The Fed Has Put a Rocket Under the Market

From Dan Denning at the Moon Factory:

"So what you're saying is that if the Fed leaves rates low, the market basically has permission to rally to new highs, even if they have no basis in projected earnings and stretch valuations even further?"

This was the question we put to our editorial roundtable yesterday. Kris Sayce, Murray Dawes, Alex Cowie, and Shae Smith were all there. The office was hot and sweaty. The air conditioners broke under Melbourne's mild heat wave. But everyone at the table seemed to be in agreement: the Fed has put a rocket under the market.

The conclusion is important to your investment strategy for the rest of this year and probably through half of 2010. The Fed is giving traders as much fuel as they'd like - via low rates - to borrow low and invest high (high yielding assets). The conclusion of the traders, the small cap guys, and the resource guys and gals in our office is that the whole market is going to float higher on a sea of liquidity.

That's just what happened yesterday in New York. The Dow rose over 2% to reach a new 2009 high. The S&P 500 was up 2.2%. And tangible assets like gold and oil surfed higher too. Only the sorry old excuse for a currency, the U.S. dollar, was lower.

Tactically, the editors here at the moon factory reckon that the way forward is up. But it's a dangerous journey. Valuations in a credit boom go out the door. If you participate in this kind of move, you have to be aware that it's liquidity driven (the Fed's liquidity) and not anything else. All the editors agreed to ride it with their open positions, but to initiate trailing stops in all the positions.

Why? The reversals - and they always come - can be brutal. A trailing stop locks in at least some of your gains. So here's a free piece of advice today: set some mental trailing stops on your open positions. No sense in not profiting from a good rally if you are in the market.

If you're not in the market, is now the time to jump in? Will you miss an even bigger upside by staying cautious? Probably. But we reckon that in the longer-term you're better off using moves like this to reduce your allocations to stocks. Sell into strength and get out while the getting is good.

Of course that's a pretty bearish view, not held (or spoken very loudly these days) by too many people. The conventional wisdom is that the stock market really is telling us that the economy is on the verge of a big breakout next year. And besides, stock rallies are always driven by liquidity.

The unconventional wisdom is that the Fed has learned nothing from the last bubble - or is so scared of deflation it's willing to gamble on another bubble in asset prices. The trouble , the eventual bust in asset prices has to be reckoned up. And the Fed, along with all central banks who key off the Fed's policy, are just kicking the can down the road, hoping asset values improve.

But stocks are not engaged in this debate. They are moving up nicely. One sign of a toppy market is an acquisition where the big fish try and eat each other (as opposed to dining on the little, more manageable fish). Yesterday AMP made a $12 billion bid for AXA. That's about all we have to say about that, almost.

Late yesterday afternoon, Kris Sayce sent out a note to Australian Wealth Gameplan readers advising to take a 37% gross profit and sell AXA (ASX:AXA) shares. He recommended the stock as an income play back in June - when we launched the super, income, and safety-focussed letter (as a companion and counterpart to the small cap letter).

Why sell a stock that's giving you capital gains as well as income?

"It's like getting nine months of income in one day," Kris reckoned. And that sounded about right. There will be other higher-yielding stocks on the market (and probably with less risk). Kris isn't changing the income strategy for AWG. But it is a good example of how you can use rallies like this to take profits on existing positions and gradually re-allocate your assets to a longer-term plan.

And speaking of super, the pressure seems to be mounting on the funds management industry to change its compensation model. That will tend to happen when you have two consecutive years of losses and charge people for the privilege. This exposes in plain sight the fact that most funds simply mimic the market (because most funds own the same big cap stocks). When the market drops, the funds go down.

Boom goes the dynamite!

"The reality of a rising market is that many managers generate large fees from general market growth rather than actually delivering out-performance for clients," wrote Frontier Investment Consulting's CEO Fiona Trafford-Walker, quoted in today's Australian Financial Review, under the category of "Gee, you don't say?"

But what's bad for the funds management industry - and end to management fees based on compulsory super contributions - is probably a good thing for investors. We say probably because most investors are lazy and don't want to actively manage their money. It involves thinking, and that competes with watching television, going to the beach, and pruning the hibiscus plants.

For those that do see this as the chance of a lifetime to take more control of super AND get better performance, it means fund managers will have work a bit harder, not just for their money. But for you. And obviously this is good news for the good funds managers. They'll get more business.

And what would a good funds manager recommend right now? Well, we're not running anyone's super. In fact, as an American we don't even have a super fund here in Australia. But we are doing exactly what we recommend to readers anyway: building a position in gold when prices look cheap and being very selective about how many and which stocks to own for this market.

By "this market," we mean one where it looks like another monster low-rate-rally....exactly the sort that preceded the all-time highs in 2007 - right before the reckoning. Once more into the breach...

By the way, we're trying out a new name for our newish offices, "the moon factory." It turns out the building we are now in is an example of Edwardian Freestyle architecture. What's more, historical records show the building has a name. It's called Thalassa.

Wikipedia tells us that Thalassa may be a primordial Greek goddess of the sea, and also a moon of the planet Neptune. The moon options just felt more appropriate than...writing as a primordial Greek goddess of the Sea. That might be interesting too, but what happens in St. Kilda should probably stay in St. Kilda.

Finally, you know you've had a good night when your dinner companion says "Waiter, could we have the cheque and another bottle of wine please?" Former Rude Awakening editor and current US DR editor Joel Bowman was in Melbourne last night with his lovely partner Anya. We joined them for dinner at Fed Square looking over the Yarra, although they had to catch a late flight back to Taiwan, hence the unusual request.

Joel is an Aussie living abroad, while your editor is an American living in Australia. We compare expatriate notes from time to time and talk about the market. We both agreed that the world is an exciting place with lots of opportunity, but probably with more risk than every day Australian and Americans are used to, or, in most cases, financially prepared for.

That's changing. For Australia, it seems to be a positive change. There are lots of income and capital gains opportunities in the Aussie stock market, although being coupled to the Chinese economy certainly has its own set of risks for the next few decades. And there is always the risk that Australia's current prosperity is largely a function of reflated asset bubbles, and thus just as vulnerable as last time (2007).

For Americans, the change is not so positive. The U.S. dollar is a secular decline, yet the American political establishment refuses to accept the fact that nation's finances are in massive disarray. They are either in denial, or just exceptionally stupid, even for politicians. Not surprisingly, their sense of entitlement knows no bounds.

They believe they will be able to keep borrowing from foreign creditors to enjoy a high standard of living. This is the same as saying that the social promises fulfilled with other people's money really are non-negotiable. This isn't high-minded. It's childish.

From our time abroad, we'd say that day of reckoning - where the world's up and coming populations subsidise American consumerism - is upon of us. Has been since 2000 really, when gold became the trade of the decade. The decade isn't quite over yet, and neither is gold's run. But we have a feeling the political, economic, and even military aftershocks from the dollar's decline are just beginning.

Dan Denning
for The Daily Reckoning Australia

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