The stock market has been on a remarkable six-week winning streak. From June 4 to last Friday, the DOW has surged by 9.7 percent. Quite impressive, isn’t it?
We had anticipated a summer downturn for the stock market, reminiscent of Charlie Sheen’s unpredictable behavior after a wild weekend. Instead, it has displayed consistent gains, similar to a relentless heat wave sweeping across the Great Plains. Stocks from major companies like Home Depot, PepsiCo, Chevron, 3M Co, and Google, along with 42 other S&P 500 members, have recently reached their 52-week highs.
If this trend persists, unexpected outcomes are on the horizon. The S&P 500 is on the brink of surpassing its April peak of 1,419.04, potentially achieving a new four-year high. At this rate, it might not be long before it breaks the all-time high of 1,565 from October 2007.
Ryan Detrick from Schaeffer’s Investment Research believes stocks will continue their upward trajectory for two reasons: “First, price action remains constructive; and second, overall expectations are still quite low.”
We’re not entirely clear on Detrick’s notion of “constructive price action.” Perhaps he means that since stock prices have been rising, they will likely continue to do so. Regarding his second point, Detrick states unequivocally that “lowered expectations make it much easier to have good news and thus, buying pressure.”
In simpler terms, Detrick argues that stock prices are climbing because they are climbing, coupled with the fact that few anticipate this rise. Perhaps he’s onto something, but it leaves us wondering: is there a better explanation out there?
A Risky Game
Periods like these can make investing appear deceptively easy. With each passing day and week, investment accounts grow larger. Average workers check their 401(k) balances after market close each day, feeling wealthier and more intelligent. Without caution, they may indulge in impulsive purchases, ranging from flashy sports cars to hair dye, potentially leading to foolish decisions.
What many might overlook is that this allure of quick riches can lead them into a perilous trap. Before long, they could find themselves in a precarious situation, reminiscent of the market crashes in 2001 and 2008.
Although no one can predict with certainty when the next downturn will occur, a closer look at a historical 15 to 20-year price chart of the S&P 500 reveals the formation of a head and shoulders pattern. Should the current upward momentum fail to surpass the October 2007 peak, a significant drop may soon follow.
Regardless of how high stocks may soar, it does not change the underlying economic struggles. Unemployment remains stubbornly above 8 percent, manufacturing exports are stalling due to global economic weakness, and while housing has seen some recovery, it lacks the strength to significantly uplift the broader economy. Adding to these concerns is the looming fiscal cliff, poised to instigate a wave of tax hikes and spending reductions.
Currently, it seems Congress lacks the resolve to steer the economy away from this impending fiscal crisis. Consequently, it falls to the Federal Reserve’s monetary policy to attempt to provide some form of artificial support.
The Fed’s Limitations
Recall that last month, Senator Chuck Schumer urged Federal Reserve Chairman Ben Bernanke to “get to work.” But what options does the Fed truly have, other than what has already been implemented?
The federal funds rate is effectively at zero, banks are awash with credit, and the Fed’s balance sheet has ballooned to nearly $3 trillion. In this environment, further monetary measures will do little to stimulate genuine economic activity. Adding another trillion dollars to the balance sheet would likely just inflate the stock market into an unsustainable asset bubble.
Today, the S&P 500 languishes above 1,400, oil has quietly approached $100 per barrel, and gold is priced at $1,619 per ounce. On top of this, food prices are expected to skyrocket later this year. Currently, assets are overvalued, inflated by the Federal Reserve’s monetary expansion, creating a stark disconnect from the actual economic landscape. If the Fed takes further action now, consumer prices could surge just as the economy slows.
At present, the Fed’s hands appear tied; if you have faith in free markets to address capital misallocations, this is a reassuring indication. While Bernanke may have a reputation for being reckless, he is not without wisdom. He understands the need to deflate these asset bubbles before resuming the growth of the monetary supply. However, some of his colleagues at the Federal Reserve seem to lack this essential insight.
Eric S. Rosengren, President of the Federal Reserve Bank of Boston, advocates for a “quantitative easing program of sufficient scale to make an impact.” Furthermore, Rosengren calls for a new program that is “open-ended.” In a similar vein, John Williams, President of the Federal Reserve Bank of San Francisco, also supports QE3.
For now, it’s likely that Bernanke will refrain from other quantitative easing measures until the S&P 500 dips below 1,200. However, if Rosengren and Williams get their wishes, the economic landscape could become chaotic.
Sincerely,
MN Gordon
for Economic Prism
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