Bubble Busters

“I had a stick of CareFree gum, but it didn’t work. I felt pretty good while I was blowing that bubble, but as soon as the gum lost its flavor, I was back to pondering my mortality.”                                                                                                                                                                             Mitch Hedberg

When the news about U.S. markets and the U.S. economy is depressing, I usually read about Europe and feel better about the U.S.

I spent a lot of time reading about Europe this week, but it didn’t do much good – even with Greece continuing to defy logic by pretending that it’s OK to live off of someone else’s money.

The problem is that easy money policy is not so easy anymore.  It never did prop up the U.S. economy, in spite of Keynesian enthusiasm, but at least it created the illusion of economic health by propping up the stock market.  Now, it’s unable to do even that. burst-your-bubble

U.S. markets fell throughout the week, but especially on Wednesday, which saw declines of more than 2% in the Nasdaq and Russell 2000. The Dow dropped nearly 300 points, or 1.6%, while the S&P 500 finished the day about 1.5% lower.  The New York composite stock exchange is now back to where it was last July and the S&P 500 is approaching November levels.

And there’s likely to be more trouble ahead, as a 4% drop in the biotech and semiconductor sectors showed a “classic parabolic reversal,” according to Peter Boockvar, chief market analyst at the Lindsey Group.  A parabolic reversal is a technical indicator that signals a change in an asset’s momentum.

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The Markets Need Psychotherapy

“The whole idea that the stock market reflects fundamentals is, I think, wrong.  It really reflects psychology.  The aggregate stock market reflects psychology more than fundamentals.”

Robert Shiller, Nobel Prize-winning economist

Tired of low returns?  You may be a bond investor.

Bond investors have been “growing tired of low returns, the endless warnings that rates are about to rise, and constant reminders of the dangers of riskier bonds,” according to Jeffrey Matthias, CFA, CIPM of Madison Investment Advisors.

At the same time, they’ve watched the stock market continue to break new records every time there’s another sign that a central bank somewhere may buy a few bonds or lower interest rates into negative territory.

“None of us have ever lived through this kind of extreme, long-lasting suppressed rate environment,” Matthias wrote, and, as a result, those bond investors who are mad-as-hell-and-are-not-going-to-take-it-anymore have been frustrated enough to take on a lot more risk for a little more yield. Central Bank Assets

When you chase yield, you catch risk.  It’s a dangerous reaction to the yin and yang of investing – fear and greed.

“Typically, when markets are moving higher,” Matthias wrote, “most investors turn greedy and want more.  Should an investor’s more conservatively positioned portfolio produce lower returns when the market surges, the investor may regret not having taken more risk.  In contrast, should a riskier portfolio drop significantly in market value, the opposite may happen and an investor may begin to regret (his or her) decision to have invested in risker assets.  This can be accompanied by a fearful overreaction.”

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No Records This Month

Markets go up and markets go down, so maybe it’s not surprising that January’s stock market performance has less exuberance to it than the performance to which we’ve become accustomed.

As of yesterday’s market close, the S&P 500 was down 0.13% year to date, which is not a big deal, especially considering that the S&P 500 Index finished 2013 up 32.4%.  Even with the recent downward trend, the S&P 500 is up 25.35% for the past 12-month period.

The Dow Jones Industrial Average has been a bit creakier, down 0.96% year to date, but still up 21.51% for the past year.

It’s doubtful, then, that the markets will break any records this month.  But if you believe the hype, good things are headed our way.  The unemployment rate has slimmed down to 6.7%, gross domestic product (GDP) was revised upward to 3.6% for the third quarter of 2013 and, with Janet Yellen’s appointment to head the Federal Reserve Board, quantitative easing can continue ad nausem.

So why worry?

To begin with, as we explained last week, the falling unemployment rate is an illusion.  The rate dropped only because so many people have stopped looking for work.  The number of non-working Americans exceeds 102 million, which is a record.

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Bully for 2013 … But What About 2014?

2013 markets were full of bull.

The economy continued to sputter along, growing at about 2%, unemployment remained high and corporate profits were mediocre.  Yet the S&P 500 index rose a staggering 29.6%, its best performance since the go-go-days of 1997.

So what sort of bull drove this bull market?  The Federal Reserve Board’s quantitative easing (QE) program, high-frequency trading and exuberant investors who shifted into stocks with renewed confidence.

Investors Intelligence SurveyWhen Fed Chair Ben Bernanke hinted in May and June that The Fed might start pulling back on its bond buying soon, the market initially fell and interest rates rose.  But ironically, rising rates drove investors out of bonds and many invested further in stocks, pushing the market even higher.

More Bull in 2014?

As 2014 begins, the bullish sentiment continues.  More than 60% of those surveyed by Investors Intelligence are now bullish and the bull-bear ratio is at a record level of more than four.

Bullish sentiment at this level is typically a good thing, though, as high investor enthusiasm typically leads to a drop in the market.  When investors are at their most bullish, that’s when the stock market usually drops.

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