It is a little surreal that stocks were poised for substantial further gains after September. All the risk factors are there, and the warning signs getting louder. However, thanks to people like John Paulson, who are “naïve optimists” as phrased by The Wall Street Journal (see Paulson and the Bulls Bounce Back), and David Tepper, who is opportunistic in taking the Bernanke put, the market got back to life in September.
What these hedge fund managers, and many other institutional managers, are doing is simply building pyramids. The liquidity is very low, with most investors sitting on the sidelines. So the strategy of Paulson & Co. is to push stock prices up to get a good return number for their own fund. More importantly, by pushing up stock prices, they create the fear in the weaker mind of some investors about missing any potential rally. If they could push hard enough, they may be able to build a pyramid scheme, and then get out before every one else, making some handsome sums for themselves.
If we do not have enough weaker minds, then these pyramid builders may have trouble holding the bag on the top of the pyramids by themselves. I sincerely hope they do not succeed in luring the weaker minds, because that is likely to make those weaker minds suffer another serious blow in their personal wealth when these weaker minds find themselves holding the bag at the top of the pyramids.
How stretched is the market? We could look at every major economic number and they are still trending down. I would post the US PMI data along with stock data here, and the European number is the same. PMI usually have strong predictive power for stock returns during the recessions. This relation may break up during recovery, because stock prices would bounce back much more quickly. However, what we see is that the US PMI is trending downward again after a good recovery late last year and early this year. The stock price and PMI have the largest diversion (stock prices sharply up and PMI down at intermediate level) in quite a long time. This only spells trouble for stock prices for months ahead, especially considering the likely trend for PMI is further down.
What’s different from the last Bernanke put early last year and the current situation is the one-legged nature of stimulus. Last year, the monetary stimulus, aka the last Bernanke put, jumped start the rally. The rally probably would have fizzled out quickly without the substantial fiscal stimulus. The fiscal stimulus also helps sustain and amplify the inventory restocking cycle. That is probably the main reason that we could have such a long rally up to today.
However, this time around, we have no fiscal stimulus to sustain the rally. The current fiscal stimulus can only provide drags on the economic growth (I talked about this in earlier posts). There will be some small fiscal package here and there, but there will be no 800 billion package any more. Although some still have delusions about a Republican sweep in the House, and potentially the Senate, the only consequence of that outcome will be a divided Congress that does not function at all. With Republican’s eyes set for the White House in 2012, do not expect any stimulus, unless the economy has already fallen into the abyss again, similar to late 2008. They would not appreciate any real recovery, which can only benefit Obama, and derail the Republican political goal in 2012.