money to the strong and healthy in order to support everyone else — doesn’t work. “The kindred policy of trickle-down economics was thoroughly trashed by the same people who now support a trickle-down monetary policy and quantitative easing,” he says.

QE is a concept that is mostly played out, especially with a likely tapering ahead. It’s important to recognize that the shift toward tapering, or the reduction in the stimulus program, is not driven by substantial economic improvement or victory of the policy, but rather by an increasing recognition within the Fed itself that its actions are creating dangerous financial distortions and asset pricing bubbles.

That being said, I believe stocks may climb further because of the Fed’s decision to delay tapering, a breakthrough in the debt-ceiling negotiations or a new policy announcement by incoming Fed Chairman Janet Yellen. But keep in mind that these are allusions. A day of reckoning lies ahead, and it’s time to begin preparing now.

Next week, I’ll tell you why investors who blindly accept Wall Street’s never-ending pitch that “stocks are cheap” are the sitting ducks of the investment world. I’ll also tell you what you can do to protect your portfolio.

bill hallThis article is brought to you courtesy of Bill Hall

Money and Markets is a free daily investment newsletter published by Weiss Research, Inc. This publication does not provide individual, customized investment or trading advice. All information is based upon data whose accuracy is deemed reliable, but not guaranteed. Performance returns cited are derived from our best estimates, but hypothetical as we do not track actual prices of customer purchases and sales. We cannot guarantee the accuracy of third party advertisements or sponsors, and these ads do not necessarily express the viewpoints of Money and Markets or its editors.

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