Is the Rally Toast?

The market was down for the 4th time in 5 days today as bonds sold off and the dollar strengthened.

A few folks out there have called me a "permabear" claiming that I missed the recovery. I wanted to try and explain to you why being bullish after a 50% bounce is simply silly.

Before I start:

I thought many of you might be curious as to how I have invested during this huge bounce.

Let me admit my mistakes by answering the following question and update you on where I stand with my portfolio:

Did I miss a nice move in stocks since March? Yes!(although I was hedged long(an S&P 500 fund, and a few other typical long funds) and short(BEARX) in some retirement funds).

Overall however, despite my super permabear stance(according to a few readers), my portfolio has done pretty well because the government backed equity bounce has also been very positive for bonds and metals which is where I hold some large positions. My largest individual holding is PIMCO's PTTRX which is up 12% YTD.

As a result I am up since March and pleased with my portfolio's performance. I will be reallocating some positions here in the near future as I prepare for the next storm that appears to be just over the horizon.

Also, to be fair and transparent(unlike our banks) let me also add that my trading account was repeatedly raped for a few months starting in March.

This wasn't too painful because my trading account is a small piece of my retirement. However, like all investors I made some mistakes:

Did I own some options that expired worthless? Yes. Did I get humiliated by SRS? Yes. Did I learn some valuable lessons? Of course. Did I blow up my trading account? No but it was down big at one point.

I have always stressed diversification on this blog, and I have also repeatedly advised everyone that money used for trading this type of market should be a very small piece of your nest egg. Congrats to anyone who caught this move.

Alrighty back to my post:

So why do I think this rally is toast? Because essentially the market is currently a total sham with zero liquidity.

As you can see below, the P/E ratios of stocks have now surpassed even the insane levels seen at the top of the tech mania:





P/E's close to 150? How did this happen?

In a nutshell: The market morphed into a rigged casino. The people that rigged the game of course were the major players on Wall St. They did it using HFT's(high frequency trades). Where did the liquidity come from that allowed them to begin such a trading game? The taxpayer bailouts of course! The Reuters piece below does a nice job explaining how it all worked.

So how out of control did this HF trading game get? Well It appears the SEC is about to dig in and find out because HFT's now account for up to 70% of all daily trading:

""High-frequency trading now accounts for an estimated 50 percent to 70 percent of all U.S. equity trading and is growing fast in other regions and asset classes. In it, banks, hedge funds, and independent shops use ultra-quick algorithms to make markets and capitalize on tiny spreads and market imbalances.

Some politicians and investors have raised concerns the practice, which effectively replaced traditional market-makers over the last decade, creates a two-tiered market favoring the most sophisticated players."

My Take:

Wall St has once again found a way to create another bubble. Basically what is going on here folks is the banks have taken your taxpayer money (via the TARP and other Fed bailouts) and created an equity bubble in the stock market by buying practically every stock under the sun(good or bad).

Look no further than the the P/E ratios above if you don't believe this is going on! The fundamentals are being completely ignored as the trading desks continually press the BUY button on their quants and bid up the markets.

Stocks now sit at unsustainable bubble levels as the economy continues to burn. Don't believe me? Take a look at Andrew Smithers comments in the Bloomberg article below:

"Oct. 26 (Bloomberg) -- U.S. equities are about 40 percent overvalued and headed for a decline as central banks pull back on quantitative easing that pushed up asset prices, according to economist Andrew Smithers.

“Markets are very vulnerable to an end of quantitative easing,” the economist said in an interview at Bloomberg’s Tokyo office on Oct. 23. “Central banks, they’ve got to stop some time and if that happens everything will come down.”

In “Valuing Wall Street,” his March 2000 book co-authored with economist Stephen Wright, Smithers argued that U.S. equities were grossly overvalued and should be sold. The Standard & Poor’s 500 Index plunged 49 percent over 2 1/2 years from a then-record high reached that month. Smithers said he stopped buying equities in the 1990s and began purchasing them again only for a brief period during the lows of the current crisis.

Asset purchases have doubled the size of the Federal Reserve’s balance sheet to $2.1 trillion since the start of the current financial crisis. The Bank of England has spent 175 billion pounds ($286 billion) over the last seven months to rescue the economy. Both banks are sending signals they may be ready to start winding down their programs."

The Bottom line:

As you can see above, Smithers is no slouch. He correctly predicted the tech collapse back in 2000.

I am very close to hopping back on the short bus. If the bond market continues to rumble the banks are going to get crushed.

The risk of higher yields in the bond market is increasing for a variety of reasons. Unimaginable government deficits and the threat of even higher deficits as a result of healthcare reform are at the top of the worry list in the bond pits.

Let us not also forget about the massive bond issuance's that must be sold this week.

Another concern regarding higher yields in the bond market is the risk that the economy might be beginning to recover. This sounds counterintuative but its factual.

Why?

Because if the economy recovers, inflation will become a large risk because rates are too low. The Fed may be forced to raise rates as a result which would be catastrophic for the banks and their bloated mortgage filled balance sheets.

Ironically, a bad economy with low rates is the perfect "sweet spot" for the banks. They can borrow short for next to nothing as rates sit at zero and then lend long. Even the dumbest of all bankers can make money in this environment. The spreads are to die for as long as the loans are good.

Overall folks, this rally looks to be on its last leg. As the government stimulus dries up, so will the economy and there is no money left for another one because we are trillions in the hole.

I think we are close to seeing another big rollover in equities. Please be very careful with your nest eggs at these levels.

Also, Keep an eye out for my 401K post that I am currently working on. Hint: It may be time to say goodbye to this investment tool.

More Later.

Disclosure: Short treasuries in longer term accounts via TBT. No new positions were taken at the time this article was published.

Long gold and silver via GLD and SLV. Long bonds via PIMCO's (PTTRX).